Avoiding The Money Pit
- Tuesday, April 16, 2002
Many so-called experts make the financial planning process much more complicated than needed. Essentially, it boils down to three steps: Determine where you are, set financial goals, and establish a method for tracking success. It's really that simple, though there are additional points to consider.
Determine Where You Are
Before you can make any financial plans, you need to know your starting point. To find out you should:
List your assets. Assets are items of value, such as your house, car, clothes and furniture, as well as cash, checking accounts and investments.
List your debts. Debts, of course, are moneys you owe: house and car payments, loans, credit card debts and other regular debts or payments. CPA Scott Weaver advises, "Be sure to count school loans that may not start for six months or so after graduation. Forgetting them will give an inaccurate picture of your total debt load."
Determine your net worth. Your net worth is obtained from subtracting your debt amount from your assets. With this figure, you can track your progress over the years. If it's not a positive number, don't worry. It's not uncommon to have a negative net worth when first launching out on your own.
Set Financial Goals
Now that you know where you are, it's time to plan where you want to be. Develop short (one year), medium (two-five years) and long-term (over five years) financial goals. Take extra time to think about your plans since these goals will set the direction of your financial life.
While every financial plan is different, here are some general guidelines you'll want to consider:
Create a reserve. Emergencies arise. Cars break down, ankles get sprained and jobs are lost. Experts suggest you set aside three to six months of living expenses as a regular reserve.
Save specifically. In addition to saving for unexpected problems, save for future plans. Maybe you want to buy a car, go back to school eventually or take a trip. You'll need to save for these. One way to make this easier is to have money automatically transferred from your paycheck to a savings account.
Avoid debt (or get out immediately). "Excessive consumer debt can quickly become a lead weight around the neck of a newly graduated college student," warns financial adviser Andy Claybrook. "Resist the urge to sign up for every credit card available, carry only one credit card for emergencies, and use a debit card or cash for routine purchases." If you already have debts, plan to get rid of them as soon as possible and remain debt free. Financial expert, author and radio host Dave Ramsey recommends a "debt snowball." This method reallocates payments for retired debts to existing loans until the payments become large enough to consume all debts.
Keep spending low. Most people spend far beyond their ability to pay. "The biggest financial mistake I see is a consumptive lifestyle simply spending more than you can afford," notes financial expert Ron Blue, author of Master Your Money. By controlling your spending, you'll prosper. In The Millionaire Next Door, researchers noted that most millionaires are just average people earning average salaries. The first of seven qualities that made them wealthy is "they live well below their means."
Put off buying a car. This is where most people get off the beaten path. They get a job, and the first thing they buy is a nice, new car that locks them into high payments for the next four or five years. The cheapest car you'll ever own is the one you're driving now. Yes, it might cost a lot to maintain, but it takes a lot of repair bills to become more expensive than high car payments. If you must buy, choose a good used car. Find a friend or pay a mechanic to check it out before you purchase.
Prepare for misfortunes. You'll need to plan for car, medical, disability, homeowner's (or renter's) and life insurance. "People starting out usually don't have many assets to protect, so your insurance will initially just need to cover replacing any minor losses," notes insurance agent Jeff Flowers. "Then, as assets grow, insurance coverage needs to increase accordingly." Flowers also recommends insuring with a financially solid company. "You want to do business with a company that will be around for years to come one that will be there if you ever need it." Insurance is complicated, so get expert advice. Ask your parents, friends or co-workers for recommendations on insurance agents, then talk to them about your needs. Also, be sure to review your coverage at least annually to guarantee adequate protection and fair rates.
Start planning for retirement. Though retirement seems like a long way off, now is the perfect time to start planning for it. In Retire Rich, Bambi Holzer notes, "Regular saving is the key to a successful retirement. Do it early and often, and it can be relatively painless. Wait till the last minute, and you could be in trouble." Begin by finding out what benefits your company offers. Usually, a company-sponsored 401k will be your best retirement vehicle since the company matches funds, you'll get a tax break this year and the earnings grow, tax-deferred. If your company doesn't have a plan, you'll need to do it yourself with an individual retirement account (IRA).
Build net worth by investing. It's likely you won't be doing a lot of investing (other than for retirement) early in your career, but this will be a long-term goal. Take the time to gather facts about investing, and consider your options. When you're ready to invest, you'll be prepared.
Give. It might seem hard to give when you're not earning much, but try to give some money from each paycheck to your local church or charity. Remember, you're rich compared to most of the world. Besides, you'll find that giving benefits you. Suze Orman, best-selling author of 9 Steps to Financial Freedom, comments, "It's the impulse to give that puts you in touch with the best part of yourself and the principles of abundance that are alive in the world. Yes, we help ourselves when we give but that is not why we give."
Organize financial records. There's no better time to organize your financial records than when you've just started creating them. Set up a system for filing checks, tax returns, financial statements, debts and other financial documents. "Get organized. Buy a filing cabinet," counsels Nancy Dunnan in Never Call Your Broker on Monday. "Unless you know what you own, where it is and how much it's worth, your financial life will be a muddle."
Study money management principles. Financial planning is a lifelong process. Taxes, estate planning, investments or buying a house may not mean much yet, but they will as time goes on. The lessons you learn today may avoid huge mistakes in the future. "Take the bull by the horns and educate yourself about financial planning and investments," suggests Claybrook. "Learn about such topics as the relationship between investment risk and reward, the different characteristics of small cap and large cap stocks, and how excessive costs and commissions can erode investment returns. After all, the best person to manage your financial affairs is you!"
Establish a Method for Tracking Success
The best way to measure your progress is to develop a spending plan (also called a cash flow plan or budget). Once you have a plan, there are three main ways to track your spending:
Envelope System. This method requires cashing your paycheck and placing dollars in envelopes corresponding to your budget categories (such as housing, food, entertainment, etc.). As expenses occur, cash is removed. When all the cash is gone, you either stop doing that activity or re-evaluate your budget.
Ledger System. With this system, you write each month's budgeted amount for each category at the top of separate pages of a ledger book. As you spend, money is subtracted from that balance until you have none left. Add more when a new paycheck is deposited.
Electronically. Quicken and Microsoft Money are two good computer programs that track your spending, teach financial principles and give great progress reports. They're also relatively easy to use, so even a novice will feel comfortable with them.
If used properly, any of these methods will help you track progress toward reaching your goals. You'll want to set up regular times to evaluate and adjust your spending plan. The first of each year is a good time for this process.
Congratulations! You have just made your first step into the world of financial planning. It's a never-ending process, but the results are well worth the effort. Now start reviewing additional resources, and you'll be heading down the path to financial freedom.
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