Personal finance encompasses the art of managing your money and securing your financial future. Every financial choice you make has a direct impact on your financial health. It’s crucial to understand what steps you can take to enhance your financial well-being. Here, we outline five essential rules of personal finance to set you on the path towards achieving your financial aspirations.
Crunch the Numbers – Net Worth and Personal Budgets
Money flows in and out of our lives, but for many, that’s where their understanding of personal finance ends. Instead of leaving your financial destiny to chance, delve into some number-crunching to assess your current financial situation and pave the way to your short- and long-term goals.
Calculating Your Net Worth
Start by determining your net worth, which is the difference between your assets (what you own) and your liabilities (what you owe). Compile a list of your assets and liabilities, then subtract the latter from the former to compute your net worth. Remember that your net worth is a dynamic figure, so it’s beneficial to calculate it regularly, preferably at least once a year. This way, you can track your financial progress, acknowledge your achievements, and identify areas that need improvement.
Creating a Personal Budget
Equally significant is crafting a personal budget or spending plan. Whether it’s on a monthly or yearly basis, a personal budget is a valuable tool that helps you prepare for future expenses, curb unnecessary spending, save for future goals, and prioritize your expenditures.
Various approaches exist for creating a personal budget, but they all involve projecting your income and expenses. Your specific income and expense categories will depend on your circumstances and may evolve over time. Common income categories include salary, bonuses, interest, dividends, and various forms of income like alimony or retirement benefits. Typical expense categories encompass housing, transportation, food, insurance, healthcare, savings, entertainment, and more.
After projecting these figures, subtract your expenses from your income. If you’re left with a surplus, you have extra funds to allocate towards spending, saving, or investing. If your expenses outweigh your income, you’ll need to adjust your budget by either increasing your income (e.g., taking on additional work) or reducing your expenses.
Recognize and Manage Lifestyle Inflation
As individuals progress in their careers and earn higher incomes, there’s a common tendency to increase spending, referred to as “lifestyle inflation.” While it’s natural to experience some spending growth due to changing life circumstances, excessive lifestyle inflation can hinder your wealth-building potential. Each extra dollar spent today translates to less financial security and flexibility in the future, including during retirement.
Evaluate your personal budget as you navigate different phases of life. Consider whether your expenses align with your current needs or if there’s room to reduce discretionary spending.
Differentiate Between Needs and Wants – Spend Thoughtfully
It’s vital to distinguish between “needs” and “wants” in your financial life. Needs are essentials for survival, such as food, shelter, healthcare, and transportation. Your budget should prioritize covering these necessities first. Only after addressing your needs should you allocate discretionary income towards wants. Mindful spending involves recognizing the distinction between wants and needs and making informed decisions about how to allocate your resources.
Begin Saving Early
The adage “it’s never too late to start saving for retirement” holds true, but the earlier you start, the better off you’ll be during your retirement years. This is due to the power of compounding, which involves reinvesting earnings. Compounding is most effective when given time to work its magic. Starting early allows you to contribute less each month and less overall to achieve the same financial goal in the future.
To illustrate, let’s assume you aim to accumulate $1,000,000 by age 60, with an expected annual interest rate of 5%:
Starting at age 20, you’d need to contribute $655 per month, totaling $314,544 over 40 years.
Starting at age 40, the monthly contribution would rise to $2,433, with a total of $583,894 over 20 years. Commencing at age 50, you’d need to contribute $6,440 monthly, summing up to $772,786 over 10 years. The sooner you begin saving, the more attainable your long-term financial objectives become.
Establish and Maintain an Emergency Fund
An emergency fund serves as a financial safety net for unforeseen expenses that fall outside your regular budget. It can cover unexpected costs such as car repairs or unplanned medical bills, as well as provide financial stability during income disruptions.
While the traditional recommendation is to save three to six months’ worth of living expenses, today’s uncertain economic climate suggests aiming for at least six months’ worth, or more if possible. Remember that building an emergency fund is an ongoing endeavor, as it may be depleted in times of need. Replenishing it after each use ensures you’re financially prepared for whatever life throws your way.