Five Rules to Improve Your Finances
The term personal finance refers to how you manage your money and plan for your future. Let us go through five broad personal finance rules that can help get you on track to achieving specific financial goals. The following is based on my beliefs an also articles from Investopedia.
Net Worth and Personal Budgets
Money comes in, money goes out. It is important that you do not ignore your finances and leave them to chance. A little arithmetic can help you evaluate your current financial health and determine how to reach your short- and long-term financial goals.
To start, calculate your net worth, the difference between what you own and what you owe. To do this, make a list of your assets (what you own) and your liabilities (what you owe). Then subtract the liabilities from the assets to arrive at your net worth figure.
Your net worth represents where you are financially at that moment and it is normal for the figure to fluctuate over time. Calculating your net worth one-time can be helpful but the real value comes from making this calculation on a regular basis (quarterly). Tracking your net worth over time allows you to evaluate your progress, highlight your successes, and identify areas requiring improvement.
Equally important is developing a personal budget or spending plan. This can be done monthly or annually and will help you:
- Plan for expenses
- Reduce or eliminate expenses
- Save for future goals
- Spend wisely
- Plan for emergencies
- Prioritise spending and saving
There are numerous approaches to creating a personal budget and all involve making projections for income and expenses. The income and expense categories you include in your budget will depend on your situation and can change over time. Common income categories include:
- Child support
- Disability benefits
- Interest and dividends
- Rents and royalties
- Retirement income
- Tips and other ex gratia receipts
General expense categories include:
- Debt payments (car loan, student loan, credit card)
- Education (tuition, daycare, books, supplies)
- Entertainment and recreation (sports, hobbies, books, movies, DVDs, concerts, streaming services)
- Food (groceries, dining out)
- Giving (birthdays, holidays, charitable contributions)
- Housing (mortgage or rent, maintenance)
- Insurance (health, home/renters, auto, life)
- Medical/Health Care (doctors, dentist, prescription medications, other known expenses)
- Personal (clothing, hair care, gym, professional dues)
- Savings (retirement, education, emergency fund, specific goals such as a vacation)
- Special occasions (weddings, anniversaries, graduation, bar/bat mitzvah)
- Transportation (gas, taxis, tolls, parking)
- Utilities (phone, electric, water, gas, internet)
Once you have made the appropriate projections, subtract your expenses from your income. If you have money left over, you have a surplus, and you can decide how to spend, save, or invest the money. If your expenses exceed your income, you will have to adjust your budget by increasing your income (adding more hours at work or picking up a second job) or by reducing your expenses.
To really understand where you are financially and to understand how to get where you want to be, do the math – calculate both your net worth and a personal budget on a regular basis. This may seem abundantly obvious to some, but people’s failure to lay out and stick to a detailed budget is the root cause of excessive spending and overwhelming debt. Most people who make more money end up spending more money, a potentially dangerous phenomenon known as “lifestyle inflation.”
Recognise and Manage Lifestyle Inflation
Most individuals will spend more money if they have more money to spend. As people advance in their careers and earn higher salaries, there tends to be a corresponding increase in spending, a phenomenon known as "lifestyle inflation". Even though you might be able to pay your bills, lifestyle inflation can be damaging because it limits your ability to build wealth. Every extra rupee you spend now means less money later and during retirement.
One of the main reasons people allow lifestyle inflation to sabotage their finances is their desire to keep up with the Joneses (I wonder what the Sri Lankan equivalent is…?). It is quite common
for people to feel the need to match their friends’ and coworkers’ spending habits. If your peers drive Mercedes, vacation at exclusive resorts and dine at expensive restaurants, you might feel pressured to do the same.
What is easy to overlook is that in many cases, these people are servicing a lot of debt — over a period of decades — to maintain their wealthy appearance. Despite this rich glow, they may be living a sort of hand to mouth existence and not saving a cent for retirement.
As your professional and personal situation evolves over time, some increases in spending are natural. You might need to upgrade your wardrobe to dress appropriately for a new position, or, as your family grows, you might need a house with more bedrooms. And with more responsibilities at work, you might find that it makes sense to hire drivers etc, freeing up time to spend with family and friends and improving your quality of life.
Recognise Needs vs. Wants—and Spend Mindfully
Unless you have an unlimited amount of money, you should be mindful of the difference between “needs” and “wants,” so you can make better spending choices. Needs are things you have to have in order to survive: food, shelter, healthcare, transportation, a reasonable amount of clothing (many people include savings as a need, probably a 10% of their income or whatever they can afford to set aside each month). Wants are things you would like to have but do not require for survival.
It can be challenging to accurately identify expenses as either needs or wants and for many the line gets blurred. When this happens, it can be easy to rationalise an unnecessary or extravagant purchase by calling it a need. A car is a good example. You need a car to get to work and take the kids to school. You want the luxury edition SUV that costs twice as much as a more practical car (and costs you more in petrol). You could try and call the SUV a “need” because you do, in fact, need a car, but it is still a want. Any difference in price between a more economical vehicle and the luxury SUV is money that you did not have to spend.
Your needs should get top priority in your personal budget. Only after your needs have been met should you allocate any discretionary income toward wants. And again, if you do have money left over each week or each month after paying for the things you really need, you need not spend it all.
Start Saving Early
The sooner you start saving for retirement, the better off you will be during your retirement years. This is because of the power of compounding, which is what Albert Einstein called the “eighth wonder of the world.” Compounding involves the reinvestment of earnings, and it is most successful over time. The longer earnings are reinvested, the greater the value of the investment and the larger the earnings.
Assume you want to save LKR 1,000,000 by the time you turn 60. If you start saving when you are 20 years old, you will have to contribute LKR 655.30 a month—a total of LKR 314,544 over 40 years—to be a millionaire by the time you reach 60. If you waited until you were 40, your monthly contribution would move up to LKR 2,432.89—a total of LKR 583,894 over 20 years. Wait until 50 and you would have to come up with LKR 6,439.88 each month — equal to LKR $772,786 over the 10 years. (These figures are based on an investment rate of 5% and no initial investment. Please note that they are for illustrative purposes only and do not take into consideration actual returns, taxes, or other factors).
The sooner you start, the easier it is to reach your long-term financial goals. You will need to save less each month and contribute less overall to reach the same goal in the future. Having a stash of cash available in case of financial emergencies is crucial to good financial planning.
Build and Maintain an Emergency Fund
This fund is intended to help you pay for things that would not normally be included in your personal budget: unexpected expenses such as car repairs or an emergency trip to the dentist. It can also help you pay your regular expenses if your income is interrupted; for example, if an illness or injury prevents you from working or if you lose your job.
Although the traditional guideline is to save three to six months’ worth of living expenses in an emergency fund, the unfortunate reality is that this amount would fall short of what many people would need to cover a
big expense or weather a loss in income. In today’s uncertain economic environment, most people should aim for saving at least six months’ worth of living expenses—more if possible. Putting this as a regular expense item in your personal budget is the best way to ensure that you are saving for emergencies and not spending that money frivolously.
Keep in mind that establishing an emergency backup is an ongoing mission. The issue is that, as soon as it is funded, you will need it for something. Instead of being dejected about this, be glad that you were financially prepared and start the process of building the fund again.