Your Recipe for Improved Personal Finance
If you want to learn how to bake the world’s best cake, filled with all the yumminess you desire, you need to start with a recipe. Sure, you can add your flavor and spice to it once the basic recipe is proven to produce a perfect cake. To start, you need the right ingredients. Personal finance is no different than baking a cake. You need the right ingredients or “tools” for creating wealth. You can add your flavor and spice once you have the basics nailed down. I’m going to give you the tools you need to create your best financial life.
#1: Net Worth Statement
Your net worth statement is a document that provides a clear picture of your overall financial health. Think of it as your diagnosis. Are you winning? Are you losing? Where are you succeeding? Where are you failing? Your net worth statement tells you exactly where you stand with your finances at any given point in time. It is very simple and easy to find net worth statement templates online for free. First, you input all the data for things you own (your assets). If you had to sell them all today, what are they worth? Next, you input all the data for the things you owe (your liabilities). If you had to pay them all off today, what amount of money would you be sending to your creditors? Your net worth is found by subtracting your liabilities from your assets. The goal is to be in the positive (not have negative net worth) and to grow this amount every year. I recommend updating your net worth annually and setting goals for growing your assets and decreasing your liabilities. This is the very basics of a financial plan and the perfect place to start when you want to improve your financial life.
#2: Monthly Spending Plan
The next vitally important ingredient or tool is your monthly spending plan, or budget. The goal with this document is to put every single penny to work towards your goals and values around money. The first step is to understand your monthly income. If you are a W2 employee, this is easy. If you are a business owner or get paid on commission, this may fluctuate and be difficult to calculate. In this case, I recommend figuring out a 6-12 month average. Next, I recommend dividing your expenses into three categories: mandatory, discretionary, and savings. A well-known budgeting rule is the 50/30/20 rule. This states 50% of your income should go to mandatory expenses, 30% goes to discretionary, and 20% goes to savings. If you don’t have a plan or look at your spending, the 20% always gets ignored and the 30% creeps onto credit cards. Stop the bleeding, get control, and have a spending plan. This is a key tool and ingredient for financial success.
#3: Short-Term Savings Plan
The short-term savings plan is the #1 tool for eliminating bad debt. I’ll say this again. If you want to remove all bad debt from your financial life, you must have a properly funded short-term savings plan and account. What goes into your short-term savings account? This is where you hold money buckets for all the items that are not regular monthly expenses, but they are expenses that tend to pop up and get thrown on the credit card if you have not set money aside. These money buckets hold funds for car repairs, home repairs, vacations, taxes, additional medical expenses, kids’ summer camps and lessons, or anything else you can imagine that is coming up in the next year or two. The short-term savings account is also where you store your emergency fund of 3-6 month’s worth of mandatory living expenses. The short-term savings plan is typically held in a high-yield online savings account paying more than your local bank (around 3% or more when this article was written). It needs to be a liquid account, meaning you can get at the funds immediately in case of an emergency. Short-term savings is not an investment account.
#4: Long-Term Savings Plan
Your long-term savings plan is for the financial events that are coming in the future and more than five years away. These are funds that should be invested for long-term growth. Typically, we think about retirement savings when we talk about our long-term savings plan. It also incorporates education/college savings, real estate down payments, business start-up funds, boat and RV money or anything else you want to do in the future. Since these items have a longer time horizon, you should think about these savings plans being invested based on your risk tolerance. There are many tax-advantaged accounts you can utilize for retirement and education savings. You want to work with an investment professional to help you create the best plan tailored for your needs. I recommend working with a CFP (Certified Financial Planner) who is with a RIA firm (Registered Investment Advisor) and works on a fee-only basis (not paid on commission).
#5: Debt Portfolio
Much of the work for creating your debt portfolio was done when you created your net worth statement. However, this report provides you with more detail and tells you exactly what debt to pay off first. The debt portfolio lists out each creditor you owe money to and then provides exact numbers on the current balance, interest rate, loan term, and minimum payment. You want to prioritize this list by placing the highest interest rate debt at the top. You want to pay off the most expensive debt first. You could even divide up the list between good debt and bad debt. Good debt is used to purchase things that increase in value over time (house, business, education/career). If the debt was used to purchase things that are immediately consumed (vacations, dining out, entertainment) or decrease in value over time (clothes, home goods, cars) this is bad debt and should be paid off asap or avoided altogether. Bad debt is usually expensive and typically sits at the top of your list. Update this portfolio every year to measure your success and keep a tight grip on your debt.
#6: Legacy File
The legacy file can be either electronic or paper or even both. This helps your loved ones manage your financial affairs if you are unable to do so yourself or upon your passing. The legacy file should contain your will (and trust if you have one), medical directive, financial power of attorney, net worth statement, past taxes, identification documents, deeds, titles, bonds, account information (with beneficiaries listed) and insurance policies. You should also have passwords and keys/combos. Give this information to a loved one or trusted friend. They will thank you for being so thoughtful, kind, and prepared should anything bad happen to you.
#7: Check-Ins and Reviews
The final ingredient and important tool for ongoing financial success is to set regular meetings with yourself and your partner to review your financial life, measure success, and set goals. I recommend all my clients to review their spending plan on a weekly basis to make sure they are staying on track. Monthly check-ins with your short-term savings plan are also necessary. Long-term savings plans really only need a 6-month to 1-year follow up depending on how many revisions/changes are needed due to life events. Your net worth statement and debt portfolio should be updated yearly and are great tools for recognizing your accomplishments and setting new goals. Thankfully, the legacy file doesn’t need to be updated unless you have significant life events that require it to be updated or revised.
So, in closing, there are seven financial tools that lead you to confidence and control of your financial life. Follow this recipe and when you feel like you have it memorized and perfected, that’s when real wealth and a sense of security starts to flow. Just add your flavor and spice and you have money working for you so you can enjoy the amazing and unique life you have created.
Want me to help guide you through this list of tools? I’m happy to! Schedule your free Q+A here.