Personal finance is a broad and subjective topic that is often expressed as objective, specific rules of thumb, such as “never withdraw more than 4% of your retirement savings a year to make sure your retirement lasts” or “don’t buy a house that costs more than two and a half years’ worth of income”. While these guidelines can be helpful, it can be limiting to only view your financial health through these lenses. Rather, personal finance should be focused on daily habits and financial decisions that ultimately determine your financial health. Here are five personal finance tips that can help get you on track to achieve your financial goals.
1. Do the Math
Money flows in and out of accounts; for many people, this is the extent of their understanding of personal finance. Rather than letting your money flow in and out freely, some number crunching can help you evaluate your current financial health. Understanding your current position will help a great deal in short- and long-term planning. A good first step is to calculate your net worth. Net worth is the difference between what an individual owns (assets) and owes (liabilities). To calculate your net worth, make a list of your assets and liabilities. Then subtract your liabilities from your assets to arrive at your net worth. Remember this number gives you a snapshot of where you stand financially at that particular moment. It is normal for this number to fluctuate, especially in our ever-changing lives. The real value of this calculation comes from doing it routinely, so you can determine if you are on track to meet your goals.
While your net worth can be helpful to evaluate on a routine basis, creating a budget can help you keep better track of your daily financial habits. A budget is an essential tool to have because it allows you to plan for expenses, eliminate unnecessary expenses, and ensure you are saving enough for your future goals. All essential expenses should be accounted for first. If you have money leftover at the end of your budget period, you can decide how to spend, save, or invest the money.
2. Recognize and Manage Lifestyle Inflation
It is natural to spend more money if you have more to spend. As people advance in their careers and earn higher salaries, there tends to be a corresponding increase in spending. This pattern is known as “lifestyle inflation”. Lifestyle inflation can be damaging in the long run because it restricts your ability to build wealth. If all your discretionary income is going towards re-vamping your lifestyle, there will be very little leftover to save or invest for retirement and other long-term financial goals.
One of the main reasons that lifestyle inflation is so prevalent is because there is a desire to keep up with the spending and lifestyles of our friends, co-workers, and neighbors. If your peer group own luxury cars and dine at premium-priced restaurants, you may feel tempted to do the same. It is important to recognize that the reality is that many of your peers may be funding their lifestyles by going into debt. While some increases in spending are natural, such as upgrading your wardrobe for a new position or adding an additional bedroom to accommodate your growing family, it is important to keep lifestyle inflation in check.
3. Recognize Needs vs. Wants
It is important to be mindful of the differences between needs and wants. Needs are things you need to survive, such as food, shelter, and healthcare. Wants are things we would like to acquire but do not need to survive, such as a luxury car. While you may need transportation, there are more economical vehicle options, which is why it is classified as a need and not a want. Needs should be the top priority in your personal budget. Only after needs have been met should you consider allocating discretionary income to wants.
4. Start Saving Early
While it is never too late to start saving for retirement, the earlier you start, the better off you will be in your retirement years. The power of compounding interest allows your wealth to grow and accumulate within your retirement account. The longer you save, the more time you can allow your savings to grow. To illustrate the importance of saving early, assume you want to save $1,000,000 by the time you retire at age 60. If you start saving at 20 years old, you will have to contribute $655.30 a month (a total of $314,544 over 40 years) to become a millionaire by the time you reach 60. If you had waited to start saving until you were 40, your monthly contribution would bump up to $2,432.89, a total of $583,894 over 20 years. If you started saving at 40 instead of 20, you would have to save an additional $1,777.59 every month in order to reach your goal.
5. Build and Maintain an Emergency Fund
A sufficient emergency fund ensures that you will have enough money set aside when unexpected expenses arise. Car repairs or unexpected medical bills can be destabilizing if you are not prepared to handle them. At least six months’ worth of living expenses is typically advised, but in today’s uncertain economic environment, more may be advisable. Adding this as a regular expense item in your budget is the best way to ensure you are constantly saving for emergencies.