How do you assess your current financial situation? Chart a path to your goals while planning for inevitable obstacles in your way.
What is personal finance?
Your financial journey is like scaling a mountain. You might be starting from the valley floor or from several hundred feet above ground depending on your current assets, debts, income, and lifestyle preferences. However, wherever you start from, understanding personal finance will help you determine how to chart your journey going forward.
Personal finance is the practical knowledge of how to manage your own personal financial situation to meet your goals. To improve your financial decision making, you need to understand your current situation by conducting an audit of your finances: you should lay all your financial cards on the table to identify how much money you currently earn, spend, save, and invest.
Throughout this pathway, we will be following the journey of one early career professional, Casey, as she examines her finances and determines how she can change her financial habits to meet her goals.
Income
Income is the amount of money you earn or receive on a regular basis from wages or other sources. Gross income is the amount of income you receive before any taxes are taken out of your paycheck. Your net income is the amount of income you receive after taxes are taken out.
To gain a better picture of your monthly income, take the average of your income over 6-12 months, not counting any one-time bonuses since they might skew the average.
Take the example of Casey who just landed her first job after college. Casey’s salary – her income over the entire year – is $60,000 and 15% of her paycheck goes to taxes. Each month, her gross income would be $5000, and her net income would be that amount with 15% subtracted from it: $4250.
Expenses
Your expenses are what you spend each month. They usually vary, so you should calculate the average amount of expenses you have over time.
To calculate your expenses, look at your bank statements and credit card statements for each month. Make sure you count credit card purchases during the month you made them even if you do not pay off your credit card balance in full during that month. You also should keep track of what you use cash for.
To understand how you are spending your money better, you can divide your expenses into wants and necessities. Necessities are the things you pay for that you need to survive, such as housing, utilities, food, childcare, and healthcare. Wants are things that enhance your quality of life, such as subscribing to Netflix or eating out at restaurants.
It is important to have the right balance between necessities and wants.
What is cash flow?
Cash flow is the amount of money left over after you pay your monthly expenses. Cash flow is important because it shows you how much wiggle room you have in your current financial situation.
If you are consistently spending more than you earn, you will soon find yourself draining your savings or going into debt. If your cash flow is positive, you already have money you can save.
Casey calculates her cash flow by subtracting her average monthly expenses from her average monthly income and finds that she only has $200 leftover each month. Since she wants to save more, she decides she needs to reduce her expenses to free up more cash flow. She decides to move in with roommates to reduce her housing expenses and saves the extra money that she would have spent on rent.
Assets
Assets are any property, cash, or investments that you own, such as the money in your bank account, a stock, or jewelry. Some assets are liquid, meaning that you can easily exchange them for cash, while others, like real estate, are considered illiquid because they take longer to sell.
Liquidity impacts your ability to access assets. For example, if you own a house but hardly have any cash, you may not be able to pay for home repairs even if your house is valuable.
Assets can either appreciate or depreciate, meaning they can either increase or decrease in value over time depending on current demand.
For example, if you buy a house in an area where many people want to live, people will be willing to pay more for it. Some assets like cars tend to depreciate because they cost more to repair and maintain as they age.
Financial risk
Different types of assets also carry varying levels of financial risk. If an asset is risky, it could lose its value entirely under certain circumstances.
For example, in many countries, such as the United States, Australia, Canada, and Germany, putting cash into a savings account is relatively low risk because the government will insure the initial amount you deposited, protecting its value. On the other hand, if you invest in the stock market, you risk losing some of its value if a business fails or goes bankrupt.
Knowing you could lose more if you invest in the stock market may make you want to avoid it entirely. However, if you are too risk-averse and do not ever purchase risky assets, such as stocks, you could lose out on opportunities to increase the value of your assets.
Debt
Debt is money that you owe in loans, such as student loans, mortgages, credit card debt, or personal loans. Most debts consist of a principal, the original amount of money you borrowed, and interest, the amount of money that you agree to pay on top of the principal to the lender.
Some debt is secured by an asset, meaning that if you cannot pay back the debt, the lender can take that asset from you. This asset is called collateral. For example, if you take out a mortgage to buy a house, your house is collateral. If you cannot make the loan payments, the lender can take your house.
Debt that is secured by an asset, such as a mortgage, is considered less risky than unsecured debt. If you borrow money on your credit card, you might not have a way of paying it back if you lose your job.
What is net worth?
Your net worth consists of your total assets minus your total debts. For example, Casey has $3000 in savings, a retirement account with $1000, and $18000 in student loans, and $2000 in credit card debt, so her net worth is negative $16,000.
However, just knowing her net worth is not enough to understand her financial situation. We also need to know what her net worth is relative to her income, expenses, and cash flow. Since Casey currently only has a cash flow of $200 per month, it will take her longer to pay off her debt than if she had more cash flow.
The overall economy also determines the value of your net worth. The price of things you need or want to buy is always fluctuating. It is better to view net worth as a snapshot of your financial health than as a number that is set in stone.
Short-term goals
Before you create a plan to increase your assets and build wealth, you need to determine what you want from your finances. Setting short term financial goals can help you stay motivated by giving you satisfaction as you reach your goals.
Start with goals that will create the most impact on your financial health. First, pay down high-interest debt so you do not accumulate as much interest. High-interest debts include credit cards and personal loans with interest rates above 10%.
Next, save an emergency fund so that you have a financial cushion for unexpected expenses. Try to save at least 2-3 months’ worth of expenses. Other short-term goals might include saving for other expensive life events that you anticipate having in the next 6 months to 4 years, such as a wedding, the birth of a child, or purchasing a home.
Long-term goals
Long-term goals are goals that require a longer period to accomplish, at least 5 years or more. Even if you are not sure about your long-term goals, you need to start planning for them, so you don’t miss opportunities to grow your wealth.
One goal that everyone needs to plan for is retirement. Each country has its own system for determining how much the state, employers, and employees contribute to retirement costs.
In the United States, there is a retirement benefit called Social Security, but it does not cover the full costs of retirement, so employees are responsible for saving for the remaining costs.
Similarly, in the UK, there is a state pension, an amount that you are guaranteed in retirement if you pay into the National Insurance System, but you still may need a workplace pension or private pension to increase your retirement income.
How to save for short-term goals
For short-term goals, save in accounts that allow you to have easy access to cash and accumulate interest. You earn interest in bank accounts because you are allowing banks to borrow the money in your account. Savings accounts still give you full access to your money if you want to withdraw it. These accounts earn a small percentage of interest.
High-yield savings accounts earn higher rates of interest and usually have some limitations on the amount of money you need to keep in your account and the number of withdrawals per month.
Certificates of Deposit (CDs) provide much higher interest rates than savings accounts, such as 2% instead of 0.15%, but traditional CDs prevent you from accessing the money in them for an agreed upon term, such as 1-5 years. When the CD matures, you can access the cash in them and receive the interest for that term.
How to save for long-term goals
For long-term goals, invest in stocks and bonds to increase the value of your initial investment. Investing, especially in the short-term, is risky because you can lose some or all your investment depending on which stocks you invest in and how much the value of the stocks fluctuates.
However, over a period of 10 years or more, the average value of the stock market, meaning the average value of all stocks being traded, tends to increase.
For example, the S&P 500 Index, a group of stocks that includes 500 of the largest corporations in the U.S. has averaged returns of 8.5% over a decade, meaning that on average the value of the stocks in that group has increased by 8.5%, every year, over 10 years.
Due to compound interest, that means that if you’d invested a lump sum of $10,000 dollars in the S&P 500 Index 10 years ago, you’d have $22,610 now. Not bad!
If you buy a diverse range of stocks in different industries, over decades they will generally gain value over time, allowing you to increase your net worth in the long-term.
