The term “personal finance” refers to how you manage your money and plan for your future. All of your financial decisions and activities have an effect on your financial health. We are often guided by specific general rules, such as “don’t buy a home that costs more than two and a half years of income” or “you should always save at least 10% of your income for Retirement.”
While many of these adages are tried and true, it’s important to keep in mind what we should generally be doing to help improve our health and financial habits. Here we discuss five broad personal finance rules that can help you get on track toward achieving specific financial goals.
- Often, “personal finance” is an intimidating term that causes people to avoid planning, which can lead to poor decisions and poor results.
- Take the time to budget your income versus expenses, so you can spend within your means and manage lifestyle expectations.
- In addition to planning for the future, start saving money today for savings goals, including retirement, leisure, and emergencies.
1. Do the math: net worth and personal budgets
Money goes in, money goes out. For many people, this is as deep as their understanding of personal finances. Rather than ignoring your finances and leaving them to chance, a little numerical calculation can help you assess your current financial status and determine how to reach your short and long-term financial goals.
As a starting point, it is important to calculate your net worth – the difference between what you own and what you owe. To calculate your net worth, start by listing 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 the time, and it’s normal for the figure to fluctuate over time. Calculating your net worth once can be helpful, but the real value comes from doing this calculation on a regular basis (at least once a year). Tracking your net worth over time allows you to assess your progress, highlight your successes, and identify areas for improvement.
Equally important is developing a personal budget or spending plan. Created on a monthly or annual basis, a personal budget is an important financial tool because it can help you:
- Spending plan
- Reduce or eliminate expenses
- Save for future goals
- Spend wisely
- Emergency plan
- Prioritize expenses and savings
There are numerous approaches to creating a personal budget, but they all involve making projections of income and expenses. The categories of income and expenses that you include in your budget will depend on your situation and may change over time. Common income categories include:
- Child support
- Disability benefits
- Interest and dividends
- Income and royalties
- Retirement income
- Salaries and wages
- Social Security
Overhead categories include:
- Childcare / Eldercare
- 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)
- Donations (birthdays, holidays, charitable contributions)
- Housing (mortgage or rent, maintenance)
- Insurance (health, home / tenants, auto, life)
- Medical / health care (doctors, dentists, prescription drugs, other known expenses)
- Personal (clothing, hair care, gym, professional fees)
- Savings (retirement, education, emergency fund, specific goals like vacations)
- Special occasions (weddings, anniversaries, graduation, bar / bat mitzvah)
- Transportation (gas, taxis, metro, tolls, parking)
- Public services (telephone, electricity, water, gas, cellular, cable, 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 can decide how to spend, save, or invest the money. However, 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 reducing your expenses.
To really understand where you are financially and figure out how to get where you want to be, do the math – regularly calculate both your net worth and your personal budget. This may seem very obvious to some, but people’s failure to design and stick to a detailed budget is the primary cause of overspending and overwhelming debt.
2. Recognize and manage lifestyle inflation
Most people will spend more money if they have more money to spend. As people advance in their careers and earn higher wages, there tends to be a corresponding increase in spending, a phenomenon known as “lifestyle inflation.” While you may be able to pay your bills, lifestyle inflation can be detrimental in the long run as it limits your ability to generate wealth. Every additional dollar 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. It is not uncommon for people to feel the need to combine the spending habits of their friends and coworkers. If your colleagues drive BMWs, vacation at exclusive resorts, and dine at expensive restaurants, you may feel pressured to do the same. What is easy to miss is that, in many cases, the Joneses are actually paying off a large amount of debt, over a period of decades, to maintain their rich looks. Despite their rich “glow” (the boat, the luxurious cars, the expensive vacations, the private schools for the children), the Joneses could be living from salary to salary and not saving a penny for retirement.
As your professional and personal situation evolves over time, some increases in spending are natural. You may need to upgrade your wardrobe to dress appropriately for a new position, or as your family grows, you may need a house with more bedrooms. And with more responsibilities at work, it may make sense to hire someone to mow the lawn or clean the house, freeing up time to spend with family and friends and improving your quality of life.
3. Recognize needs versus desires and spend wisely
Unless you have an unlimited amount of money, it is in your best interest to keep in mind the difference between “needs” and “wants” so that you can make better spending decisions. Needs are things you must have to survive: food, shelter, health care, transportation, a reasonable amount of clothing (many people include savings as a necessity, be it 10% of their income or whatever they can afford. side every month). Rather, desires are things you would like to have but don’t need to survive.
It can be a challenge to accurately label expenses as needs or wants, and for many the line gets blurred between the two. When this happens, it can be easy to rationalize an unnecessary or extravagant purchase by calling it a necessity. A car is a good example. You need a car to go to work and take the children to school. You want the luxury edition SUV that costs twice as much as a more practical car (and costs you more on gas). You could try calling the SUV a “necessity” because, in fact, you need a car, but it is still a desire. Any price difference between a cheaper vehicle and the luxury SUV is money you didn’t have to spend.
Your needs should have the highest priority in your personal budget. Only after your needs have been met, you must allocate any discretionary income to the wishes. And again, if you have money left every week or every month after paying for the things you really need, you don’t have to spend it all.
4. Start saving early
It is often said that it is never too late to start saving for retirement. That may be (technically) true, but the sooner you start, the better it will be during your retirement years. This is due to the power of capitalization, what Albert Einstein called the “eighth wonder of the world”. Capitalization involves reinvestment of profits, and is more successful over time. The more the profits are reinvested, the greater the value of the investment and the greater the profits (hypothetically).
The sooner you start, the easier it will be to achieve your long-term financial goals. You will need to save less each month and contribute less overall to achieve the same goal in the future.
5. Build and maintain an emergency fund
An emergency fund is just what its name implies: money that has been set aside for emergency purposes. The fund is intended to help you pay for things that would not normally be included in your personal budget: unexpected expenses like 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 of living expenses in an emergency fund, the unfortunate reality is that this amount would not be what many people would need to cover a large expense or loss of income. In today’s uncertain economic environment, most people should aim to save at least six months of living expenses, more if possible. Putting this as a regular expense item in your personal budget is the best way to make sure you’re saving for emergencies and not spending that money frivolously.
Keep in mind that establishing an emergency backup is an ongoing mission. Chances are, as soon as it’s funded, you need it for something. Instead of feeling dejected over this, be glad to be financially ready and start the fund building process all over again.
The bottom line
Personal finance rules can be great tools for financial success. However, it is important to consider the big picture and develop habits that help you make better financial decisions, leading to better financial health. Without good general habits, it will be difficult to obey detailed adages like “never withdraw more than 4% a year to make sure your retirement lasts” or “save 20 times your gross income for a comfortable retirement.”