The secret to personal finance is managing your money and planning for your future. Each activity you partake in and each decision you make affects your overall financial health.
We often allow ourselves to be guided by rules such as "put at least 10% of your income toward retirement" or "don't buy a car that costs more than half your yearly salary."
Sure, many of these rules and strategies are helpful — some are even time-tested and proven to work — each of us must consider what we are doing to help improve our overall financial health and habits.
In the post below, we will discuss three broad rules of personal finance that should get you back on track to achieving your personal finance goals.
How to Improve Your Personal Finances?
Personal finances can sound intimidating, and the term itself can cause people to avoid planning. This is a surefire path to bad decisions and unfavorable outcomes. What we all need to do is take the time to budget.
Calculate your income and compare it to your expenses. This way, you can keep spending within your means and manage your lifestyle choices accordingly. Aside from this, everyone should take the time to learn personal finance.
Once you've made your plans for the future, you want to start putting money away today. This money will serve to reach your savings goals, including emergencies, but also leisure and a comfortable retirement.
Let's break this process down into a few simple yet essential steps.
1. Calculate Your Net Worth and Personal Budget
The thing about money is that it is transitive, almost ephemeral unless you're paying close attention. Many people understand this, but unfortunately, this is as deep as their understanding of personal finance.
Rather than leaving your finances to chance and simply ignoring them, you should crack down on some number crunching and evaluate your current financial health. This will help you figure out how to reach both your long-term and your short-term financial goals.
You're probably thinking, "this all sounds well and good, but where do I start?" We're glad you asked.
First of all, you need to calculate your net worth. This is the difference between your assets and your liabilities — or in simpler terms, what you own vs. what you owe.
Start by making a column for each category and subtracting the liabilities from the assets to get your overall net worth. This number represents your current financial status, but you should understand that this figure is malleable — it fluctuates over time.
While it is certainly helpful to calculate your net worth once, the real value from this practice comes from repeating the process relatively regularly (once a year at the very least).
Tracking your net worth helps you evaluate your situation at all times, identify the areas in need of improvement, but also highlight the things you've excelled at.
Developing a personal spending plan or budget is equally important. Created monthly or annually, a personal budget is an indispensable financial tool as it can help you do a wide variety of things, including but not limited to:
- Expense planning
- Eliminating or reducing unnecessary expenses
- Saving for goals and retirement
- Spending money more wisely
- Planning for emergencies
If you've spent any time researching the topic of personal finance, you know that there are as many approaches to this subject as there are people alive. However, all of the approaches have one thing in common — calculating and projecting your income vs. your expenses.
Your budget's asset and liability categories will change over time depending on your current situation, but it is vital to keep track of them. Common income forms include:
- Salary
- Bonus
- Disability benefits
- Child support
- Alimony
- Retirement
- Interest and dividends
- Tips
- Social security checks
- Rent and royalties
When it comes to expenses, the categories include:
- Food
- Debts (student loan, credit card, car loan, etc.)
- Education
- Recreation and entertainment
- Housing and rent
- Gifts
- Insurance
- Savings
- Health care
- Utilities
- Transportation
Once you've made the relevant calculations, simply subtract your expenses from your income. Any money you have leftover is considered a surplus which you can either invest, save or spend.
Conversely, if your expenses exceed your income, you'll have to make adjustments to your income. The simplest way to do this is to reduce your costs, but you may also have the option of increasing your income by adding more hours at work or picking up another job.
The only way to truly understand your current financial situation is to do the math. Keep calculating your budget and your net worth regularly. Be sure to claim all that you are entitled to in order to maximize your earnings and include this in your calculations. For instance, if you have been injured at work, perhaps you are a veteran injured in the line of duty, for example, you may be able to claim compensation or disability benefits. You can see more here and use the disability calculator to get an idea of what you could be due.
This piece of advice may seem elementary to some of you, in which case, kudos! You're on the right path to financial freedom. However, most people fail to layout (and stick to) a budget, which is the root cause of their financial troubles.
2. Manage Lifestyle Creep
If they have more money to spend, most people default to spending more. As we advance in our careers and start earning more, we tend to increase our spending as well. This phenomenon is known as "lifestyle inflation" or "lifestyle creep."
Although it likely won't affect your ability to pay the bills, lifestyle inflation can pose problems for you in the long run, limiting your ability to build wealth. In other words, every extra dollar you spend now is one dollar less during your retirement.
Probably the main reason people allow lifestyle creep to affect their finances comes from their desire to "keep up with the Joneses." People tend to match their neighbor's, coworker's, and friend's spending habits, so if your peers dine at expensive restaurants or spend their vacations at exclusive resorts, you may begin to feel the pressure to do the same.
We tend to forget that the Joneses are often not in such a great place financially as it may seem — they're likely servicing a lot of debt to maintain their appearance of wealth. They're probably not saving enough for retirement and may even be living paycheck to paycheck.
As your career evolves, you'll feel a natural urge to increase some of your spending habits, and that's fine. You might need to upgrade your wardrobe to dress more appropriately for your new managerial position, or you may need a bigger car as your family expands.
With more responsibilities at work, you may even find that hiring someone to clean or mow the lawn makes sense, freeing you up to make even more money, or better yet, spend some time with your loved ones.
That said, think carefully about every purchase decision and reflect on whether you're buying something because you need it or simply because you can.
3. Start Saving as Soon as Possible
It's never too early to start saving for your retirement. The sooner you start, the more time you have to accumulate wealth, particularly if you're taking advantage of the power of compound interest.
Compounding relies on the reinvestment of earnings, and as its name suggests, it accelerates your profits over time. The longer you're able to reinvest your earnings, the greater the overall value of the investment, and (hopefully) the larger the gains.
We can illustrate the importance of starting early with your retirement savings through a simple example. Let's say you're looking to save $1 million by the time you're 60.
Assuming that your average annual interest is 5%, you'll have to contribute around $650 a month to reach a million at 60 years of age. Conversely, if you start at 40, your monthly contribution would have to go up to roughly $2,500 per month.
It's, therefore, easy to conclude that if you want to reach your long-term financial goals easier, you'd be better off starting as soon as possible.
Bottom Line
These three rules of personal finance can be essential weapons in your arsenal on the quest of achieving financial freedom. It is also important to keep an eye on the big picture, and build better financial habits overall, as financial success is about more than a few tips and tricks.
Without proper financial hygiene, you'll have trouble amassing wealth, no matter how many strategies you attempt to employ. No tricks can substitute an ironclad will and discipline.
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