A financial plan is exactly what it sounds like – a plan for your finances. Building a true financial plan typically involves evaluating your current financial situation (things like how much you make and how much you’re spending) and then developing a strategy for your future based on your personal goals and stage in life.
Many people, especially those just beginning to focus on personal finance, find the idea of building a financial plan overwhelming. You might be thinking, “Where do I even begin? Do I even need a financial plan?”
The short answer is – yes.
Building a financial plan makes it far easier to reach your short and long-term financial goals because you have clear and measurable targets to reach. For example, if you’re looking to purchase a new house within the next two years, you can research how much you need to save each month for a down payment. Without understanding how much your dream home will cost and setting a time-bound goal, it would be next to impossible to build an appropriate savings strategy.
1. Cash Flow
The first step in developing your financial strategy is to evaluate your cash flow –the money that comes in and goes out every month. Money comes to you from both income sources (such as salary) and asset sources (such as cash dividends or withdrawals). This money is used for outgoing payments (such as taxes, debt payments or lifestyle expenses). Some payments are fixed and essential, which we label here as your non-discretionary total. Other payments represent discretionary spending which are expenses that often represent the “nice to have items, or wants” and not the basic “needs” of everyday life, and which may be reduced in an emergency.
After all outgoing payments have been made each month, the portion of the money left over is known as discretionary income. Each month, you choose to spend this money on unspecified expenses, or you choose to save it. If outgoing payments exceed incoming cash flows, the difference between them is known as a shortfall.
2. Debt Management
The effective use of debt can enhance your financial plans. On the other hand, few things can derail your financial dreams faster than excessive, revolving, high-interest credit card debt.
Good Uses of Debt
There are situations where debt is not only a necessity, but potentially smart. Debt can actually provide flexibility and convenience that can help you manage your money and provide for your lifestyle needs. Even when using debt for “good” purposes, though, care must be taken that the debt balance doesn’t outpace your ability to make the payments. Good uses of debt may include:
Purchasing a Home
Purchasing an Appreciating Asset or Investment
Investment in Education
Bad Uses of Debt
Bad uses of debt can be the biggest obstacle for achieving your desired lifestyle. Debt that spirals upward because of high interest charges and poor purchase decisions can strain monthly cash flow. Large interest payments perpetuate the debt and can consume the cash flow necessary to maintain your lifestyle and to accomplish your goals. Bad uses of debt include:
Using Credit Cards to Pay for Lifestyle Needs
Using Credit Cards to Pay Credit Cards
Using Credit Cards to Purchase Depreciating Assets
Analyzing Your Debt
All debt, good and bad, must be analyzed together for proper debt management. Better debt management means better cash flow and better financial planning. Debt management starts with examining your existing debt. You should examine each individual debt as well as your total, overall debt. Total debt is often analyzed by comparing earned income to debt payments.
Debt as a percent of earned income is known as Your Debt-to-Earned Income Ratio.
A debt-to-earned income ratio of 20% is considered average. The lower your debt-to-earned income ratio, the better your financial flexibility will be. Depending on your particular circumstances a ratio of 20% or higher may be a sign that your credit is out of control, could lead to difficulty obtaining future loans and/or a lower credit rating. You may also be unable to qualify for the best rates and terms.
Becoming Debt Free
Accelerating the payoff of your debt can be achieved by strategically applying regular additional payments. Becoming debt free often takes courage, resolve, and discipline applied over an extended period of time. The peace of mind and the sense of freedom that come from being debt free are well worth the effort. Further, you’ll likely save yourself a significant sum in potential interest payments. Generally you will save the most by paying off the highest interest debt first, but some individuals find it is easier to maintain the program if they see early success by eliminating some debts entirely; this can usually be achieved faster by paying off the lowest balance first.
Here are some additional ways to manage your debt:
Pay Yourself First – simultaneously work on savings and debt elimination
Cut Spending and Stop Borrowing
Pay Off the Right Debt First
Pay More than the Minimum Payment
Consider Restructuring Your Debt
Consolidate Multiple Credit Cards to One Card with a Lower Rate
Consolidate Bad Debt into Better Debt at Lower Rate
Call the Credit Card Company and Ask for a Lower Rate
Cut up Credit Cards You Don’t Need
Stop Credit Card Solicitations (1-888-5-OPTOUT)
3. Emergency Fund
Whether natural or man-made, disasters and emergencies can happen at any time. Even a small catastrophe, requiring cash, can occur with little or no warning. The key is to be prepared for whatever events life throws your way. Consider how you would pay for any of the following unexpected events. A source of available funds can provide the peace of mind of knowing you can recover quickly—with the least disruption to your life.
Major Car Repairs
Major Home Repairs
Major Appliance Replacement
Rainy Day Fund
A good rule of thumb is that your emergency fund should equal 3-6 months expenses. Emergency funds should be kept in the form of liquid (and generally “safe”) assets that can quickly provide the resources needed during a short-term financial crisis.
4. Proper Protection
Common Uses for Life Insurance
– Funeral Expenses
– Medical Expenses
– Probate Fees
– Administration Fees
Protect the Family
– Income Replacement
– Education Funding
– Disability Funds
– Home/Property Protection
– Protecting Business Interests
– Cash Value Accumulation
– Mortgage Protection
– Settlement of Individual
– Loans at Death
– Consumer Debt
– Income Taxes
– Estate Taxes
How Much Life Insurance Protection Is Enough?
The basic rule of thumb is to have enough life insurance to provide approximately 10 times your annual family income. But there are many other factors that should be taken into consideration, including your age, your medical condition, how many dependents you have, your income or current financial status, and most importantly, which tasks, or uses, do you want to assign to your life insurance policy.
In the event of your death, your life insurance policy can accomplish the following tasks:
Pay all of your final expenses — including any final medical bills and funeral arrangements
Immediately pay off your present debts (including your mortgage)
Establish a fund to protect against a family emergency
Establish a fund to provide income for your survivor(s) for a certain period of time or for life
Establish a fund to pay your children’s education expenses