Step 2 of Better Money Management
In Part 1 of this series, I discussed the importance of getting a grip on how much money has flowed into and out of your life. You had two choices on getting started:
We start here to paint a very clear picture and teach you just how inaccurate your lifelong story about money truly is. You need to understand what your previous money management routine has yielded because it creates an excellent way to track where all your money has gone over your earnings lifetime.
The first step of this program was to find out how much your worth. Now what? Step two has three phases - debt elimination, emergency funds, mortgage payoff.
Phase 1 - Debt elimination
If you are in debt, and have a negative net worth, there is no such thing as good debt vs. bad debt.
It's all bad debt if you owe more than you have saved. If you are living beyond paycheck to paycheck, stay away from borrowing any further. Slowly begin to turn the ship around on your debt. Start with all forms of debt except for your mortgage (that comes later).
Begin with the debt snowball or debt avalanche methods. They have been hashed out in great detail and people love Dave Ramsey's Total Money Makeover book for strategies on how to kill debt as quickly as possible. To that end, I will not repeat what others have already outlined better than I. Go read Dave's book or Google search "debt snowball" or "debt avalanche" to pay off all forms of debt except for your mortgage.
Phase 2 - Build Emergency Fund
Age old wisdom advises 3-6 months worth of expenses in your savings account. That is your emergency fund. If you have had difficulty with savings in the past, especially if you have accumulated a history of significant debt, then aim for 12 months of expenses in an emergency account. History tends to repeat itself and the larger cushion you have the greater space you put between yourself and toxic debt.
Above and beyond your emergency fund, maximize your effort to phase 3 (highlighted below).
How much for an emergency fund? Anywhere from 3-12 months worth of expenses. The way to decide where you fall in the 3 to 12 month spectrum is being honest with yourself about your previous spending and saving habits. If you have never owed significant debt and are already a disciplined with your savings, 3 months works out just fine. If you previously owed more than $100,000 (excluding your mortgage), aim for closer to 12 months in an emergency fund.
To has this out further, let's use an example. Say you previously had $25,000 in student loan debt and $30,000 in car debt, after you pay off the full $55,000 consider having 6 months worth of expenses in your emergency fund (right in the middle of our 3-12 month range). If your monthly expenses are $2,000, you would want to accumulated $12,000 in savings and/or checking accounts to fully load your emergency fund. This is not money earmarked for spending however. You are not to touch your emergency fund unless there is a major repair, accident, or true emergency that requires immediate cash-flow.
After eliminating all forms of debt (excluding your mortgage) and building 3-12 months in an emergency fund, the next step is to finish off your mortgage debt.
Phase 3 - Mortgage Payoff
Many self-proclaimed professional money managers disagree with this one. However, consider that the average person who takes the full 30 years to payoff their mortgage pays 2.5 times as much for their home as the original listing price.
Even in a market with all-time low rates under 3%, the effect of interest can be brutal when factoring the full cost of homes. Consider that the average American has $202,284 in outstanding mortgage debt according to Experian. Even at historically low rates of 3%, that can be $6,000 per year in interest alone early in your mortgage due to the typical amortization schedule. By the same schedule, nearly all of your initial payments for the first few years of a mortgage go towards interest payments. This means you will initially live in your home without actually paying down your principal whatsoever!
Paying off your mortgage as quickly as possible is like earning a guaranteed rate of return on your money. Early on, you will be getting a rate of return equal to the interest rate on your loan.
I do not make this recommendation likely however, have you ever met anybody who has significant financial trouble who has a fully paid off home? Neither have I. Not yet, at least.
Part 2 of this series has three distinct phases. Phase 1, eliminate debt excluding your mortgage. Phase 2, save 3-12 months in an emergency fund. Phase 3, pay off your mortgage in full.
In part 3 of this series, we will discuss what to do once you have established and completed Steps 1 and 2.
How to Quit Complaining About Having No Money
Money is something that needs to be managed. Whether you make minimum wage or well over six figures, you must understand how to manage your income if you ever expect any of it to hang around.
The first order of business in managing your finances is to understand when, where, and how much money flows into, and out of, your life. To solve this mystery, first begin with finding out where you spend your money, on average, every month. It is imperative to understand where you money ends up at the end of every month so you can begin to identify how you can keep more of it around!
At the end of most months, most Americans have little to no disposable income. In the present situation, most of us are actually able to spend more than we earn thanks to the world of creditors and financing.
However, there might just be hope for you yet.
Ponder the following: if you are over the age of 30, you likely have already had more money pass through your life than you realize. Don't believe me? Take a look at this example:
Chances are, most of you make more than just $10k per year. Where has it all gone?
Consider that he average single individual income is just north of $56,000 (according to 2015 US Census data). So how much money does a person making an average of $56,000 earn in their lifetime? Answer: $2.2 million by the age of 65.
Where does all the money go?
"In one hand, out the other" typifies money management in the United States. Worse yet, many are spending well beyond our earnings as evidenced by the $8,398 credit card balance of the average American.
Perhaps you find yourself in the same situation. Somewhere along the ride you decided keeping more of your income was not all that important. You may have decided a new car, new clothes, a brand-new house were all worth having savings in the "slim to none" category.
You may have decided that it was more important to own something, rather than own your own life. Your decisions make the indentured servitude of regular "nine to five" employment a guaranteed certainty until you meet an early grave.
You are responsible for this. Not your neighbor, Not your brother. Not a divorce. Not the weather. Not your injured knee. Not that tree that fell on your uninsured home. It's your fault. End of story.
Why do we need the pressure of it being "our fault"? Because by assuming it is your fault, then you can begin to understand that you are the one responsible for changing it. Life happens to all of us. Unexpected expenses will continue to come. They do not end and they come at the worst time. Even innocent expenses like birthdays, holidays, baptisms, wedding, you name it, will continue to come at the most inopportune time. This is life my friend.
I take the extreme "my fault" approach to money management because it carries with it a zero-tolerance policy for excuses. Excuses are wasted energy. They rarely, if ever, do anything to change the actual situation at hand. Excuses are a coping mechanism that are designed to make you feel better about why you are not doing better. They are also used to help explain to other people why you aren't doing better in the hopes they won't judge you (trust me, they still are judging you anyway).
In the words of the late Jim Rohn, "Don't wish it were easier, wish you were better".
While the lifetime earning numbers that we calculated above might be very impressive (especially if you make more money than the example I provided), you may actually find that you are spending more than your annual after-tax income.
To make the examples above more accurate, use your actual tax returns from previous years and add up what you have made in your lifetime (note: if you need these but don't have them, visit the IRS Website's "Get Transcript" page to learn how much earnings have been reported on your behalf to date) . This can be a very enlightening exercise, good or bad. If nothing else, it should merely demonstrate how little awareness you have about how much money you actually have made.
The concept of calculating your lifetime earnings is a great place to start to introduce you to your income and create a visual of how well (or poorly) you have managed it throughout your lifetime. It is an important first step to understanding how to manage your money.
*If you would like greater depth on the concept of lifetime earnings, take a look at Your Money or Your Life by Viki Robbin.
Where To Start If You Want to Improve Your Money Management Skills...
Choose one of the following to get started:
Calculate Your Net Worth (assets minus liabilities)
Calculate Your Lifetime After-Tax Earnings - for increased accuracy, use the IRS Website for attaining prior transcripts of your tax returns
You must begin this journey knowing where you are so that you can figure out where you want to go. All directions require a starting point.
If you insist that you never have enough money, start by looking at where your money actually goes. I don't mean simply looking at your checking account every other week, I mean look at your longer term trends. If someone is 200 pounds overweight, it would be wrong to assume that only last week was to blame for this situation. We need to look at things longer-term.
Pick one of the above, and get started. Increasing your net worth can literally be as simple as gaining a deeper understanding of your personal financial snapshot. Just knowing how much money flows into your life (lifetime earning) or simply understanding how much you have saved in your lifetime (part of net worth), you can begin to identify areas where you require significant input (expenses, savings, tax efficiency, retirement accounts, investing, etc.).
Part 1 concludes with encouraging you to understand where you are starting from. Two choices:
Regardless, you decide.
Better Money Management Series
I started this blog because friends and family often asked me similar questions regarding personal finance. I was surprised just how much people were interested in improving their financial situation, yet had no idea where to start. It made perfect sense to start a blog and share all the information that I have learned along the way with others. You will find many resources and links referred throughout the blog. I have found all of this information useful and continue to grow my knowledge and understanding in the personal finance space. Admittedly, even I struggled heavily in the beginning with understanding how to improve my financial situation. The power of reading and note taking got me where I am today and will continue to provide a return on investment for years to come. I look forward to sharing with you along the way.