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Darrell Himmelspach
dhimmels@sdccd.edu
Phone: 847-746-2790
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Basics of Personal Financial PlanningThe_BasicsIncentives Understanding Your Current Position Gaining Control Balanced Financial Life The BasicsPart of the problem with the "world of finances" is that it is a huge space with hundreds of options and its own peculiar vocabulary. If you take it step by step, however, you actually can penetrate this field and completely understand it. So let's start at the beginning and see how the most basic things in life directly affect you and your finances.
If you are like most normal folks, you have a job. You go to your job every day. Every week or two weeks or month you get a pay check for some amount. For the sake of example let's imagine a fictitious person named Bob, a 24 year old computer programmer out of college two years. Bob is paid $3,000 each month, or $36,000 per year.
You have taxes. The government, in an effort to make your life easier, politely lifts something like a third of your pay check without your having to do a thing. Poof, it's gone - you never even get to touch it. The federal government takes perhaps 23%. The state government takes perhaps 7%, depending on the state. The social security administration (FICA) and Medicare take another 7.5% or so. Bob's $3,000 paycheck therefore diminishes to perhaps $1,850 by the time he sees it: $3,000 gross income
- $ 690 Federal income tax (23% of gross)
- $ 210 Typical state income tax (7% of gross, depending on state)
- $ 250 FICA, medicare, and other witholdings
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$1,850 Bob's net take-home pay
The amount subtracted depends on whether Bob is married (and if so whether his wife works), whether he owns a house, and so on.
You have expenses. As you live your life it costs money. A normal person in America has some pretty typical monthly expenses. Bob is a single guy, and his monthly expenses look like this:
[For many people it would mark a major financial milestone if they could create a simple, clear monthly vision of their expenditures like this one. See the article on "Understanding your current position" for details.]
The total expenditures shown here are $1,850 per month. If that were all there were to life, Bob would be set to some degree, because in this example expenses exactly match income. Unfortunately in life there are two other things…
You have problems. For example, you get a speeding ticket one day. The court fines you $60 to begin with, and then your insurance goes up $30 per month. Or your car blows a gasket and it costs $500 to repair. Or you meet "special friend" and feel compelled to take him or her out to dinner 14 times in one month, tripling your entertainment budget. Or you lose your job.
Then you have desires. All humans do, some more than others. You might desire new living room furniture, a new TV or stereo, a nice gift for your mother or spouse at Christmas, a special piece of jewelry, new clothes…. Whatever. You may desire all of it all at once. Occasionally you cannot control yourself and one of your desires is filled. Perhaps one month Bob buys a $400 TV without realizing it.
Therefore you have debt. Debt makes up the difference between income and expense. For most people day-to-day debt goes on a credit card, and large items like cars and houses are handled with more formal loans. Debt itself is not bad. The problem arises when debt accumulates for no apparent reason. In Bob's case, problems and desires would push his credit card balance upward each month because there is no other place for the money to come from. Since his expenses match income in a normal month, any abnormal spending will go on the credit card.
Notice what Bob does not have in the above scenario. There is no mention of a "savings program", for example. Nor a "retirement plan". There is no particular hope of reaching future financial goals (in fact, no goals to begin with). No "safety net." And most importantly, no peace of mind. Let me make an assertion: For a thinking person, it is very difficult to feel comfortable when you have no savings and a rising credit card balance. It feels uncomfortable because you know it cannot last; it is not sustainable. It also eliminates any sense of control, and most thinking people would like to have control of their lives and therefore their finances. It is as simple as that. This is a bad place to be because there is not a lot of future in it.
Let's say I waved my magic wand and doubled Bob's salary. Wouldn't that be nice? It would indeed, except that 99% of us (Bob included) would feel an irresistible urge to double our expenses at the same time. In fact, it is likely that if I told 100 people that their salary would double in six months, 99 of them would begin doubling their expenditures immediately, in anticipation of the actual funds. They would immediately move to a nicer place, drive a nicer car, buy more stuff, and so on until they got in exactly the same expenditures-are-greater-than-income position again. Clearly, making more money is not going to solve this problem, because we seem to have a natural tendency to spend what we earn in the same way that we eat everything on our plate and fill all available closet space. It is normal. That is why there was a "welcome to the club" message in the introduction to this series. The vast majority (90% or 95% of the people in the U.S.) live their lives just this way.
So is there a solution to this problem? The answer is "maybe." It requires a big mental shift. If you are willing to make the mental shift the answer is "yes." It turns out there is a different way to live life. This way of life involves figuring out what you really want to do, and what is really important to you as an individual, and then working toward those goals rather than proceeding randomly. What you gain in the process is a sense of control and satisfaction, and a sense of achievement, that is difficult to beat.
The rest of this series shows you how to start down that path. IncentivesOne of the very hardest things about "controlling your finances" is getting started down the path. During high school and college, and even after college for most people, finances are mysterious and maddening. There is never enough money.
One way to start down the path of control is to give yourself some sort of incentive to do so. If you feel that you are getting something from controlling your finances, then it is much more likely that you will do it. Different incentives work for different people. Let us try two approaches that might incent you to at least look into the prospect of starting to control things better. Approach 1: Becoming a MillionaireMany people find it hard to believe, but becoming a millionaire is fairly easy. Becoming a millionaire overnight is more difficult, but doing it over time is a reachable goal for every American citizen who is 25 years old.
Here is how you can become a millionaire. Start at age 25 and simply deposit $20 every week in an account that earns 12% interest. $20 is not a lot of money. If you smoke, it is the amount of money you are probably spending on cigarettes each week. If you go out to eat for lunch every day, it is less than what you are probably spending on your lunches. It is less than $3.00 a day. Every American - even homeless Americans begging at a New York subway stop - can put together $3.00 each day. If you added that much money to an interest bearing account earning 12% every week, and you did that starting at age 25, then by age 65 you would have a million dollars. If you started at age 20 instead of 25 you would have a whole lot more.
Here is another way to think about it. Imagine your first child. Imagine that your first child is to be born tomorrow. If, on that day, you opened an account earning 12% and deposited just $20 per week in that account, then at age 20 you would be able to write your child a check for about $80,000. Hard to believe but true. Small amounts of money, accumulated consistently and earning interest over a long period of time, really add up.
You probably have three questions:
One other question you need to ask is, "Where can I find an account that pays 12% interest?" We will discuss this question later in this series.
The point is, with just a little discipline over time you can accumulate huge amounts of money. That is what "control" is all about. You will learn a lot more about accumulating wealth in the other articles in this series.
Approach 2: Getting Something You Really WantLet's say that the thought of a million dollars in 40 years doesn't do anything for you. You want something now. Here is another way to think about your finances.
Television is a funny thing. The technology behind it is simple and seemingly harmless: television transmits moving pictures to your home. What could be the problem with that? The weird thing about television is that if the proper images are transmitted to your home, they can change the way you think. In particular, they can increase your desires. Take, for example, the Salad Shooter. Would it have ever sold without the mind-bending influence of TV? No. At the same time television tends to encourage you to satisfy all of your desires immediately. That is why, two weeks after you have purchased a brand new car, commercials can make you believe that you need another one.
Let's try to imagine an alternate and parallel universe without television. In this universe, a person who wants something stops and says, "in order for me to have that something, I need to save up enough money to buy it first. Then I will go purchase it." Would this work? No it would not in some cases. For example, is it worthwhile to wait 30 years until you save up enough money to buy a house, and then go buy one? No. See the section on buying a house for a discussion of this particular purchase. Is it worthwhile to save money for five years before you buy a car? Not necessarily, mainly because you have to have a car to survive in most American environments.
But let's say that on all other desires in your life you were to follow a "save first, buy later" rule. What would happen? Two things: first, you would notice that your desires might suddenly change dramatically. Second, you would have to find a way to accumulate money over time and hold it so you could realize your desires.
It is this simple but fundamental change of thinking - the "save first, buy later" rule - that can lead to the concepts of "controlling your finances" and "accumulating wealth". If you can make that change, it will cause you to modify your thinking so much that in a short period of time things like stocks, bonds, CDs and all the rest suddenly become interesting and relevant.
You may find yourself thinking one of three things right now:
If you find yourself thinking one of those things, let me ask you simply to put the idea on hold for a few minutes. Suspend your disbelief long enough for a new concept to enter your mind.
In order to organize your life in this "save first, buy later" way, you have to determine your financial priorities. This can be hard, and to do it right it helps to have some experience with other financial concepts. Therefore, a later article will help you to see how to do it right. In this article let's ignore doing it right and simply try out the concept to gain some experience with the process.
To determine your financial priorities, the first thing you have to do is think of the things you would like to have in the future, and then organize them. Therefore, I would like you to try taking 15 minutes to come up with a list of "things you would like to have one day." Simply take out a sheet of paper and list as many of your desires as you can think of. It may take a few minutes to get started; if you find yourself staring at a blank sheet of paper here are some thoughts to help you get started:
Just start imagining all the things you would love to have one day, and write as many of them as you can think of down on the sheet of paper. For most folks, if you think about all of the things you want to have both short- and long-term, you end up with a pretty long list. If you have a spouse create the list together. Come back in about 15 minutes.
Now you have a list. Take another five minutes and write down prices next to everything. If you don't know the exact number, write down an approximate number. If you don't know an approximate number, just guess and then double that number.
Now take your list and find the one thing on that list that you REALLY want. The thing that would make you happiest or solve the most problems or bring the most joy to you or a friend. On that list there is one thing that brings the biggest smile to your face when you think about it. Put a big star next to it and focus your attention on it.
Now here is an important fact: You can have that thing. It will take some work but you can have it, and you will have it if you can gain control of your finances.
Let's go back to Bob from the previous article. He made his list. He put prices next to everything. Then he took about half an hour to think about everything on the list and discovered the one thing that he really wants, more than anything, is a pilot's license. Bob wants to learn how to fly. He can't exactly explain why. He just wants to get his license and he has wanted it since age 13. He called a local airport, and it costs about $4,000 for a person to get a private pilot's license. So what Bob needs is $4,000. And his question is this: "This is great. Now I know exactly what I want, and I can taste it I want it so bad. But where in the world am I going to get $4,000???"
You may find yourself thinking exactly the same sort of thing. In the next article we will discuss this problem and how to solve it.
Understanding Your Current PositionIn the last article you made a list of all of your needs and desires. You then picked the one thing you really want and focused on it. As you recall, Bob picked pilot lessons as the one thing most important to him. You might have picked a down payment on your first home, or a really nice new car, or a college education for your daughter. The problem for Bob, and perhaps for you as well, is that the chosen thing requires a rather sizable amount of money. For example, Bob's pilot lessons cost about $4,000. Bob's question: "Where in the world am I going to get that kind of money??? I have not saved a dime in the last two years and I have a $2,000 credit card balance. There is no way I am going to be able to collect $4,000 any time in the next decade."
This question - "Where in the world am I going to get that kind of money???" - is the central question for anyone who wants to gain control of their finances. It is the one question that can trigger the transformation from random money management to controlled money management. The reason you made a list of all of your desires and then picked the one thing you really want is simple: If you really want that one thing, you may be willing to put in some extra effort, and perhaps endure a little pain, to get it.
For Bob (and for you) the first step down the path of control involves a discovery process. Bob earns plenty of money, but it all dissappears. Bob needs to figure out what happens to all of his money on a monthly basis. There are many ways that you can do this, but probably the easiest is to put a piece of paper in your wallet or check book and try, for a period of one month, to track every cent that you spend during that period of time. The reason that you want to do this is because you will probably be amazed at how you spend money right now. You must go through this step if you are to gain control of your finances and get the things that you really want.
So give it a try: track all of your expnses for one month. Put a piece of paper in your wallet or your check book and write down every cent that flows through your fingers in a given month, whether it goes out in the form of cash, charges on your credit card, checks, or automatic bank withdrawls. Quicken or Microsoft Money are good tools to help with this process if you like to use tools like that, or just do it on a sheet of paper. Accumulate the list and take a look at it at the end of each week and then at the end of 30 days. Click here to look at Bob's list.
There are several conclusions that you can draw from Bob's expense listing:
The next thing to do is to divide all of the money you spend up by category to try to organize it a little. Bob's categorization looks like this: Rent 700.00
Car payment 300.00
Gas, oil change, etc. 70.47
Power bill 76.47
Phone bill 37.16
Groceries 134.19
Cell phone 42.76
Cable TV 49.17
Computer 122.81
Music 25.66
Entertainment, lunches, etc. 421.94
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1980.63
Note that the total number here is lower than the grand total from the expense listing. The $275 Visa payment from the expense listing was eliminated, on the assumption that it paid for the previous month's expenses and would therefore be redundant to include here (to be technically correct, however, you might want to include the interest charge from the Visa bill among the expenses that you list in your categorization).
To complete your categorization, you really have to think a little bit more deeply than this. A one-month expense listing is likely to either over-estimate or under-estimate your actual monthly expenses because some expenses do not occur every month. For example, Bob has to pay a $487.42 car insurance payment ever 6 months. He also pays $85 in renter's insurance each year. He has the following gift occasions each year: mother's day, father's day, Mother's birthday, father's birthday, sister's birthday, Christmas. The total gift giving each year is about $350.00. There was a $112 property tax bill last November that came at a bad time. The car will need new tires every three years and tires cost about $360.00. And so on. Try to determine all of "hidden" expenses like this, make a list, and divide by 12. For Bob the annual hidden expense total is a little over $1,100 so the average monthly expense is $96.21. His true monthly expenditure is therefore $2,076.84, or $226.84 greater than income.
If you took the time to do this exercise, and really recorded all of your expenses over 30 days, and considered your longer-term expenses as well, and came up with a total expense number and compared it with your income, then what you have just completed is a true cash flow analysis. You know how cash flows in and out of your household. It may be that you found this analysis depressing. You may find that your situation is very much like Bob's. Your monthly expenses may be just a bit higher than income, leading to a slowly growing credit card bill. You may also have a big problem every six months when the car insurance bill comes due. Or maybe not. Maybe you are a bit more prudent than Bob and actually have a little money left over at the end of each month. Either way, it is important to know your true position.
The other half of understanding your household finances is to create what is called a balance sheet (also known as a net worth statement). A balance sheet shows where you stand in terms of your assets and liabilities. The assets are what you own, while the liabilities are what you owe. Here is Bob's balance sheet. Balance Sheet for Bob
Assets
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Savings account $230
US Savings Bond $500
Furniture $4000
Computer $1000
Camera $600
Car $6000
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$12330
Liabilities
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Car loan balance $6500
Visa balance $2000
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$8500
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Balance $3830
This balance sheet shows Bob is $3,830 ahead. That is, he has more assets than liabilities at the moment. Note that his car is worth slightly less than the loan amount. That is not good, but if you are in that position there is nothing you can do about it but attempt to avoid it in the future. If you happen to own a house, you may want to leave the house out of it for now to create a simpler view of things. If you are married with three kids, a house, two cars, a boat and a dog, you may find that your expense listing and balance sheet are somewhat more complicated than Bob's. Persevere, because knowing where you are at is important to gaining control.
You now have a good view of where you are. You may not like it, but at least you have it. In the next article we will explore how you can use this information to reach your one true desire. Gaining ControlNow let's come back to Bob's one desire: pilot lessons. How in the world is he ever going to accumulate $4,000 given the facts gathered in the previous article? How are you going to achieve your goals? You have to gain control of your finances.
This is why you were asked to choose the one thing you really want right now. This one thing is something that you have to want so badly that you are willing to make a bit of a sacrifice to obtain it. You've got to want it very badly, because what you are about to be asked to do will be impossible otherwise. What you need to do is cut some of your expenses in order to save money. This is hard, I know, even though it sounds simple. It is sort of like the famous dieting advice: "If you want to lose weight, you need to eat less and exercise more." What could be simpler than that? It is hard to save money because it is so easy to spend it.
None the less, Bob is willing to give it a shot. Bob looks at his expenses (see the previous article). There is one easy option: cut that entertainment number significantly. Say he were to cut the entertainment number in half: he could save $210 each month without effort. Since Bob is actually in the hole $226 each month, he could reduce the hole to a mere $16 per month by cutting the entertainment budget in half. Here are some of Bob's other options:
Let's say that out of all of those options, the only one Bob is willing to try is getting rid of the cell phone. He cannot live without ESPN. He has eight months left on his lease. He loves his car and cannot part with it. And there is no way he is selling his pit group.
So let's look at Bob's entertainment expenses and see if there is room for savings. This is going to be hard. Speaking as a person who once went out to lunch, and often dinner, every single day, I know how hard it can be to give up lunch. It makes you look like a fuddy duddy to bring a lunch to work every day. It is too much work in the morning to make a lunch. People ask you to go out and you don't want to say "no." And so on. There are two things to do here:
We are going to rely on your desire for the ONE thing you truly want to carry you through the hard times that are to come.
Let's look at Bob's expenses again:
Rent 700.00
Car payment 300.00
Gas, oil change, etc. 70.47
Power bill 76.47
Phone bill 37.16
Groceries 134.19
Cell phone 42.76
Cable TV 49.17
Computer 122.81
Music 25.66
Entertainment, lunches, etc. 421.94
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Total 1980.63
Other expenses 96.21
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Grand Total 2076.84
If you look at it closely, the primary area for expense cuts is in this region - the junk:
Cell phone 42.76
Cable TV 49.17
Computer 122.81
Music 25.66
Entertainment, lunches, etc. 421.94
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Total 662.34
If Bob could eliminate the cell phone, eliminate the music, cut the computer expenses in half, and cut the entertainment in half, he could save a total of about $340 per month. Two questions to ask are:
You need to look at your own expenses, go through the same analysis, and ask the same questions.
The answer to Bob's first question, "Will it help?" is YES, of course it will. If Bob could free up $340 per month it would get him to the point where his Visa bill would stop growing, he would be able to handle unexpected monthly expenses, and he could put about $120 in the bank each month toward his goal.
The answer to the second question, "Can it be done?" is less clear. Can Bob (and you) really change his lifestyle and save $340 per month? The answer is YES, and the sub-answer is it will work a lot better for some people if they start slowly. Some people are able to make rapid strides, once they clearly see their true desire. But a majority of people have to make the change over time. So what can Bob do to change his habits slowly?
The other problem most people have, and this explains the random music and computer expenditures seen in Bob's expense summary, is the credit card. It is too easy to whip out a credit card to buy something whenever the mood strikes you. This is fine if you are living a random lifestyle, but to get what you REALLY want this sort of behavior has to end. You can take several steps:
You have to do something to break the bad habit of random spending and replace it with consistent saving toward your goals.
Let's say Bob does this. The first month is kind of rough, but by the second month he is in a groove and accomplishes the following:
Now, $50 is not a lot of money. In fact, at that rate it will take Bob something like 80 months, or almost 7 years, to get his pilot's license. It is really hard to get excited about a seven year wait. Really really hard. In fact, nearly impossible. So he can do one of four things:
Bob does have other options. It turns out he also has other responsibilities he is not considering. We will examine these in the next article. 10 action items for you to tryIf you want to try following in Bob's foot steps, here is a set of action items for you to try:
Balanced Financial LifeLet us imagine that you were to hire a professional financial analyst to come to your home and look over your finances. What the person will say to you will vary depending on your situation, but in general you will hear at least the following:
These are the fundamental elements of stable financial life. If you are going to "control your finances," this is where you start. Bob, our hero from previous articles, had none of these when he started and has just tasted the first two. You may find that you are lacking one or more as well.
Why are these elements important? And why were you never told about them if they are? It is an odd thing, but for some reason there is very little "financial education" that occurs in this country. That is probably because, for most people, the education would be totally meaningless in high school. If you took a 17 year old high school senior and started talking about retirement, wills, life insurance and credit card debt in a high school class, it would all be totally meaningless. This sort of information has no relevance until you turn 23 or 24 (or even 33 or 34) and have been working for a while.
These elements are important because without them you live a life of financial randomness. You lack control, or even a basic understanding of where your money is going. If something goes wrong, you have no reserves to fall back on.
The previous articles have discussed the first three topics. If you have followed the steps as Bob has, you have created a clear list of financial goals (which you may want to revise based on what you have learned in these articles), you have built a clear understanding of your income and expenses (as well as your "hidden expenses"), and you have changed things so that income exceeds expenses and you can save toward financial goals that are important to you. The importance of your goals cannot be overstressed.
The following sections introduce you to the other elements. Credit Card DebtCredit card debt tends to be rather wasteful and unnecessary. If you have followed the ideas in the previous articles, you have gotten your credit card spending under control so that, at the very least, the balance is no longer growing. You will want to do something fairly quickly to begin reducing the debt you owe on your credit card(s), perhaps by paying an extra $50 or $100 per month (beyond the minimum payement) if you can manage it. This is important: Credit cards tend to have very high interest rates. If you have a $2,000 balance on a credit card, you are paying something like $30 per month in interest alone ($360 per year). That's a lot of money. That's $360 that could be going toward your financial goals instead. You want your financial plan to demonstrate a clear reduction in credit card debt, and you want to stop using your card on "random purchases". It is the random purchases that prevent you from getting the things you truly want. Safety NetsExperts tend to recommend a safety net of three to six months of your salary. As you recall, Bob brings home about $1,850 per month. Therefore he would want to have a safety net of $6,000 to $11,000 dollars sitting in a savings or money market account to use in case of an emergency like corporate downsizing. The problem with a safety net is that $6,000 is a lot of money. We will therefore talk about other ways to create a safey net when we talk about retirement plans.
If you are considering creating a safety net but cannot imagine saving $6,000, try this. At the very least you want to have three months worth of rent in savings, and enough credit card headroom to last for three to six months should you need it. That will be much easier to achieve. RetirementRetirement savings may seem totally and absolutely irrelevant to you right now, especially if you are under 30 years of age. The next article will attempt to convince you otherwise. Please read it, and read it with an open mind. A WillThey are incredibly important if you happen to die, because without one your estate gets locked in court. This is fairly harmless if you are young and single without many assets, but if you are married this can be a disaster for your spouse. If you do nothing else, purchase will software or a will kit by mail and use that. Or you can spend something on the order of $200 for a local lawyer to create a simple will for you. Life InsuranceSee the article on life insurance for more information on this topic. Restating your financial goalsIn light of all of these facts, you may wish to recreate or modify your list of financial priorities and your expenses. You may need to add a savings component for a safety net, or add an expense to cover life insurance premiums.
As you are revising your financial plan, it may seem a little like you have been cheated. Here you've been living a life thinking you were pretty much under control, but once you start to factor in things like credit card debt repayment, life insurance costs and retirement savings, you may find you aren't making nearly enough money any more. There is not a lot you can do about it in the short term. Assume a mature attitude and put things in order. Once you have lived with these new realities for a month or two they won't seem so bad, and you will have the distinct pleasure of knowing that you are really covering all of the bases.
In the following articles, a variety of new topics are discussed. These topics include retirement planning, investing strategies, life insurance and so on. With these new tools in hand, you will possess the essential ingredients of stable financial life. | ||||||||
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