Financial Planning Building Blocks

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There are a few foundational pieces of financial planning advice that can help make sure that everyone starts their path to financial security on the right foot. Despite the jargon and complicated technical subject matter in financial planning, as with most things, you will succeed if you consistently do the basics well.

Get a Clear Picture of Your Spending

This is often difficult for a lot of people because there is a sense of fear that comes with actually understanding how you’re spending your money. Take some time to go through your credit card and bank statements and figure out how much you’re spending each month, and compare it to how much money you’re bringing in. Expenses can range from rent or mortgage payments, to gym memberships and Netflix. There are no right or wrong ways to spend your money, but it is important to figure out how much you’re spending against how much you’re taking in each month.

It’s not uncommon to realize that you’re breaking even each month, or even spending more than you’re taking in. If this is the case, take a look at your expenses and cut out unnecessary items, or expenses that you aren’t as passionate about. There is absolutely nothing wrong with spending on items that bring you joy. Money is a tool that should be used for exactly that!

Build Up Your Emergency Fund

Most financial planners recommend that you have 3-6 months of cash in an emergency fund. This can change depending on your particular situation but the idea is to have enough to cover your fixed expenses (rent, mortgage, utilities, phone bills, transportation) in the event that you have lose your income.

This fund is available to cover unexpected surprises like job loss, a global pandemic that completely shuts down the economy, or a healthcare related expense. With the emergency fund in place, you will be able to work through an adverse situation without the added pressure of having to worry about paying for your existing bills and expenses.

The idea behind limiting your emergency fund to 3-6 months of income comes from the belief that cash has a huge opportunity cost associated with it and is almost always better off invested in some sort of  asset. However, if saving up a year’s salary helps you sleep better at night, then that is what you should do.

If, on the other hand, creating an emergency fund sounds near impossible to you at this time, start off small! This can be $20 a week, or $50 a month. There is no amount too small, and you’ll be surprised at how quickly those deposits add up.

The key here is to create a high yield savings account, separate from your checking account. One of the secrets to building financial security is automating transfers, withdrawals and investments to the extent possible. Automating this will save you the work of manually transferring the money every paycheck and will keep you from wanting to dip into it every time you’re browsing on Amazon.

Pay Off Credit Card Debt

I can’t stress this enough. Credit Card debt is worse than opening the fridge for the 15th time only to find that no additional snacks have magically appeared. Credit Cards charge insanely high rates, which leads to higher interest payments and higher balances. Please pay your credit card off in full each month.

If you do have credit card debt, all is not lost. Creating some savings is more important, but once you have a month or so of expenses saved, you should shift your focus to tackling any outstanding credit card debt. I’m not the type to advise against all of life’s pleasures in pursuit of creating wealth but limiting spending until your credit card is paid off is highly advisable. Take a look at which balances have the highest rates and start picking those off one by one. Treat yo self once you wipe that credit card debt away, you’ve earned it!

Credit cards aren’t all bad news though, in fact, when used effectively, they have many perks that I urge you to take advantage of. Cash back rewards, travel rewards and fraud protection are just a few of the many benefits credit cards can provide. Just make sure that balance is paid off in full every single month.

Investing and Saving for the Future

OK, so you have your spending figured out, a few months in your emergency fund, and your credit card debts are all paid off. You’re the boss now and nothing can stop you. The next step is to invest in your future self.

To many, investing is a process best left to geniuses and prodigies. You have thousands of books, articles, podcasts and newspapers filled with jargon and equations. Stories of prophets who correctly predicted the future and used their intellect to make billions of dollars on opportunities us mortals simply couldn’t see.

These stories are true. There are some people who understood things before others and were able to make huge profits off of it. But these stories are few and far between. The truth is, you can buy an index fund or ETF, and beat almost all of these brilliant financiers. According to Barrons, only 29% of active managers beat their index in 2019. And that 29% is actually high if you go back even further in time.

Simply stated, you can buy a very low-cost investment that imitates the market and outpace the professionals a majority of the time. With this knowledge in hand, you should have all the confidence you need to take the plunge into investing.

If your employer offers a 401(K) or a 403(B), think about contributing at least the amount they match. If they match up to 3%, that’s free money for you! Take it! The catch to these retirement accounts is that you won’t be able to touch the money without incurring a penalty until age 59 1/2. Depending on your age, this actually works in your favor since it can keep you from overreacting to short term market movements.

If you don’t have access to a 401(K) or a 403(B), you still have a few options. Opening up a Traditional or Roth IRA is incredibly easy today and provides that same tax-free  or tax deferred growth. You can also withdraw contributions (not gains) at any time penalty free. The maximum contribution for 2021 is $6,000, and there are adjustments depending on how much you make.

If you have some cash left over after you have a properly diversified allocation within your retirement accounts and want to dabble in more speculative assets or emerging technologies, then go for it. Investing can be exciting and if you love the thrill of putting money into cryptocurrency or electric vehicles then have at it. Just make sure you would be comfortable with the prospect of losing a substantial amount of the money you’ve invested and enjoy the ride. An allocation of 5%-10% towards more speculative investments can help you fulfill the need to take some risk and won’t have a debilitating effect on your portfolio should things go awry.

Pay off Remaining Debt

After your investment plan is in place, any remaining cash should be used to pay down any other debt you may have. Student loans, mortgage payment and car loans tend to have much lower interest rates, and may provide some tax benefits as well, so they aren’t as high of a priority as credit card debt.

If you find yourself with some extra cash, paying down the principal balance on your car, or on your student loans may makes a lot of sense. Paying down balances can help you save thousands of dollars in interest over the life of the loan and can help you reach any short term or long-term goals you may have. It’s not the end of the world to have debt, but there is a reason legendary investor Ray Dalio refused to use any debt, even to buy his first house!

There is a lot of up-front work that goes into these steps, but if you take the time to get through them, you’ll have a much clearer picture of your finances, and what it’s going to take to reach your goals. The end result will look different for everyone but understanding and mastering the basics is the most important step you can take.

Disclaimer: The information on this site is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This information should not be relied upon as the sole factor in an investment making decision. This content is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Hereford Financial disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose.

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