Personal finance is a multi-faceted discipline. Even though you are not a finance professional, you have to manage the different faces of your own finances. This is similar to solving a Rubik’s Cube Puzzle.
The 6 sides of the personal finance cube are:
- Cash flow
- Debt or Leverage
Each of these sides has a challenge and can be managed with certain amount of discipline and the right tools.
Even though this may sound obvious to some, it is the synergy of a good system that holds the cube together.
Like a Rubik’s cube, as you turn one of the levers to adjust one side, it affects the other sides.
Let us look at how each side is managed and how it affects the other sides.
It all starts from here. No matter whether you are starting off in a new job or career, or you are in your mid-40s or even retired, cash flow is paramount. It impacts our day to day finances and life.
Anyone starting to organize his/her finances will need to start from an accurate understanding of the cash flow. Below are some tools/methods of how this can be tracked and organized.
- Observing the cash flow – This involves tracking the incoming and outgoing money flow into accounts for about 3 months. Within 3 months, a person will be able to get an idea of how much he/she earns (even if variable) and what is the flow of money out of the account.
- Planning the cash flow – This is the next step based on the 3-month trial period. This is where systems are put in place like auto-debits and auto-invests, or debt payments with more than the minimum, and chipping towards savings goals.
- Tracking the cash flow – Here we finally deploy a tool like YNAB or any good budgeting tool. This gives a plan and tracker to setup the various categories of income, savings, investments and spending.
The different stages of cash flow actually flows from one to the other. As the observation over 3 months gives an estimate of the spending and fixed expenses, the planning stage can determine how much can be set aside for investments and savings. Finally the tracking takes over where every month, the set goals are tracked and adjusted.
Once you have an idea of cash flow, the planning stage can consider the next steps in more detail.
Debt and leverage
As we all know, debt takes various forms – credit card, personal loan, consumer loan, car loan, mortgage etc. Living a debt free life is obviously better, but sometimes impractical. Everybody has some amount of debt in their financial lives at one point. The idea is not to avoid debt always, but know how to manage it.
An important tool of personal finance is debt management. Whenever you take on debt, there should be a tool to guide whether that debt makes sense or what is the timeframe or payment to manage it with ease.
For example, the most common debt is a mortgage. However many people overspend on their housing budget, and the mortgage payment hits them hard when it cannot be managed in the overall cash flow system.
The Debt-to-Income (DTI) ratio is considered by lenders in underwriting but its too narrow a scope, since it only looks at the other debts a person has in addition to the new one sought for. However it does not take into account other financial goals or situation of the person.
Hence the ideal debt to income ratio should be calculated by the individual alone, knowing all his goals and other obligations.
On the other hand, credit card debt should not be allowed to carry revolving balance. The very high interest rates on the balance will snowball into a financial crisis if not managed and if the balance is not reduced to zero soon.
Overall, the following are tools for effective debt management.
- Pay off credit card bills in full every month.
- Pay off car loans as soon as possible. Owning an affordable car in cash prevents one going upside down (amount of loan is greater than the value of the car) on the loan.
- Limit mortgage and all other payments (property taxes, insurance, maintenance) related to housing within 20% of take home income.
- Completely avoid any other form of debt – student loan, store credit, personal loan.
The next useful tool in personal finance is a savings plan.
The confidence in personal finance comes when you have money in the bank.
A savings plan is highly goal oriented and can apply to various situations like emergencies, job loss, vacation, obligations etc.
The best tool for increasing savings is budget for it every month. Any good budgeting tool will provide a way to define goals for savings, and tracking them as money is set aside from the cash flow.
Here are few tools/tips on how to set it up.
- Open a savings account separate from your main/checking account.
- Setup a direct deposit or automatic transfer from checking account to this account.
- Set a goal and once achieved, keep that account untouched until the money is required for the specified goal.
- Open another account for a different goal and repeat the same process.
Money should be invested for it to grow and beat the monster called inflation.
Thus every cash flow planning needs to plan for investments. Just like savings or debt management, regular payments should be setup to an investment account and let the money grow.
One of the vices of investment is it constantly draws attention of the investor to do something always.
Instead, the following simple tools/steps are good enough for most people to build wealth.
- Decide how much you can invest every month.
- Decide on a simple asset allocation – stocks, bonds, real estate, precious metals etc.
- Decide on the accounts which will hold the investments – 401-k, Roth IRA, Taxable and more.
- Setup direct deposit or auto transfers in the allocated proportions to each account.
- Buy the simplest, cheapest and most diverse product in each asset class and let it grow.
- Stocks – Index Funds and ETFs.
- Bonds – Index Funds and ETFs.
- Real Estate – REIT Index Fund and ETFs.
- Precious metals – Physical gold or silver if possible or skip this.
- Never sell if possible.
Taxes are inevitable and can only be managed according to the IRS (or your country’s) laws.
Since I am not a CPA, tax advice is something I will avoid.
At a high level, below are the simple tools/methods to follow.
- Hire and consult a good CPA according to your personal situation.
- When in doubt, play safe and declare everything to your CPA.
- Read the basics of taxation rules so that you are aware.
- Use tax advantaged accounts for investments.
- Keep records of every year’s tax return and the documents to prove the basis.
I like this to be the last. But it is never the least.
Instead of a stingy attitude, spending should be seen as what defines our personality and life.
It is important to align the spending with our own values and happiness criteria. For example, if you love something, there is nothing wrong in spending on it but avoid overspending.
Here are few simple guidelines/tools to keep track and enjoy spending.
- Mentally purchase it first. I always imagine I have purchased it and try to justify its usefulness in my mind before I actually go ahead and buy it.
- Wait for a week before buying anything costing over a threshold. The threshold depends on your personal wealth, it could be $100 or $100,000.
- Find the useful lifespan for the purchase. How long will this item serve you right or is it just a temporary fad?
- What are you trading for? Are you sacrificing bigger goals like investing for your retirement or getting into more debt?
Those were all the different aspects of personal finance that need simple tools and habits.
If you can think of anything more, I would love to hear and add to the list.