Posted in Budgeting, Personal finance, Savings

It is not a good IDEA

There are four aspects of personal finance that we deal with every month, unlike taxes and insurance which are typically annual affairs.

  • Income
  • Debt
  • Expense
  • Asset

Thus the I, D, E, A is what one deals with every month – month after month in that same order.

Typically a household finance (or monthly cash flow) goes like this:

Income (I) -> Pay Debt (D) -> Pay Bills (E) -> If left over, invest in assets (A)

The problem is that the IDEA is wrong. It will never make one financially independent as the Asset part is only an afterthought, and mostly never happens.

This requires a correction in perspective and is much touted by financial advisors as Pay Yourself First, where A should come before D and E.

So the IDEAL sequence is I,A,D,E,L.

Income (I) -> Pay for Assets (A) -> Pay Debt (D) -> Pay Bills (E) -> If Left over (L), have fun. 

The last part if consistently found to generate surplus, can also be adjusted for subsequent months to increase the “Pay for Assets (A)”.

How does one do this course correction? Here is one simple technique.

  • You know how much Income comes in. 
  • Decide a percentage (start a bit aggressive, like 20%) to set aside for A. 
  • But do not invest yet, just set it aside to another savings account. 
  • Pay your debts (D).
  • Pay your bills and monthly expenses (E).
  • If shortfall, pull a bit from the A saved aside. 
  • If not, good news. Invest the 20% into assets (A) and enjoy any surplus (L). 

This habit if done over 3-6 months, will build the automatic flow of savings and investment.

The sequence described above has the following automatic advantages.

  • It starts with an aggressive savings goal of 20%. 
  • As one sees the expenses budget drying up towards end of the month, it encourages one to cut unnecessary spending. 
  • The savings is still saved aside till the end of the month, so can be pulled in if needed. 
  • Pulling in the savings every month however has a mental resistance, hence should be difficult to do month after month. 
  • To make it more difficult, put the A into another bank so that the transfer will take some time and effort to execute. 
  • As one adjusts to a comfortable level of savings (A) percentage, it brings in awareness of how the budget and cash flow works. 

The IDEA is not so bad after all, you just need to fit it in the right sequence to work.

  • No coupon cutting
  • No writing down daily expenses
  • Automatic resistance to debt
  • Steady build up of assets. 
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Posted in Personal finance

Five FAQs of personal finance

Throughout my journey with personal finance, and through the mistakes and learning, I compiled a list of Top 5 questions that come to my mind, time and again. 

So I decided to compile these as a FAQ and try to answer them to the best of my knowledge and experience. 

  • Buy vs. Rent
  • How many accounts to have
  • How and where to invest
  • How to save more money
  • How to manage my portfolio

Buy vs. Rent?

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One of the biggest financial decisions in everyone’s life is to buy a house. However there are pros and cons that need to be weighed against renting similar or better homes. There are lots of views and articles on Internet which give both a logical as well as emotional opinion to this question. In my opinion (just another), only You know better whether you are ready to buy a home.

To put it logically from what I know, there are few costs and factors that need to be considered.

  • Save up for a down payment of at least 20%.
  • Consider closing costs, it can easily be in the range of $4000-$5000.
  • Consider any rehab budget if you are not buying a recently updated home. You will pay for it either way. 
  • Aggregate of all monthly expenses of home ownership should be less than the current rent paid. These expenses are: 
    • Mortgage payment
    • Taxes
    • Insurance
    • Maintenance (1% of home value per year)
    • HoA fees
    • Lawn care and utilities
      • if you had paid these apart from rent, you need to make sure the costs are almost identical

Only after you have made the calculation above, and convinced yourself that total monthly housing expenses will be less than the rent, you can consider buying provided there is the cash cushion of down payment and closing costs.

One argument which is floated in favor of ownership is that rents are going to increase per year, whereas the mortgage will remain constant. However please consider that Taxes, Insurance and Maintenance will go up too year after year.

On the other hand, the mortgage will get paid down giving a little more advantage to the ownership since you are building equity and hence net worth.

The other factor is how long you are going to stay in the home to recoup the costs of mortgage interest, taxes, insurance, upgrades, maintenance etc. 

One day (in a few years), you may want to move out and convert this house into a rental.

Will the rental numbers in the area completely cover all the expenses? You certainly don’t want to pay for new house as well part of the expenses for your tenant.

All of these factors should be taken into calculation before making the big decision. 

The following post may help in setting up the calculation, but I suggest do your own homework too. 

How to decide on a purchase – the P.V.T formula

If you are interested in scenarios of managing a mortgage or multiple properties, here are couple of previous posts on the subject. 

The Paid Piper of Hamelin

Don’t twist your ARM, fix it !!!

How many accounts should I have?

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There are many banks and financial institutions who are vying to keep your money, earn fees and lure you into a long term relationship. These marketing flyers and lure of higher interest rates or credit offers make us open many bank accounts indiscriminately.

The more you spread out without a purpose to each account, it will become unmanageable and have overlapping features. There are many cases where people (or spouses after the death of one) forgot about their accounts, and the money lies there idle never to be claimed again.

So bank and brokerage accounts all should be tied to specific goals and purpose in your regular financial picture. Typically the following should suffice:

  • A checking account and a debit/credit card
  • A savings account, if more than one, each should be for a specific saving goal
  • A retirement account (typically 401k or IRA)
  • An investment account (outside the 401k/IRA for medium term investments)
  • A special purpose account depending on needs
    • 529 – Kids’ education
    • HSA – Health Savings Account if you have high deductible insurance

Beyond this, it becomes fancy and unmanageable.

The following post shows a step by step guide to open and manage these accounts.

The Starter Kit

How and where do I invest?

One of the main hurdles of personal finance is to find out how and where to invest. There are many risk-return trade-offs from cash savings to mutual funds to real estate, and even exotic investments like art and commodities.

The simplest investment however is a balanced indexed fund, where there is an automatic asset allocation of stocks and bonds and which can vary according to your age and risk tolerance. These are also called Target date funds. Being an index fund, the costs are extremely low (0.0x%) and you get instant diversification.

Most portfolio should not need more that this. However if you are a little bit more knowledgeable, then you can create your own basket of index funds. For example, the three fund portfolio is very popular. Here is a good link: Three-Fund Portfolio

One of my previous posts mentions the various investment accounts that you can setup. 

Investing in the High Five portfolio

Know yourself and your investments

How do I save more?

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This is one of the questions which has many different ways of asking.

  1. How do I spend less?
  2. How do I pay myself first?
  3. How do I increase my income?

The answer lies in all of the above questions. You have to do all to be able to save for emergency, goals, vacations and fun.

The topic on how many bank accounts to have, takes into account this aspect. It is very important to build a cash cushion along with your investments and lifestyle.

See below posts on why and how to do this effectively.

One essential comfort zone

Budget – Grow the tree upside-down

How do I manage my portfolio and reach my goals?

black mazda steering wheel
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Managing your investments and financial system may not be a complex or time consuming task. It needs essentially three things. 

  1. Automation 
  2. Tracking 
  3. Learning

The following post describes a step by step process for managing and growing your personal finance system. 

Five components of a personal finance system

All it takes is to first setup the automatic payments and investments, then a weekly tracking mechanism and weekly reading and exploring more.

With time, you will start flowing like a pro. 

Shun that perfection

Conclusion

While the list of FAQs above is not exhaustive, these are questions that I have seen people struggle with or make irrational decisions on. Or to put it another way, I have done same mistakes and learnt that if you manage these aspects well, you don’t need to worry any more. 

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Posted in Budgeting, Investing, Personal finance, Savings

The Starter Kit

If you are just starting off with organizing your personal finance, or restarting from scratch, here is a step by step way to get started.

Most of the times, we get started haphazardly, the first account in the local bank or the ad-hoc insurance policy or even the next stock tip forces us to open a  brokerage account.

However there is a need to get started in a more planned way.

When I moved to the US couple of years back, the below is how I setup my money system. I had a similar one running in India for a long time and it has given me very good results.

Here is the starter kit that you need to get organized and get started. 

Since it is built in a systematic manner, it will help you automatically organize and keep your finances in order.

A checking account

This is the first step as you need a place to deposit your income, be it direct deposit from your employer or you get checks at the end of the month.

Get a simple checking account at a Credit Union which provides you with a basic ATM and Debit card. Try to find a credit union or bank which has very low fees. Obviously they will have some like overdraft fees that we will anyway avoid, but others like ATM access are something unavoidable, so shop around a little.

This is where all your income will come in and get deposited. 

A credit card

We are going to be responsible spenders, right? If not, do not get this and use your debit card from your checking account.

The key to being a responsible spender is to make a budget, stick to it and pay off the credit card bill in full every month. Lets just assume you agree to all of this. 

There are many credit cards in the market with various features like cash back, travel rewards etc.

As a starter kit, you will just get one from the same bank or credit union where you hold your checking account. The reason is ease of payments and setting up automatic transfers from your checking account to pay it off at end of month. 

The bonus will be of course if  the card also has generous cash back benefits or other similar perks. But get a free one and not one with annual fee loaded just for extra perks.

The credit card will be your main expense vehicle. It gives you automatic fraud protection, insurance and easier account tracking. 

Budgeting

If you do not do any further, you have setup the very basic system. You earn money which get deposited into the checking account, you spend with your credit card (on a budget!!) and your checking account pays it off every month.

But this sounds like living paycheck to paycheck or Living on the Edge, right?

We are going to do better – save and invest. 

First what we need is a planner. As the above system of checking account and credit card gets working in a flow, you will start getting an idea of how much you are spending every month.

For the next 2-3 months, track your spending to categorize your money into only 4 parts.

  • Food and Dining
  • Utilities and Transportation
  • Clothing and miscellaneous
  • Surplus

You will automatically get motivated to squeeze the first 3 categories and increase your surplus every month. 

Check out this post on how to budget: Budget – Grow the tree upside-down

The above technique will help you generate surplus for both savings and investment, make it your goal to only increase it and not fall back to paycheck to paycheck cycle.

Savings Account

There are unexpected events or expenses that will always come up. You need to be prepared for it and the only way is to build up a cash cushion.

One essential comfort zone

This is similar to Dave Ramsey’s first 3 baby steps, where you start with saving $1000, then get out of debt (hopefully you have none if you started with this) and finally build a cushion of 3-6 months of expenses.

I use an online savings account like CapitalOne 360, Ally Bank or Synchrony. There are many others, and online banks provide little more interest on your deposits than brick-and-mortar banks, or the one where you have your checking account.

Setup an automatic transfer of your Surplus from your checking account to this Savings account. Set this up for beginning of the month, so that your budget works with just the right amount needed (to pay off the credit card at end of month). 

Investment Account

Get to this step only when you have a running budget, able to generate surplus consistently and stacked up 3-6 months of expenses in your savings account.

From here on, you become a pro in personal finance as you are about to invest and grow your net worth. 

There are two main investment accounts, a retirement account and brokerage account.

Contact your employer for a 401k (Pretax or Roth) account and contribute to it, if there is a match. If this exhausts your projected surplus, no worries you have got started.

If there is still surplus, good news. Open a brokerage account in one of Schwab, Vanguard or Fidelity. Preferably open a Roth IRA account if your income is within eligible limits.

Roth IRA rules

Then invest in one or two broad index funds with very low expense ratio (< 0.05).

Here is a classic 3-fund portfolio from Vanguard index funds.

  • Vanguard Total Stock Market Index Fund (VTSAX)
  • Vanguard Total International Stock Index Fund (VTIAX)
  • Vanguard Total Bond Market Fund (VBTLX)

Similar portfolio can be constructed from Schwab Funds too.

https://www.wallstreetphysician.com/three-fund-portfolio-using-schwab-index-funds-etfs

Managing and growing the investments

You have done a great job in the above steps and at par with average disciplined investors.

In investment world, “average” is what wins. If you get average returns of 8-9% over a very long time (decades), there is nothing more you need to do. 

To know how to structure and maintain your investment accounts, read this blog post

Investing in the High Five portfolio

Conclusion

The above is a simple 5-step process to take you from a personal finance newbie to a disciplined investor and saver. Taking action in a systematic way is the key to financial bliss.

If you need motivation to get started, read this:

Shun that perfection

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Posted in Personal finance

Shun that perfection

One of the lessons we learn in our early childhood is to be perfect in whatever we do. We were told if you are not perfect, you will not be able to compete in the real world. 

While it may be true for some disciplines like music, medicine and mathematics (the only subject in our times in which we could score a perfect 100/100), personal finance needs an opposite attribute.

There is nothing perfect about investments, budget and savings.

Things change rapidly like the stock markets fall when a leader in some nation sneezes, or unexpected events in life happen.

While the perfectionists among us keep waiting for the sun, moon and the earth to align to begin to invest or budget. Some of the common quotes which I am guilty of uttering at many times in my financial life.

“I will invest once I get the next raise” – when and who guarantees that today?

“I will save from next fiscal year” – hello, which fiscal year and which month does it start?

“I am too scared as the markets are going down”  – which means I will invest when they are up, exactly at the wrong time.

The end result is that the perfectionist gets a perfect ZERO in his/her investment and savings goal. 

You have to unlearn the perfections and not apply them at all in personal finance.

What is important is to get started and be consistent. 

Anyone who has not yet started or planned own finances should do this in below 3 steps.

  1. Budget – Keep it simple by following the methods described in : Budget – Grow the tree upside-down
  2. Invest – Slowly build the 5 account portfolio. Start today with at least one of the accounts : Investing in the High Five portfolio
  3. Save – Save for your important goals even if you allocate just $50 to one goal today : One essential comfort zone

Perfect plan? Now execute it imperfectly by just getting started.

Write one goal each of budgeting, saving and investing for this week. 

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Posted in Savings

One essential comfort zone

There is one cushion or comfort zone that you don’t want to get out of.

Everyone knows the importance of saving that cash. No I am not saying investing but just plain boring savings in a savings account.

Sometimes this is done as a byproduct of spending less in a month, which means there is some surplus left after you pay yourself and pay your bills, including the credit card.

However this surplus does not stay for long, as invariably next month it gives you a good feeling and you say “what the heck” – I spent less last month, so let me overspend a little this month. Hence it just disappears in next month’s bills.

Like investing, it is important to plan for savings too. The cash required to be saved is for various reasons, like a rainy day, home maintenance, car maintenance or even bills to be paid at the end of the year such as insurance and taxes.

According to Dave Ramsey, you should be in a position to pay cash for everything, except for buying a house or investment property.

How to build the required cash cushions

The blog post on budgeting talks about how you can partition your paycheck to investing, expenses and savings.

The savings part can be divided into four important goals.

  1. Emergency Fund
  2. Maintenance Fund
  3. Obligation Fund
  4. Leisure Fund

The Emergency Fund

This is for that unforeseen day when things will go wrong despite your best efforts to prevent them. It can be medical emergency, job loss, the damaged roof or the HVAC stopped working. These all can be high valued expenses, and if there is no reserve it will cause much financial distress and debt.

The general notion is to maintain 3-6 months of expenses in a savings account.

Since this money is not intended to be spent in short term (and as long as there is no real emergency), there are two important aspects.

  • The savings need to be in a separate bank account than your normal day to day checking account. In fact, it is best kept in an online money market savings account (FDIC guaranteed) to earn a little more interest than a plain vanilla savings account.
  • It should be difficult to access that account for day to day expenses and should require a special trigger (a real emergency) from you to transfer funds back to your regular checking account.

Just like pay yourself first, keep transferring a quarter of your savings goal to this account every month, till the 3-6 months reserve is built up.

The Maintenance Fund

This is the catch all maintenance reserve. It is important if you own a home or car, or even expensive gadgets that will require maintenance.

This account can be maintained in a separate savings account but in the same institution where your checking account is, so that small maintenance tasks can be serviced easily.

You should be able to move funds in a matter a seconds from your maintenance savings account to the checking account, to pay for repairs etc. or pay the requisite credit card balance arising due to the maintenance expense.

The Obligation Fund

The Obligation Fund is actually part of your expenses but not monthly paid out. There are those bills that hit us at the end of the quarter or year, for example HOA bill, Property and Income Tax, and Insurance premiums.

It is a good idea to pay as much of your bills every month, but in some cases you may get a good discount paying it for the entire year in advance. I mostly pay the car insurance and home insurance (bundled together with one provider) annually to get a special discount.

This requires me to save up for the next year’s premium in advance. The best way to build these savings, is to divide the expected amount by 12, and keep stashing away as if you are paying a fixed bill every month.

This account can be maintained in yet another separate savings account than your checking account. Or better is to save this in a money market savings account since you know when exactly you need it, and it can accumulate some interest in that time.

The Leisure Fund

The Leisure Fund is the one which helps you save for vacation, indulgence, or plain simple fun spending.

It is same as an Obligation Fund – think about it as an obligation to yourself.

For me, visiting India every summer is a priority and hence a part of this fund is allocated to save up for the expensive airfare.

This account can be maintained in a money market savings account since you know when exactly you need it, and it can accumulate some interest in that time.

Conclusion

In this post, I have presented a simple plan how to be prepared for unforeseen events and short term obligations.

Action

Automating the bank transfers from your main checking account will build these savings in no time. Also as you spend according to the purpose, the automatic transfers help keep replenishing the savings month after month. 

Here are some recommendations for bank accounts for the above 4 savings goals. I personally use the Capital One 360 Savings and Money Market accounts.

Best Online Savings Account – Top 10 Banks to Start Making Interest Today!