Personal Finance Basics
by David Berky
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The
subject of personal finance is very broad, but as a beginning, I would
like to discuss what I consider the foundations of personal finance:
Security, Stability, Growth and Protection & Management.
Security
Security
to me means that I am prepared for the "hit by a bus"
scenario.
I
have life insurance to provide for my wife and children. Health,
disability, auto and home insurance policies also provide me additional
protection in their respective areas. I also have a list of where these
policies are, who my agents are, phone numbers and basic policy
information (account numbers, amounts, costs, etc.) I keep this
information both in a file at my house and in a safety deposit box at
the bank (a friends home will also work - think: "house burns
down" scenario). Also my wife and my brother and sister-in-law who
live nearby also know where these things are.
I
also try to maintain an emergency fund of cash in a bank account or
money market account (with checks) so that I am prepared for a financial
disaster, layoff, or natural disaster. It took several years to build up
this cash fund. I started with a goal to have enough cash for 6 months
of my normal financial needs (mortgage, food, insurance, transportation,
etc.). Now I am trying for 12 months' worth. I do this by saving a
little each month, and "investing" a portion of all
"found" money (gifts, inheritances, tax returns, anything
unexpected).
I
have a will and update it each year around New Year's to reflect any
changes in my life during the past year (new children, new home or
business, etc.). Most people don't need an extensive will, the forms you
buy at your office supply store will do. But in some states if you die
without one, watch out. What happens to your money and even your
children could be entirely up to some state or court appointed official.
Stability
The
next level of personal finance is stability.
Stability
to me means that first of all I live within my means. I don't spend more
than I earn. Otherwise I am spending my savings, investments, emergency
money, or getting into debt. I have a lot of debt, but most of it is
real estate which is producing some income. I try to avoid credit card
debt and purchase everything with money I already have. I don't buy
things expecting that next month I will have more money or I will get a
big raise or promotion. You can't sell me a car based on a monthly
payment amount; I want to know the final price!
In
order to make sure that I am living within my means, I created a simple
budget and I track my expenses using Simple Joe's Expense Tracker. I can
tell how much I have spent in each budget category and I know when to
keep a closer eye on certain types of expenses, or when and where I can
cut expenses and what I can live without in order to stay within my
budget. Counting pennies is pretty tedious, but tracking where the
dollars go can be eye-opening.
Another
aspect of stability is avoiding or eliminating debt. Debt in itself is a
form of stability; you always have to make those payments until it is
all paid off.
Some
recent reports show that the average American is $7,000 - $20,000 in
debt. Most of it is consumer debt: credit cards, store accounts,
rent-to-own, auto loans, etc. And those types of consumer debt usually
charge a higher interest rate than any savings account, CD, or money
market account; even more than most high-flying risky investments.
This
means that $1,000 in debt at 18% is costing you 9 times what your $1,000
savings account at 2% is producing. Consumer debt is a dangerous spiral
that is very hard to get out of.
The
first problem is, as mentioned before, living within your means. Don't
get further into debt to support an extravagant lifestyle. Or even if
you are frugal, if you are using credit cards and debt to finance your
purchases, you either need to stop purchasing luxury items or find a way
to increase your income to support these purchases/payments.
You
may even have to lower your standard-of-living because you have racked
up considerable debt and need to free up some money to pay it down. But
don't wait to start. Those minimum payments are often designed to keep
you paying 18% interest for 40 years! That's longer than most home
loans. You could even end up paying more than 10 times the original cost
of the item just in interest payments. Is that new stereo really worth
that much?
To
help people get themselves out of debt we created the "Pay Off My
Debts" tool in Simple Joe's Money Tools. It is also available as a
stand-alone product called Simple Joe's Debt Eraser. These tools help
you create a Rapid Debt Reduction Plan which shows you how much to pay
on each debt each month in order to save as much on interest charges as
possible and pay off your debts as soon as possible.
These
tools can help you systematically eliminate your debts whether you owe
$1,000 or $100,000. The key is to start living below your means and
start focusing on paying off your debt.
It
doesn't make much sense to be worried about whether or not your 401k
earns 8 or 9% this year, if you are paying 21% on your credit card debt.
A
third aspect that starts in the stability category and transcends to the
next personal finance level, growth, is the concept of investing in
yourself. By this I mean spending time to educate yourself in personal
finance matters, as you are doing right now and spending time gaining
more knowledge and improving your skills or even developing new ones.
As
an employee, this can have a direct relation to who gets laid off during
the next round of cutbacks. If you have some skills or have demonstrated
some abilities that are not possessed by your co-workers and these
skills make you a more valuable employee, you are less likely to get the
pink-slip.
Also
while you are making yourself more valuable to your current employer,
you are also making yourself worth more to future employers. It is much
easier to land a job if you have some special skills that are in high
demand or even if you bring some special knowledge or experience that
you fellow job-seekers may have overlooked or failed to invest in.
Being
in the computer industry, I have to spend hours each week reading trade
magazines, exploring web sites, and reading emailed newsletters to keep
abreast of what is new in my field. If I stopped learning just five
years ago, I would have missed out on the Internet revolution, email,
web sites and the majority of the income I now enjoy.
Keeping
myself informed and up to date takes time and resources, but it helps me
protect my current income and expand my skills to help me earn income in
other areas. This increases my stability by allowing me to not have to
rely on one client, employer or source of income. A chair with four legs
will always be more stable than a stool with only three.
Growth
The
next level of personal finance, as I alluded to before, is growth.
Once
you are secure and stable, you can begin to think about building your
wealth. Not that you have to figure out how to become the next Bill
Gates or Warren Buffet. But you have to start building the
"nest-egg" that you will rely on when you retire.
And
don't think that Social Security has you covered, or that your 401k will
grow back to what it was a couple years ago. Or that your current
employer is going to re-institute the generous pension plans of
yesteryear. 401ks are much cheaper to administer and you, the employee,
take the hit when the market goes down, not the employer.
My
father is nearing retirement age and I think he has a good plan. He has
done some research and estimated what his expenses are going to be when
he is retired. He then took a look at his potential sources of income
during his retirement.
He
figured that Social Security would cover about a third of what he wanted
to live on. Only a third! And he has worked his entire life. Would you
like to instantly have to live on only one third of what you currently
make? Retirement is suppose to be the golden years, so where's the gold?
Luckily
throughout his career, my father has worked for companies that have had
pension plans and he had worked long enough at each company to be
eligible for some pension money. This is rare these days because today
the average worker will change jobs and companies at least five times
during his/her career. Also, as I mentioned before, companies are
switching to lower cost 401k plans that do not guarantee you any fixed
payments.
In
my father's situation, his pension money would cover another third of
the retirement income he wanted. So now he had to either figure out
where the last third was going to come from, or start cutting out
expenses during retirement, like not visiting his children so much. None
of us liked the sound of that.
So
my father started learning about the stock market and investing in
stocks and mutual funds. He made a plan for growing his wealth and then
educated himself as to how he could accomplish his plan. I wish I could
say that he is doing better than he is, but luckily he has some time
still to put his plan into action and ride out any market downturns. (He
can do this because he has the security of insurance and emergency
money, and the stability of little debt and a strong set of skills.)
By
learning about how stocks, bonds, mutual funds, index funds, options,
futures, commodities, real estate and other financial tools work you lay
the foundation for growing your wealth. You may start with just $100 in
a bank CD, but as you learn more and become more sophisticated, you can
invest in more and more opportunities.
You
will learn about how risk and reward are related, that as the risk
increases so does the size of the potential reward. Just like at the
race track, you'll make more on the long shot, but the odds are against
it. Also you can learn how to tilt the odds in your favor and protect
yourself against risk.
For
those who are just starting out in the growth phase or who want to
dabble a bit before completing the other levels of personal finance, my
suggestion would be to look into index mutual funds. Especially no-load
index funds (no initial/sales fee).
These
funds are made up of the same stocks that make up the popular market
indexes like the Dow Jones, S&P and NASDAQ100. The costs are low
because management is simple and as a mutual fund you can invest a
little at a time. Also they are easy to follow since you see them on all
the news shows and in the newspaper.
Protection
and Management
The
final level of personal finance is the protection and management of your
wealth. Most people never develop wealth enough to need this level. But
some of the concepts can be applied to any amount of wealth you possess,
$10,000 to $10,000,000.
Part
of the protection harks back to your will as we discussed on the first
personal finance level: security.
With
any significant wealth or valuable asset (your home, car, heirlooms,
401k, IRA, business, etc.) you will want some way of disposing of that
asset upon your death. Whether it is go to go your family, favorite
charity, or local church, if no one knows about it, "it ain't gonna
happen".
As
you start to accumulate wealth in excess of $350,000, you may want to
consult an attorney about creating a trust. A trust is an entity that
can own property and pass that property to anyone you name in your will.
Usually the trust is designed to provide income to children from the
assets that are placed in the trust.
The
trust can survive you so that your assets and income may be passed on to
your children or next-of-kin without excessive taxation and legal
entanglements. Some states will take up to 55% of your assets as taxes
when you pass away.
Protection
also relates back to insurance. Now it may be time to look at a
multi-million dollar umbrella policy that will protect you from lawsuits
designed to part you and your wealth. You may now be a bigger target, so
purchase a suit of armor.
The
management aspect comes into play where you may start to concern
yourself with taxation, ownership, distribution of income and possibly
endowments to charities or other non-profit institutions.
You
may hire a person or company to manage your wealth, or you may choose to
do it yourself. Most people who have earned their wealth through the
"sweat of their brow" have already become adept at managing
their assets. Some continue to personally manage their wealth because of
the enjoyment or challenge it gives them.
Others
are ready to turn it over to a trustworthy manager (who only gets paid a
percentage of your increase) and travel the world, or sit on a beach and
count the waves.
Whatever
your dreams for retirement (and why wait until you are 65),
understanding the different levels of personal finance and spending the
time and resources to educate yourself will pay off whether you live
next to Bill Gates or Homer Simpson.
Keywords: personal finance david berky simple joe
About
the Author
David Berky,
dave@simplejoe.com
http://www.simplejoe.com
David Berky is president of Simple Joe, Inc., a marketing company that
sells simple software under the brand name "Simple Joe". One
of simple Joe's best selling products is Simple
Joe's Money Tools - a collection of 14 personal finance and investment
calculators.
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