My friends and family often come to me for advice on personal finance. I am a CPA and have been working in accounting and finance for over 10 years for some of the largest financial institutions in the country.
With the volatility and uncertainty that was brought on with the COVID-19 global pandemic, I have received more questions than usual from my friends and family. As the world changed before our very eyes, the financial situation for many of us changed as well; people lost jobs, retirement accounts took hits, and anxiety about the future grew. And then, the market rebounded while the prospects of the economy remained questionable.
During this time of volatility, I took what I knew about personal finance, and I looked for opportunities; Opportunities to save, recalibrate my investments, revisit my goals, and help my friends and family. Often times challenges give us a chance (or force us) to recalibrate and pivot, and that is what I am hoping to help you do. I also looked at this time as an opportunity to memorialize the information I share with my friends and family, and share with the other like-minded people e.g., those seeking to achieve their financial goals.
I hope this plain English article provides you with the the fundamental knowledge to achieve your financial goals. After reading this article, you should feel empowered to set realistic goals and devise a roadmap to arrive at your financial destination. All it takes is discipline.
The Fundamentals of Personal Financial Literacy
Clearly identify your goal
Is it paying off your student loans? Buying real estate? Investing for the future? Once you have identified your goal, work your way backwards. That is, figure out how you are going to get from your current state, to your identified goal. A favorite example of mine is buying real estate. Identify the property you want.
Work your way from the purchase price of the real estate to the down payment and the monthly mortgage payment. Can you afford this? How long will it take you be able to afford that down payment based on your current lifestyle? How important is your lifestyle compared with financial goals?
Answer these questions. Write your answers down. Post your goals on your cell phone lock screen and home screen. Post your goals on social media. Or don’t. Say them out-loud. Hold yourself accountable. Make a budget. An honest one.
The road to achieving your financial goals commences with a budget that is honest and realistic. A good budget may take months, if not a year or two to build. Now, a budget doesn’t need to be adhered to perfectly. Don’t be discouraged if you exceed a budget item in a given month. A budget is a guide to help you, not make you feel guilty about living your life.
But if you find that you are trending towards spending obscene amounts of money on dining out, drinking, and experiences, then you should think about what is reasonable, and plan your nights out (or take-out) responsibly. Keep your financial goals in mind and distinguish between “wants and “needs.” There are a number of tools to assist in keeping track of your spending on your road towards budgeting. To keep track of spending, consider one of the many free applications available, such as Mint by Intuit, and an excel file.
Budgeting applications keep track of spending in a number of custom categories with easy to follow color coded charts and graphs. Keep track of your monthly spending and saving in an excel budget file. identify budget category fluctuations to determine a realistic monthly amount budgeted to that category.
As you contribute to your budget for a couple of months you can identify where you overspend, and determine if the budget needs adjustment, or your lifestyle does. When we think about a budget, we have to start with three aspects of budgeting.
Fixed costs are costs that you incur every day, month, or year. Fixed costs do not change period to period, hence the adjective fixed. You can not easily change your fixed costs to save money. Examples of fixed costs are your rent/mortgage, daily commute, or monthly car payment. Begin your budgeting process by identifying your fixed costs.
If you have well defined long-term financial goals, you may reconsider your lifestyle. Depending on how you work and commute, the car you drive may be an example of a fixed cost that can unlock savings in your budget. When you think about the car you drive, you should also think about how that car sits idle most of the time while you continue to pay for it, especially with many of us working from home during the pandemic and potentially indefinitely.
Compare your monthly car payment, gas mileage, and maintenance with the cost of other cars. Add up the monthly difference. Think about this number over the life of your car. That can be a real savings. There are many different variables that should be accounted for in this simplified car scenario, but apply the logic here to your other fixed costs.
Variable costs vary from period to period. Variable costs are your opportunity to be smart about your spending and where you can find opportunities to save. Examples of variable costs are dining out, clothes shopping, and entertainment. This is where we need to be honest and disciplined with ourselves. It’s easy to justify going out with friends especially when we are constantly reminded what everyone is doing via social media.
Unfortunately, sometimes we need to say “no” to our friends to achieve our financial goals. Nobody needs to eat sushi 3 nights a week. It’s expensive, and can also lead to mercury poisoning. But seriously, keeping your financial goals in mind can help you stay disciplined about saving and telling your friends you will go out next time.
Again, nobody is saying never go out, just be disciplined and have a “go out” budget. Don’t let me stop you from having a social life just do it responsibly and in moderation and not in pursuit of a perceived life on social media.
Once you have spent a couple of months analyzing what you spend on a month-to-month basis, both fixed and variable costs, you can analyze your seasonal costs. Examples of seasonal costs are vacation expense, holidays (Valentine’s Day, Mother’s Day, Father’s Day), and birthdays. You may find that seasonality will also impact your variable costs.
You may spend more money in the summer months on gas if you drive to the beach often or take a road trip vacation. It has taken me over three years to have a good handle on my seasonal costs, as these are variable in nature and are dependent on a number of factors.
COVID-19 for instance is an example of some seasonal costs decreasing as less people are traveling for vacation. As you prepare your budget and organize what you spend monthly and yearly, you can calculate what you can save during a year. Your seasonal costs will be a subtraction from your annual savings.
Once you have a budget prepared, you should begin preparing your balance sheet (also known as a statement of net worth). A balance sheet is one of the most important financial statements. A balance sheet discloses your assets, liabilities and net worth, and a balance sheet summarizes how financially healthy you are.
If you ever want to buy a house or take out a loan for a business, your lender will ask for your assets and liabilities to review how “liquid” you are, or your ability to pay debts, should you come into financial hardship. It’s best to have a balance sheet prepared in advance of a request; its professional and shows you are confident about your finances.
A balance sheet begins with your assets. Assets should be listed in the order in which they can easily be turned in to cash without penalty (current assets), beginning with the most liquid assets. Your checking and savings accounts are your most liquid accounts and are listed first. If you have any investment accounts (401(k), IRA, Brokerage account (eTrade, Robinhood, etc), you would enter these assets next, beginning with your brokerage accounts, because should you come into financial hardship, you could sell your assets to pay your debts.
Assets that are not easily turned into cash without penalty would come next, e.g., retirement accounts (consult a financial advisor or broker before considering liquidating your retirement accounts), automobiles you may own, and real estate. If you are in a pinch for cash, you likely couldn’t turn these assets into cash quickly unless you are willing to receive less than fair market value or incurring penalties. After organizing your assets, the next section of your balance sheet is your liabilities. This is everything you are obligated to pay in the short- and long-term.
Some examples are your student loans, credit card bills, mortgage or rent, organized similarly to the asset of your balance sheet, with your liabilities that need to be paid in the short term (current liabilities) listed first. A lender wants to know what you owe to other creditors before they will approve you for a loan. By looking at your balance sheet, a creditor can get comfortable lending to you because they know you have adequate assets to pay them back should you encounter financial hardship.
Once you have all of your assets and liabilities organized, you can calculate your net worth by subtracting your liabilities from your assets. You have now completed the most important financial statement. As you update your balance sheet over time, you compare period to period and see how your net worth changes. This is the rewarding part of having a balance sheet.
Compound interest can be your best friend or your worst enemy. Compound interest is simply interest on your principal and the interest you have already earned. When you have an asset that pays interest or dividends, and you reinvest that interest or those dividends, your balance will continue to grow exponentially, or compound.
The inverse is also true; if you are carrying a balance on your credit Card and don’t pay it off in full, the amount you owe will continue to grow and can get out of hand. (We will learn more about credit later on in this article.) Read more about compound interest at investor.gov/financial-tools-calculators/compound-interest-calculator. A financial advisor at your local bank branch can tell you more about other options to help you grow your money in the meantime.
Balance sheet optimization
Once you have your budget and balance sheet prepared, you can analyze and optimize your balance sheet. Your budget will tell you where you can cut back on spending on a monthly basis to save money. Your balance sheet will help you analyze where you should put your newfound budgeted savings to use.
As you look to optimize your balance sheet, you should review your debts and determine which debts carry the highest interest rates. If you pay down your highest debts first, you can save on interest expense.
If you have high credit card balances, that is usually the first place to start. Most of all, please use your credit card(s) responsibly. There are huge implications of irresponsible credit card use, the most immediate of which is sky high interest rates.
See below for more information in the section titled “Credit.” We may be tempted to pay off our largest balances first, but we should be focused on the balances that carry the highest rates. If the liability side of your balance sheet is in good shape you can focus on the asset side.
Building a strong credit profile is incredibly important. When you want to buy or lease a car or buy or rent a home, a prospective lender is going to rely on your credit report and credit score (your credit profile = your credit worthiness), not you the person and your story before extending you credit.
Often times, irresponsible credit card usage is what leads to a poor credit profile and keeps us from achieving our financial goals. If you use your credit card irresponsibly, this activity will show up on your credit report. High credit card balances, opening many credit cards in a certain time frame (usually more than five within 24 months), failing to pay on time and defaulting on a credit card will all negatively impact your credit score and show up on your credit report.
Because the credit card company gives you a $10,000 credit limit doesn’t mean you should spend $10,000 and pay it off over time. That will result in sky high interest costs. If you have poor credit, you could face interest rates of up to almost 25% per year! Try to pay your credit card off in full every month and avoid carrying a balance.
Carrying a high balance results in high interest expense and a negatively impacted credit score. There are also benefits to certain credit cards where you can earn money by spending. Yes, you read that correctly. You can earn money from spending; 3% back on gas, 6% on groceries, and 3% on dining for example. But if you don’t pay off your balance, then likely your benefit will be diminished if not eliminated.
There are also options to consolidate your debt with credit card balance transfers that can provide for a favorable interest rate for a certain period of time. I will not get in to any further detail on credit card usage but will refer you to thepointsguy.com and nerdwallet.com for more information, as those are the subject matter experts on credit cards. The bottom line is this; use your credit card like cash. If you don’t have the ability to pay off a discretionary purchase you make with a credit card, reconsider.
Becoming financially literate and achieving your financial goals does not happen in one article. This is your introduction. Your runway. You now have the requisite knowledge to confidently begin budgeting, preparing your financial statements, optimizing your balance sheet, and enhancing your credit profile. As we progress through getting our finances in order and paying off debt, we can begin the next step; that’s putting our hard earned money to work.
“Stable financial position can weather the difficulties we are witnessing” – Jay Clayton, former Chairman of SEC
“Your future is created by what you do today, not tomorrow” – Robert Kiyosaki, author of the Rich Dad, Poor Dad series of books