LISTEN: For Those Just Getting Started (mp3audio) (13:30 min)
Suppose you have just secured your first “adult” job, or just gotten married, or just decided to put down your Xbox and get serious about your financial affairs. Where do you start? Where to start with financial planning?
Well, it depends on where you are. If you have three student loans, a maxed-out credit card and a minimum-wage part-time job, the steps are different than someone who has already staggered into steady employment, a mortgage and family. Still, no matter what your individual circumstances are today, there are some time-tested fundamentals that apply to everyone’s situation. Successfully implementing these steps will almost guarantee positive financial outcomes in your future.
Establish a good recordkeeping system. Even though almost every financial transaction in our lives comes with a paper trail, very few people take the time to follow it. Indeed, the only financial statement most of us assemble is our annual income tax return. Consequently we make many financial decisions in a fog of uncertainty. Sometimes we think we can afford it, other times we can’t see how to make it happen. If you don’t know where you are, you will have a tough time figuring out where you want to go, and how to get there.
The biggest perceived recordkeeping challenges for most people are the time required to track their finances and the complexity of the process. But these issues may be overstated. A good record-keeping system doesn’t necessarily require a personal-finance computer program with lots of data entry; your situation might be addressed simply by sorting receipts and statements once a month. And no one said you have to do it all yourself. A lot of us would benefit from retaining the services of a bookkeeper or accountant. After all, you pay a doctor to monitor your health and a mechanic to take care of your car. So why not get some expert assistance to check your finances? It doesn’t have to be a do-it-yourself project.
Save first. All wealth-accumulation strategies, large or small, simple or complex, start with the same prerequisite: You must have excess capital. If you are serious about wealth-accumulation you will have to get serious about saving. And the most efficient way to save money is by saving first – i.e., making saving a priority that comes ahead of any spending or consuming. (Saving first is also a simple way to budget. Once you’ve met your saving priorities for the month or pay period, all the remaining money is available to be spent. It’s a simple, yet effective approach – and requires a minimal amount of recordkeeping.)
How much should you save? The simple answer is as much as you can. But “as much as you can” is a fuzzy number, and most of us do better with specific targets. Aim for saving 15% of your after-tax income. For most people, consistently saving 15% of after-tax income will result in significant long-term accumulations. If a 15% target is too high for your current circumstances, start lower and work your way up. But whatever you do, save first. Regular saving can offset or overcome many other financial missteps.
Build a liquid emergency fund. Many financial experts recommend establishing a cash reserve to satisfy three to six months of living expenses. This money is readily available to handle unexpected occurrences such as interrupted employment, medical expenses, major auto and home repairs, etc. Besides avoiding potentially costly borrowing expenses, a cash cushion makes it possible for regular long-term saving and investing.
Carefully study long-term wealth accumulation strategies. As you are building your emergency reserves, take time to consider and learn about what vehicles you might like to use to accumulate wealth. Do you want to invest in stocks and bonds? What about real estate, or owning a business? Many of these options have long time horizons and/or require substantial investments. Some, while offering the potential for greater returns, aren’t very liquid. The financial media may tout products that work for “everyone,” but you might be surprised to find the best fit for your situation is something completely different.
Because the objective of your plans is accumulation, some of the more pertinent issues involve taxation*. How will your gains be taxed, and when? Will they be considered capital gains, or regular income? A big question: when will the profits be taxed – now or later? Often, many people slide into the default options placed before them (like the company 401k), without considering these issues.
Define your parameters for borrowing. There are legitimate reasons to borrow. There are also plenty of financial institutions willing to extend credit for all sorts of other purchases; in America, it is obscenely easy to get in debt.
What are legitimate reasons to borrow? Here’s a simple standard, but one that few people follow consistently: Borrowing should be used to acquire assets with the potential for appreciation. Using this rule, taking on a mortgage to buy a home would qualify as prudent borrowing (depending on the property). And borrowing for a college education seems to fit too, if the degree increases your earning potential. Taking on debt to purchase or establish a business makes sense in this paradigm as well.
But what about automobiles? A car is an asset, but most don’t appreciate in value. The end result of most automobile transactions is a used-up car, not an appreciating asset. For people who are just starting to get their financial life on track, the financial reality is that most big-ticket necessities (like automobiles and home appliances) will probably require financing. But just like your saving needs to progress upward over time, your borrowing should track downward. However, even as their incomes increase, many people also proportionally increase their debt. Why? Because they can afford the payments, and don’t have an understanding of the “opportunity cost” of their debt (see the article on opportunity cost).
Embrace insurance – and get the right kind. Insurance is so pervasive in our financial universe that many people do not consider it part of their wealth accumulation plans; rather, it is considered a regular monthly expense, like groceries and utilities. But if you intend to accumulate assets, insurance is the most financially efficient way to secure and preserve those assets. It makes no sense to invest time and effort on wealth accumulation then neglect taking steps to protect the fruits of your hard work.
Some types of insurance, like auto and homeowners, are virtually mandatory; either the lender or the state requires the coverage. But don’t assume that what is required is all you need. If you are paying the premiums, the insurance should protect your interests as well as the bank or the government.
Your ability to earn an income and create wealth is arguably your most important asset. Considering the importance of your human capital, one of the smartest things you can do when you are starting out is to insure yourself by securing disability and life insurance coverage.
According to a Social Security Administration Fact Sheet from January 31, 2007, three in 10 workers entering the work force today will become disabled before retiring. While Social Security provides a minimum level of disability income insurance, under most circumstances, SSA benefits will most likely not be sufficient to preserve your wealth. Especially if you are engaged in a professional occupation (with potentially high long-term earning potential), you should consider personal disability income replacement insurance.
Likewise, many individuals “just starting out” would be well-served by obtaining at least $1 million in 20- or 30-year term life insurance with conversion privileges. If you are young and reasonably healthy, the premiums will never be lower, and the underwriting will never be more favorable. Buying life insurance now not only provides immediate protection to those dependent on your earning capacity, it also ensures you will have the option of using life insurance later – in various forms – to further enhance or protect your financial assets. Waiting to buy life and disability insurance until you are sure you need it is a dangerous game; you have no guarantee that you will be healthy enough to qualify for the insurance when you realize how much you need it.
Are there other “basics” to consider when you’re just starting out? Maybe. Among the items most likely to be recommended, some financial commentators might push for establishing a will and trust. (It’s a valid concern – especially if you have assets and children.) Others might emphasize starting contributions to a retirement plan as early as possible to take advantage of compounding over a long time period. (This idea is really an offshoot of saving first, and a specific item to consider when determining your long-term wealth accumulation strategies.) But honestly, if you do a good job with the actions listed above, your “start” will be better than the lifetime financial results of many Americans.
The very best thing you can do? Get started today. If you were to ask people you know who have achieved a degree of financial success and stability, almost all of them will say, “I wish I knew then what I know now…and I wish I had started sooner.”
By the way… while you are ultimately responsible for getting started and establishing a sound financial life, it doesn’t need to be a do-it-yourself project. The financial service industry exists to provide products and services to make your financial objectives possible. If you want to keep good records, save first, build a cash reserve, borrow prudently, get the right insurance and develop long-term accumulation programs, this is the place to go for assistance. Ask some of those friends who’ve already made financial progress to refer you to their financial, tax and legal professionals and get the benefit of expert knowledge and experience.
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*(Disclaimer: we do not offer professional tax or legal advice. Please consult your legal or tax expert for advice on your particular situation.)