Statements
Create and use a personal financial statement. It’s your best financial tool. A financial statement shows your financial condition. Wouldn’t you want to know? Businesses routinely use financial statements. Yet financially responsible individuals need a picture of their finances, too. A statement gives you that picture. Personal finances can take twists and turns and show trends that might not be apparent without a financial statement. Don’t you want to know if your savings and investments are trending up or down? If your debt is growing or shrinking? If your emergency fund has dwindled? If you’ll have enough money left at the end of the month to pay the mortgage or rent?
Complexity
You especially need a personal financial statement because your personal money management can be surprisingly complex. There’s more to it than meets the eye. On the debt side, personal finances typically involve not just revolving credit-card balances but also short-term debt like vehicle loans and long-term debt in the form of home mortgages and student loans. Managing your debt portfolio can be harder than it looks. On the asset side, you may have not just substantial personal property including motor vehicles, recreational items, and household goods but also real property in the form of a home, cottage, land, or rental property, and brokerage and retirement accounts. That’s a lot to manage. Get a good picture of it with a personal financial statement.
⤠ Riches distract from more important things. ⤟
Monitoring
Personal finances are not only complex. They are also significant. Your money management influences your ability to meet both basic needs and critical financial obligations. With money, timing is everything. Addressing obligations and seizing opportunities early or late can make big differences in the short run and long term. Five or ten years can pass swiftly, never regained, with your money headed in one direction or the other. Because you need to manage your money consistently and timely, you should be recording and tracking your personal finances. Write it down. Write it down. And write it down again. Update and evaluate your personal financial statement at least quarterly.
Pictures
To manage your money meaningfully, you need not one picture but two pictures. You first need a view of your immediate situation so that you can daily answer the question of whether you can afford an expenditure. That picture is called a budget, also formally known as a cash-flow statement. It shows you the flow of your cash before you spend it. Yet you also need a second view of your big financial picture. You need to know whether you are ahead or behind, an increasingly secure property owner or instead a struggling debtor. That picture is a balance sheet, also called a statement of assets and liabilities. Consider each statement in turn.
⤠ A good crop yields a hundredfold. ⤟
Budget
Your cash-flow statement or budget estimates your monthly income and expenses to ensure that you can sustain your daily finances. You need to keep the right balance between your income and expenditures. The balances in your checking account and on your credit cards only hints at that picture. Account balances do not show your patterns and prospects. You may feel you are doing all you can to pay off debt and increase savings. Your budget might show otherwise. You may believe that your restaurant, entertainment, or clothing expenditures are reasonable. Your budget might show otherwise. Your budget reflects your anticipated income and expenses by category, giving you instant insight into every dollar flow. What are your money’s source and destination, and how do the two compare?
Decisions
The point of your budget isn’t to chain you to a rigid program. It is instead to help you make informed decisions about spending and saving. Advertising floods us with opportunities to spend. Food, entertainment, clothing, recreational items, and everything else that money can buy are at our fingertips, a tap and swipe of the cell phone away. Life isn’t all about denying pleasures. Spending money can enhance experiences. Yet every time you hike with friends on a local trail or read a book instead of spending $100 on a concert ticket or $5,000 on a vacation, you are better positioned to deal with unforeseen financial emergencies, increase your savings, and come closer to financial freedom. A budget helps you decide when to save and when to spend.
⤠ Wealth deceives, concealing truth. ⤟
Variation
A budget also helps you track variations in your income and expenses. Cash flow in and out of your budget may seem to you relatively fixed. Think again. Cash flow is instead often highly variable. Income can include wages, interest from savings, dividends or gain from investments, and money from selling vehicles, furniture, or a home. Some income is relatively fixed, such as salary at a primary job. You may control other income by, for instance, taking overtime if paid hourly, taking a second job, or selling things you own. Expenses are likewise both fixed, for housing, transportation, and food, while also discretionary expenditures for travel, entertainment, and investment. A sample budget appears below, based on median household data.
[Table omitted. See the print guide.]
Taxes
Your budget should, for instance, help you account for taxes. Taxes take a bite out of income, as the above budget shows. Employment taxes come off the top. You never see them. Your employer withholds them and pays them directly to the government. By contrast, you must budget for self-employment taxes, which you pay quarterly out of your retained income. Either way, though, you must pay taxes. Just because you receive a nice big deposit in your checking account doesn’t mean that it’s all there to spend. Tax savings, investment planning, and other savings within a thoughtful and faithfully executed budget can make you financially independent years earlier. It can also reduce your retirement age by years.
Erin had just to keep a written budget. She had always just relied on being stingy with money. Gradually, though, she realized how wrong stinginess can both look and be. Erin needed more confidence in where she spent and where she saved, to be able to say both yes and no to spending, with sound reason. While her first try at a budget was pretty far off, she found after another month or two that her budget actually worked. She was learning that she could say yes in some places she had been saying no but should say no in a few places she had been saying yes. Soon, she was wondering how she had gotten along without a budget.
Rates
Smart money management involves accounting for tax rates. Tax rates vary. Federal income taxes increase as income goes up. Whether a taxpayer files singly or as a married couple also affects federal income taxes. The tax code provides different rates for single heads of households and for married taxpayers filing separately. Married couples filing jointly pay income tax at significantly lower rates but must combine their income, meaning that their total household income can reach the higher graduated rates more quickly than single or separate filers. A married couple in which only one spouse earns income, or one spouse earns much more income than the other spouse, can gain significantly lower rates than would the same two individuals if unmarried. Married joint filers whose incomes are about the same, though, can incur a marriage penalty relative to single filers by seeing their joint incomes more quickly reach the higher progressive rates. Tax-savings strategies are thus important for both joint filers and single filers with higher incomes.
Deductions
A deduction is an amount by which the taxpayer gets to reduce income before paying taxes on it. The standard deduction is the amount, adjusted year to year, by which all taxpayers may reduce their adjusted income before paying taxes. Filers with minor children or other dependents may receive additional deductions. You get a tax break for having children.
⤠ Guard against your own greed. ⤟
Itemizing
The tax code uses other deductions to relieve taxpayers of a greater amount of income than the standard deductions, in certain situations. Home mortgage interest, local real-estate taxes, and charitable giving are common itemized deductions. If you spend more than your standard deductions on these other special expenses, you may itemize your deductions to save federal income taxes on the money you earned to pay those expenses. The federal tax code also permits itemized deductions for medical expenses exceeding a percentage of your income and certain other qualifying expenses. Do not plan expenditures simply for the tax advantage. But know the tax advantage of certain expenditures. You may, for instance, be able to increase charitable giving because of tax savings.
FICA
Federal and state income taxes are not the only significant reductions in earned income. The Federal Insurance Contributions Act (FICA) adds both a Social Security tax and Medicare tax. Employers pay a percentage of an employee’s compensation into Social Security, while the employee pays an equal amount on earned income, up to an annual limit. Employers and employees each pay an additional amount in Medicare taxes, with no annual limit. Self-employed individuals pay the full Social Security tax and full Medicare tax, paying both the employee and employer portions. Taxes significantly reduce income available for other purposes, making budgeting all the more necessary.
Pat felt good about his sales rep job. He was also confident in how he managed his money. Yet he was growing increasingly frustrated with his inability to make any real progress toward accumulating investments. Taxes were his biggest problem. His paycheck looked tiny after all the tax deductions. He was beginning to feel that as a single wage earner, he stood little chance of doing anything other than treading water. He was also beginning to think that investing would require one of two things, either that he take a second job or that a second wage-earner join him in his household. Frankly, he had far more interest in the latter than the former. Pat was also frustrated that he had no clear tool for knowing whether his overall financial situation was improving or declining.
Balance Sheet
A balance sheet is your other main financial tool to manage your money meaningfully. A balance sheet shows your assets, liabilities, and overall net worth—what you own and owe, and the total of the two. Income enables you to buy things. Some items you consume quickly, like groceries, a taxi ride or airplane flight, or a gym membership or visit to a doctor. Other purchases last, such as a vehicle, house or other real estate, stocks and bonds, artwork, or furniture. Treat items of lasting value as assets on your personal balance sheet. List as liabilities on your balance sheet amounts you owe, such as credit-card debt, student loans, a vehicle loan, or a home mortgage. The difference between assets and liabilities is your net worth. Examine the financial condition of an individual with the following balance sheet, to see how useful the statement is.
[Table omitted. See the print guide.]
Ratios
A balance sheet gives you a snapshot as to where you stand overall. It shows not only your total assets and total debts but also the ratio and balance between the two. Individuals can have few assets and little debt, especially earlier in life. But over time, individuals can accumulate lots of assets but also lots of debt. Individuals can also have any other combination of the two. Generally, you want more assets than debts, meaning a positive net worth. Indeed, all assets and no debt would be even better. Earlier in life, borrowing for education, transportation, or housing may make sense. Yet in time, net worth needs to turn sharply positive, if you are to gain financial stability and security, and plan for retirement and legacy.
⤠ If you’re rich, don’t put your hope in riches. ⤟
Monitoring
A balance sheet lets you track how your net worth is changing over time. Sound money management should result in an increase in your net worth, giving you greater financial security and personal freedom. Poor money management can result in the opposite stress, anxiety, and inability to pursue personal goals. Date your balance sheet. Then update it quarterly, saving the old balance sheet so that you can track your net worth over time. Review your balance sheet quarterly to examine whether you are gaining or falling behind on overall net worth. Whether you are gaining or losing financial ground can help you evaluate marriage, vehicle or home purchases, funding children’s education, developing your business, and retirement planning. Your balance sheet eliminates uncertainty over where you have been, where you currently stand, and where you are headed. You might even sleep better knowing that you are monitoring and managing your finances.
Tools
Together, a budget and balance sheet are especially powerful management and planning tools. Younger individuals often take on substantial personal debt for student loans, vehicles, a home and furnishings, and business start up. Your personal balance sheet helps you track your debt relative to your accumulating assets, showing whether you are gaining or losing. Yet the balance sheet gives little clue as to why you are gaining or losing. Instead, the budget will show your need to generate additional income or decrease personal expenditures to reduce personal debt and increase net worth. Use your budget and balance sheet together.
⤠ Having a lot of things doesn’t mean you have a good life. ⤟
Management
Use your budget and balance sheet to manage your money. Your budget may show substantial income exceeding reasonable expenses. Yet your balance sheet, not your budget, will show whether your savings are meeting benchmarks for marriage, child-bearing, children’s college education, business development, vacation or mission plans, and retirement. Your budget may look great, but if you are far behind in preparing for these important events, then you’ll need to do better. You need both a budget and balance sheet.
Erin and Pat had continued to see one another for lunch and had even had dinner and gone to the movies a couple of times. Then one day Pat emailed Erin asking if she knew anything about financial statements. At first, Erin assumed that Pat meant for work purposes. But Pat’s email reply explained that he was looking for personal-finance tools. Erin replied that she had indeed been keeping a budget but had also just created her personal balance sheet. They agreed to get together over the subject. Erin laughed at Pat’s sign-off that “great minds think alike.”
Fortress
Your budget and balance sheet should help you develop the financial security to manage life’s financial challenges responsibly. The path to financial security is seldom smooth. Job loss, property loss, accident, illness, liability, and turbulence in economic markets can all threaten your finances. You can, though, build a fortress against those threats. A fortress balance sheet has no debt with the exception of a reasonable home mortgage and a substantial reserve fund for living expenses up to a year to two years. Achieving a fortress balance sheet takes time. Limit and repay debt, especially high-interest credit-card balances. Then fund an appropriate reserve. Then add investments.
Choices
Creating a budget and balance sheet confronts you with your financial position and future. Use them to improve your position and future. Now, make wise choices. Use your cash-flow statement and balance sheet to guide you in those choices. For example, your student loans may take years to repay. How should you live to accelerate their repayment? To maximize loan repayment, you should limit consumption, living well within your means. Think of the long-term consequences of each significant financial decision. Living with a roommate, parent, or sibling, and paying cash for everything while you retire debt may be your answer. Short-term sacrifices often mean long-term gain.
⤠ Be rich in good deeds. ⤟
Expenses
Spending less is often the first and best option for improving a personal budget. Budgeting helps you reduce the impact of unavoidable declines in earnings. When you see hard times coming, you can adjust spending and take other actions to avoid financial problems. How do you spend less? Bring lunch to work rather than go out to eat. Reduce coffee and other drink purchases. Fix meals at home rather than go out to eat. Refinance your mortgage at a lower interest rate. Pay off highest-interest debts, especially credit cards, first. And if you’re still short on your budget, sell jewelry, art, vehicles, and other personal assets. If you’re temporarily unemployed, consider unemployment or other welfare benefits.
Cards
When your expenses exceed your income, the money has to come from somewhere. Credit cards are the tempting answer. A credit card is, in effect, a pre-approved loan. Every time you use a credit card, you are borrowing money, usually at an exorbitantly high rate. Thus, avoid credit-card debt like the plague that it is. Credit-card debt often means you are not budgeting, carefully controlling personal expenses. To avoid the temptation of easy credit, keep just one no-fee credit card for transactions that require a credit account, like renting a car or reserving a hotel room. Do not carry a balance month to month. Timely pay your credit-card balance to zero at the end of every month to avoid interest charges. Carrying even a small balance month-to-month can result in substantial interest charges because of the high interest rate and manner credit-card companies calculate average balances. Always pay timely to avoid late fees.
Debit
Debit cards can be a great alternative to credit cards. When your bank offers you a debit card, it is permitting you to withdraw amounts of your own money with each charge to the debit card. Using a debit card is not taking out a loan. You do not pay interest on debit card charges because you do not accumulate a credit balance. Instead, with each charge, your bank reduces the balance of your own money in the debit card account. Some banks offer free debit cards, without any annual or other fee. To avoid the interest charges of a credit card and their temptation to spend more than you should, use a debit card for ordinary cash-free convenience.
⤠ Those who are trustworthy with a lot, you can trust with a lot. ⤟
Data
Financial services industry data shows just how tempting and expensive credit cards are. More than three-quarters of all U.S. adults use credit cards. Credit-card users tend to use more than one card. Adults using credit cards hold an average of 3.5 credit cards. Incredibly, cardholder debt averages over $15,000, with an average 15% annual interest rate. Those figures mean that cardholders pay an average of nearly $2,500 in annual interest. You could think of better things to do with an extra $2,500 per year, like paying off school or home loans, or saving for children’s education, vacations, or retirement. Credit-card debt also brings health effects. The book How to Be Richer, Smarter, and Better-Looking than Your Parents shares studies showing that higher credit-card debt leads to higher anxiety, depression, ulcer, and suicide rates, and less satisfaction with life.
Pat and Erin had each managed to avoid serious problems with credit-card debt. Neither could say the same for their co-workers. Pat had a colleague who confided in him about his tens of thousands of dollars in credit-card debt. Everyone in the office seemed to know it. Yet the colleague’s behavior never changed. Collection actions soon followed, then an employer investigation, and finally the colleague was gone, out of a job and moved to another state. Erin saw similar behavior among some of her co-workers, although their higher salaries seemed to insulate them at least for a time.
Vehicles
After excess credit card debt, the next greatest temptation and easiest way to financial ruin is excess spending on vehicle leases or financing debt. Americans treat vehicles as status symbols, not just for transportation. The book How to Be Richer, Smarter, and Better-Looking than Your Parents reports studies showing that Americans often spend well beyond their means on vehicle expenses, with huge monthly lease or loan payments. Your vehicle does not define who you are. Until you achieve your financial goals, treat your vehicle as transportation, not a status symbol. A $50,000 income cannot support a $50,000 vehicle, whether purchased or leased. Vehicle leases are notoriously expensive, often with high buyouts at the end. Continuously financing or leasing vehicles keeps you on a treadmill of unending payments, eating up your discretionary, investment, and retirement income. Instead, buy lower-cost vehicles with cash.
Reserve
While controlling your debt, you also need to build a cash reserve for emergencies, a just-in-case fund. A cash reserve allows you to meet unexpected events without incurring debt. Use your cash reserve only when you must, for things like an unexpected vehicle repair, emergency medical or dental bill, or if you lose your job. Initially, your cash reserve should equal three to six months of expenses. But your reserve should increase as you age, when it can become harder to respond flexibly to meet emergencies. In your middle years, ages 40 to 60, your reserve should be more like at least a full year of expenses.
⤠ Be generous and willing to share. ⤟
Account
Hold your cash reserve at a bank, preferably in an interest-earning account. Compare interest rates for bank savings accounts and short term certificates of deposit when you start building your cash reserve. Websites provide comparison shopping tools for savings accounts and certificates of deposit. A sure way to increase your savings is to arrange automatic transfers with your bank, from your checking to savings. Make saving your default, forcing you to act in the event that you unwisely decide to stop saving.
It had been a hard lesson to learn. Pat had grown so comfortable with his free-and-easy, man-about-town finances that he had barely noticed the depletion one summer of his small savings and checking account. It must have been the extra travel and recreation that summer. Then, an abscessed tooth and medical bills following a sports injury brought Pat up short. He was out of money. He reluctantly paid the bills using the credit card that he kept on hand for online orders, rental cars, and emergencies. But then, for the first time ever, he was unable to pay the balance to zero when the account statement arrived at the beginning of the next month. The next account statement showed a much larger interest charge than he expected. Pat then needed a few more months to get the credit-card balance back to zero. At that point, he vowed to build and keep an emergency reserve, so that he didn’t fall into that vicious credit-card cycle.
Compensation
You now see how expenses may affect your money management. Yet budgets and balance sheets are not simply about controlling expenses and debt. You have two ways of improving your balance sheet and overall financial situation: earn more or spend less. To improve your personal budget, consider your ability to earn more income. You may be able to earn more income within your current job, either by taking on more hours and overtime if you are an hourly employee or gaining job advancements. You may alternatively be able to take a second job or start your own business on the side. Even if you have limited time and ability to work outside the home, you may find part-time online jobs you can do from home, with flexible hours.
⤠ Be content with your pay rather than extort money. ⤟
Employment
Your current employment may have clear opportunities for advancement. Investigate those opportunities with your co-workers, supervisors, and human-resources personnel. Even if advancement does not appear possible or likely, you may be able to take any number of steps to improve how your employer values your work, placing you in a better position for retention, promotion, wage increases, and bonuses. Consulting firm Altman Weil in Compensation Plans for Firms lists compensation criteria including leadership, management, customer service, client recruitment, increased hours, increased productivity, seniority, quality of work, expertise within a specialty field, teaching, published writing, media work, training, collegiality, teamwork, volunteer service, and professional or trade association leadership. Use these criteria to improve your work value and advocate for compensation increases.
Differentiation
Increasing your current employment earnings may require that you distinguish yourself from your co-workers, based on the above criteria. Often, new employees start with the same compensation. But over time, employers often distinguish among employees in compensation. Employers reward with promotions and pay increases employees whose work is more valuable and whom they wish to retain. Employers also retain higher-value employees in economic downturns, when layoffs are necessary. Some employers also use year-end bonuses to reward and retain higher-value workers. Learn the possibilities of your current employment.
Pat wanted to make more money. It was that simple. He was still satisfied with his sales-rep work, especially its collegial atmosphere. Yet while his co-workers often said how glad they were not to have billing pressure and collection worries like sales reps who ran their own companies, Pat was not so sure. He felt he might enjoy placing a value on his work and having clients pay for it. More significantly, he and Erin were talking about Erin spending more time at home. She was thinking of joining a new company that was splitting off from her old one, so that she could keep more flexible hours and do some work from home. Pat felt that he had better work habits and skills, or at least was more disciplined and productive, than his colleagues. He was pretty sure now that he wanted financial reward for his commitment. But Pat also knew that staying where he was, he would not get it.
Benefits
Employers provide benefits in addition to compensation. Your benefit package may have substantial value. Benefits packages can cost employers an additional 25% or more of an employee’s base compensation. Whatever you are earning in pay, your benefits may be worth another quarter of that amount or more. Healthcare insurance coverage including family plans is often the benefit with the greatest value. Employers typically pay most of healthcare insurance expenses. They may also offer health savings accounts with tax advantages for uncovered healthcare expenses. Many employers also offer dental coverage, although often paying only half or less of the cost, and with a low annual maximum benefit limit. Many employers also offer retirement contributions, discussed in Part I.D. below. Fewer employers offer vision coverage, life insurance, long-term disability insurance, parking or mass-transit costs, tuition reimbursement, signing bonuses, child-care assistance, long-term-care insurance, or adoption assistance. Value employment benefits when evaluating opportunities to increase your compensation.
Checklist
Reflect, research, investigate, and act until you are able to confirm each of the following statements summarizing the advice in this section:
I have a written budget to which I refer when deciding on irregular purchases.
I have a written balance sheet from which I know my personal net worth.
I consistently make choices that reduce and control my household expenses.
I maintain a credit card solely to accommodate purchases and for emergencies, paying it to a zero balance monthly.
I maintain a cash reserve sufficient to cover my expenses for the next six months or am saving diligently to do so.
I give regular thought to increasing my earnings to meet my financial goals and am currently pursuing options.