The Foundation of Personal Finance: The Basics

Jul 30, 2019 | Eddy Mejlholm


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In my first post on personal finance, I outlined the 6 steps that are the foundations of personal finance.  Now that you’ve got a solid understanding of your personal financial situation, it’s time to work on the basics. 

The Foundation of Personal Finance: The Basics

 

Too many people spend money they haven’t earned to buy things they don't want to impress people that they don't like. --Will Rogers

 

In my first post on personal finance, I outlined the 6 steps that are the foundations of personal finance.  In my last post I showed the importance of monitoring your net worth and cash flow, in addition to some practical ways to actually achieve your goals. Now that we have the outline of where we are headed and you’ve got a solid understanding of your personal financial situation, it’s time to work on the basics.

 

The basics are:

    1. Develop a monthly cash flow surplus
    2. Have at least $1,000 on hand for emergencies
    3. Give to charity regularly and proportionally
    4. Start paying off non-mortgage debts with surplus

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery. --Charles Dickens

  1. Develop a monthly cash flow surplus

 

The world is full of clichés and pithy sayings about spending more than you earn, and for good reason.  Spending more that you earn puts you on an unsustainable path to potential financial disaster.  This is why, after you know the true state of our financial affairs, developing a monthly cash flow surplus should be your top priority.  Developing a surplus can be done by 2 primary means:

  1. Spend less money – This seems quite obvious but, just because it’s simple, doesn’t mean it’s easy to make a change to your personal spending habits.  If you need to spend less money, then you are going to need to take a long hard look at all of the things you choose to purchase and find ways at getting better deals or going without.  Go back to Step 1 and look at all of the items you’ve purchased in the past 3-12 months, then categorize them into 3 categories:
    1. NEED – The most basic food, shelter, and transportation costs are here.  The lease on your late model vehicle is not here, Steak dinners at a local restaurant are not here, just the very essentials make the list of things you need.
    2. WANT – The majority of your spending is likely in this category.  This likely includes the discretionary upgrades to things in your ‘NEED’ category.  Find and prioritize these items that you can go without or spend less on.
    3. What was I thinking!?! – Do you regret some of the things you’ve spent money on?  Put those things here and do some soul searching.  Why did you buy that?  Why do you regret it? How can you avoid that situation in the future? 
  2. Earn more money – The most overlooked part of fixing your cash flow deficit is to make more money!  I’m not sure why most of us think that the secret to balancing the budget is cutting spending, but it is very effective to fix your shortfall by making more money.  This can be done in some simple short term ways and some very effective long term ways. 

In the short term, you can sell things that you no longer need.  Most of us own a lot of stuff that we don’t use or need any longer and we can get rid of it, often putting a bit of money in our pocket.  Right sizing your vehicle, home, or other belongings can really help bring in some much needed cash in a time of need and can often lower expenses at the same time. 

Over the long term, upgrading your skills and getting a new job to earn more money might take some time but it is usually worth it.  Getting a second or third job for a short time to help pay the bills is often essential to get out of a tight financial situation. 

 

  1. Have at least $1,000 on hand for emergencies

 

This brings me to the next part of step 2, which is to make sure you have at least $1,000 in your bank account to deal with life and the unexpected things that can come up.  You need to secure this as soon as possible and I would strongly advise selling items and forgoing all spending until you have these funds on hand. 

  1. Give to charity

 

Once you have a cash flow surplus and at least $1,000 on hand then I offer the unconventional advice of giving some money away.  You might be thinking that I’ve lost my mind and why on earth would I tell you, that after working hard to get your finances under control, to give away some of your hard earned money?!  I’m not going to tell you where you should donate your money but, I can let you know that I’ve seen generosity and freewill giving absolutely change many people and their attitudes towards money.  If the attitude is changed then everything changes. 

Personally, my own financial circumstances changed dramatically after I started giving regularly.  I was at this step in the process when I started giving to charity and it changed my attitude about my money. It shifted my focus from myself and what I could buy next, to others and how my giving could change their situation.  I also got more involved in other people’s lives and became less selfish, which, in turn, helped me turn around my own finances for the better. 

 

  1. Debt repayment plan

 

So now you’ve got a cash flow surplus, at least $1,000 for emergencies, and you are giving to a cause that’s not you. Finally, in this last step, you need to start to pay off your debts. You need to develop and begin a plan to become debt free.  This plan will focus on getting you debt free as fast as possible and give you motivation to keep going as aggressively as possible.  There are 2 methods for tackling your debt problem and they are:

  1. The Debt Snowball – This method focuses on paying off your smallest debts first and moving to the next smallest.  It is very effective if you have a lot of debts and you find yourself making minimal payments on several cards, loans, lines of credit.  It can be very motivating as you see your debts disappearing quickly and your stress level of juggling debt payments goes down. 
    Dave Ramsey is a big advocate of the Debt Snowball and so am I.  Here is a link to how it works:
    https://www.daveramsey.com/blog/how-the-debt-snowball-method-works
  2. The Debt Avalanche – This method focuses on paying off the highest interest debt first and moving to the next highest.  This method is very effective if you only have a couple of debts and have a lot of fortitude to see it through.  Here is a link to an explanation about how the debt avalanche works: https://www.investopedia.com/terms/d/debt-avalanche.asp

 

In the next installment, we will look at “Step 3: Expanding on the Basics” where we will build on what we’ve accomplished in Steps 1 and 2.