Establishing sound personal finance practices while you are young is essential. For those just starting out who are new to money management, you need to consider your financial future. Discipline and having the right mindset will help you stay out of debt and achieve your financial goals.
Track and Analyze Your Spending
The first step is to analyze your spending to see where your money is going. Limit yourself to one or two credit cards, using one for most day-to-day purchases. This makes it easier to track spending and your total credit card balances. Having multiple credit card accounts is a major reason that card debts grow. As credit card balances climb, it also hurts your credit score. Even if you can pay off your balance every month, using more than 30% of your credit line has a negative impact on your credit score.
Peer-to-peer (P2P) networks offer convenience and flexibility. At the same time, it is important to be cognizant of the reason behind P2P transactions. Limit your P2P transactions to entertainment and recurring bills such as splitting utilities with roommates.
With online banking, thoughtful use of P2P networks, and having only one or two credit cards, you can easily track your spending. Download and view all activity for a period of time such as three months. Assign each expense to one of three categories:
- Essentials: rent, transportation, groceries, utilities, insurance.
- Savings and Debts: establishing an emergency fund, saving for retirement, paying off loans.
- Everything Else: travel, entertainment, shopping.
Analyze the Everything Else category very closely. These are non-essential expenses and usually stem from lifestyle choices. This is where you can make changes to reduce overall expenses and increase the amount you are able to save every month. Not monitoring the Everything Else expenditures is often the reason that credit card debts build.
Think About Cash Flow and Not Just Income
Cash flow depends not only on your income but also on changes in your savings and debts. If, at the end of the year, you have not saved, and your credit card balance has grown there is only one explanation – you consumed more than you earned. If, at the end of the year, you were able to save money, and/or your debts have declined, you consumed less than you earned.
It is especially important to analyze cash flow before any life transitions such as
- Buying a home
- Getting married
- Having a child
- Changing careers or starting a business
- Going from two incomes to one
These transitions can have a big impact on your financial life. Taking a close look at your cash flow will help you determine if you are prepared. Doing this analysis in advance of a big change will give you piece of mind. Whenever you face a life transition, it is a good idea to have extra money put aside for unexpected expenses and other unknowns.
Consider Your Net Worth
When making a financial decision, always think about the repercussions for your net worth. This practice will have a profound impact on your financial profile. Remember the following formula from Accounting 101:
Assets = Debts + Net Worth
A balance sheet is a financial statement that lists your asset, your debts, and your net worth. Your assets are anything you have of value such as your home, checking account, savings account, investments, 401(k), and car. Debts include any outstanding liabilities or obligations such as a mortgage, student loans, car loans or leases, and credit card debts. A balance sheet, by definition, must balance. Your net worth is the difference between your assets and your debts. In other words, your net worth is an outcome, and you can think of the formula:
Assets – Debts = Net Worth
For important financial decisions, always consider the effect on your net worth. All else equal:
- If you increase your assets, your net worth goes up — you earn a special bonus from work and invest the money.
- If you decrease your debts, your net worth goes up — you receive a tax refund and pay off debt.
- If you increase your debts, your net worth goes down — you take a vacation and run up credit card balances shopping and eating out.
Cash flow takes into account both your income and your balance sheet. It also highlights the difference between income and consumption. Getting in the habit of thinking about net worth will help reduce the likelihood that you will accumulate debts that negatively affect your financial well-being. It will also increase the likelihood that you will stay out of debt and achieve your long-term goals.
If you want to learn more about how to stay out of debt and get started managing your financial life, see our collection of Analyze Finances posts.
