The last few days we've been talking about how you can prepare yourself for emergencies, both big and small. We looked at what you should put in a safe deposit box. We discussed making “What If I Die” spreadsheet, putting all of your important information in one place in case you pass on, or become incapacitated. Finally we took a look at what kind of insurance you should have, and the importance of emergency funds.
Today I thought we could talk about an extremely important thing that can help you to weather just about any storm, a financial plan.
A Financial Plan
Having a sound financial plan is key to being able to survive an emergency of any kind. When you have a plan, you're going to be much more sure about where you are, and where you're headed. The confidence that comes from having that plan will allow you to put worry to the side, and just focus on remedying the source of your emergency.
So what are the different components of a sound financial plan?
- A budget.
- A plan to pay off debt.
- An emergency fund (we've already covered this one!).
- Transferred risk through insurance.
- Short, Mid and Long Term savings and investment goals.
Setting Up Your Budget
One of the most important steps you can take is to set up your first budget so that you can figure out exactly where you are, and what you need to do to reach your goals in the future.
Step one is to figure out what your total income and expenses are:
- Income: Write down all of the income that is flowing into your household through day job income, side income, gambling winnings (heh, yeah right).
- Expenses – Necessities: Figure out what you're spending on the necessities. Necessities would include food, clothing, transportation and shelter. If you have debts, these would be included here as well.
- Expenses – Less Frequent or Variable: These expenses can be a bit tougher to nail down as they’re either variable month to month or they’re paid less frequently. These can include things like food, entertainment, gas, property taxes, pets, hair care, etc. To figure out these types of expense categories you may need to track your expenses over time, and modify your budget accordingly.
Once you've figured out what's coming in, and what's going out, it's time to setup a monthly cash flow plan – a zero based budget where every dollar of income is allocated to either a giving, saving or expense category.
- Write down net income.
- Write down and allocate for all giving and saving and investing categories. Come up with a total for giving, saving and investing.
- Write down all set expenses (like mortgage, insurance, debts, etc).
- Write down all your variable and miscellaneous expenses. It's ok to be off your first couple of months – these expenses take time to figure out. Make your best guess.
- Figure out a dollar figure for total expenses
- Subtract total expenses and giving/saving from total net income. You should come up with zero as the final tally. If you have money left over it needs to be allocated to a category, preferrably a saving or giving category – not miscellaneous expenses.
Once you've got a budget set up, track it month to month (preferrably using a software like Quicken, Microsoft Money or at least a software like mint.com. You'll quickly find categories that you may be spending too much in, and others where you need to allocate more than you currently are. By most accounts it will take 60-90 days to implement an effective budget, so if you don't succeed right away, don't worry. Just keep plugging away and it will come together after a few months.
Pay Off Debt
As part of your budget, if you have debts you'll want to set up a plan to pay off your debts. My preferred plan for getting rid of debt is the debt snowball. The idea behind the debt snowball is this:
- Pay the minimums on all your debts.
- Pay all the extra that you can on your smallest debt.
- Once you pay off the smallest debt, take the extra money that you're not paying on that paid off debt, and snowball it into extra payments on your next smallest debt.
- Repeat the process until all your debts are paid off.
In my opinion the debt snowball is probably one of the best plans for getting out of debt, but it's definitely not the only one. If you don't like the snowball method, just choose an alternate method that you like better and go with that. Remember, you can't go wrong getting out of debt
An Emergency Fund
After all your debts have been paid off another huge step is to make sure you have plenty of emergency savings to cover you in the event of just about any emergency. We covered this more in depth in yesterday's post, so I'll just touch on the key points here.
- Save $1000 baby emergency fund before your debts are paid off (to cover most small emergencies)
- Save 3-12 months of expenses, based upon your risk tolerance, job situation, and other personal factors.
- When disaster strikes and you need to spend your funds, take some time to re-fill your emergency fund for the next emergency.
Insurance To Transfer Risk
Another important component of a complete financial plan is setting up insurance to reduce your risk in key areas to the insurance companies. Why take thousands or millions of dollars worth of risk when you can pay your premiums every month and transfer that risk to your insurance provider?
Key areas to get insurance:
- health insurance
- life insurance
- homeowner’s insurance
- auto insurance
- disability insurance
- long term care insurance
- umbrella insurance
Setting Short Term, Medium And Long Term Goals
When setting up your financial plan you will also want to make sure you're setting goals for the near term, as well as for years down the road. Those goals will help you to set up savings and investment plans, get rid of debt as well giving you the peace of mind of knowing you're working towards something.
Short Term Goals
Short term goals are ones that can be achieved within the next year. Examples of short term goals might be:
- Saving $3000 for a vacation in 7 months
- Paying off credit card debt in 11 months.
- Cutting spending by $100/month
- Saving for Christmas gifts
Medium Term Goals
Medium term goals are one that take 1-5 years to achieve. Examples of medium term goals might be:
- Saving for a 20% down payment on a house
- Saving money to pay cash for a used car to replace a current one
- Increasing income by $20,000/yr
Long Term Goals
Long term goals are goals that take longer than 5 years to achieve. Examples:
- Saving 1.5 million for retirement by age 65
- Saving for a child's education
- Being able to 30% of income to charity within 10 years
When setting your goals make sure to make them specific, measurable, achievable, realistic and time bound. If you don't do those things achieving them will be that much harder.
Once your goals are set, work on ways to achieve them. Set down specific things you'll need to do to accomplish what you want to do. Work your goals into your budget and your financial plan.
Your Complete Financial Plan
So the things I've mentioned above are all important in creating your complete financial plan. Set up your plan and you'll be well on your way to creating a sense of peace in knowing that you're on your way to reaching all your goals. The emergencies that you encounter along the way, while they'll still be hard, won't seem quite as daunting when you have a plan.
Are there other things that you think are important to creating a complete financial plan? Do you have a financial plan setup? Tell us about it in the comments!