Personal Finance 101: Staunch the Bleeding

PURPOSE

I'm going to start an occasional series here about personal finance. Why, might you ask? Well, remember, first and foremost this is a blog about personal responsibility. Yes, we talk about guns a whole lot, and some emergency preparedness, and some stuff that just pisses us off or catches our interest, but I'd argue that one of the foundations for all that stuff is having your finances put together.

Another reason is that most people are woefully ignorant about money. At all levels from the individual to the national, America is just generally clueless. The problem with this is that people end up expecting a bailout. They become looters and moochers. My hope is if we had more financially wise and independent people we'll have fewer people looking for bailouts.

Additionally, it is a good chance for me to learn. I'm always gathering more information about this stuff. "Simple to learn, hard to master." You may have good cause to challenge one of my precepts or good information to share. Plus, if you can explain something to someone else, it helps you understand it better yourself.

Finally, I end up answering the same questions over and over. It will be easier to just post my philosophy in one place and be done with it. This will be the first in an occasional series which will start simple and get more complex as we go on.

DISCLAIMER

I am not a CPA nor am I an attorney; I don't hold a business degree. I'm just a guy who has thought about this some, done some research, and have an opinion. All investments are subject to risk. Do your own research and double check the facts.

GET YOUR SHIT OUT OF THE STREET

Many people are literally hemorrhaging money. For example, DW pointed out a poll on a military spouse forum she visits where the top option for emergency fund savings was something paltry like $3K. Money comes in, and it flows out faster, and there are literally no assets. Personal Finance 101, IMHO, is about staunching the bleeding, getting your cashflow under control, and dealing with the most egregious fouls. That is, getting your shit out of the street.

This is the outline of what the plan looks like:

1. Understand income vs. expenses and assets vs. liabilities
2. Get your cash flow under control
3. Establish a 3-month emergency fund
4. Get your insurance under control
5. Deal with high interest consumer debt
6. Expand your emergency fund to 6-12 months and revisit your insurance
7. Congratulations! Reassess, recage and get ready to invest
   

STEP #1: UNDERSTAND INCOME VS. EXPENSES & ASSETS VS. LIABILITIES

Rich Dad, Poor Dad by Robert Kiyosaki is not the best book in the world, but one idea I like to steal from his is his view of Income, Expenses, Assets, and Liabilities. Most people do not understand this. Many people see their mortgaged house, expensive golf clubs, shiny new rifle, and car (also with payments) as assets. They think that these things make them wealthy. This is wrong.

• An asset is something that puts money into your pocket.
• A liability is something that takes money out of your pocket.

Using these definitions, it is clear that something like golf clubs is a liability; you pay money for insurance, and they add no income. Credit card payments are a liability. Likewise, your personal residence is also potentially a liability; you pay money out of your pocket every month for interest. Cars are another classic liability. Examples of assets are rental properties, dividend paying stocks, interest bearing savings, and so on. All things that put money into your pocket.

Income vs. Expenses are also important to keep a handle on. Most people have no idea where all their money goes. You need to figure out what you have coming in, and what you have going out, and be honest about it. In fact, I suggest you add 10% to all your "fuzzy" cost estimates because you will be likely to underestimate them. That is vital for step #2.

STEP #2: GET YOUR CASHFLOW UNDER CONTROL

This step is vital. If you are running up debt to pay your monthly expenses, or have no extra cash at the end of the month or quarter for savings, you must stop the bleeding. You have a few options:

• Increase Income
• Decrease Expenses
• Acquire Assets
• Divest Liabilities
  

You may be able to do several at once; take a second job while cutting expenses. But you have to do one or the other. We will talk more about sophisticated ways to increase income later by acquiring assets, but most of them require capital, which you won't have until you get your shit out of the street. Getting rid of liabilities may be an option: Sell that maintenance-hog gas-guzzling Earthfucker for a practical commuter car, move to a more reasonable house, get rid of money sinks.

Decreasing expenses is probably most manageable. Remember that no-kidding look at your cash flow in step #1? Now you need to use that. Separate the must's, should's, and want's.

• MUST'S: Taxes, food, transportation to work, shelter, clothes, catastrophic insurance
  
• SHOULD'S: Good insurance, local reasonably priced R&R, little creature comforts (to keep yourself sane), safety/security, possibly phone/internet, reasonable gifts for family
  
• WANT'S: New cars, big house, vacations, toys, going out to eat, cable TV, Smart Phones, gadgets, vices (booze/tobacco are the most common), extravagant gifts
  
• SAVINGS: This is what is left. We will include retirement money here.

$80/month IPhone bill? That is clearly a "Want." $9/month prepaid tracfone? Probably a "should," for safety reasons. New cute shoes? "Want." Practical interview shoes for work? "Must or should." Buying spaghetti and chicken breasts and canned veggies? "Must." Buying organic gourmet stuff and picking up coffee on the way out? "Want."

Now build your budget. First, all of our "musts" come out of the budget. They must be paid up front. The "shoulds" get paid next. Savings should be considered after the musts and probably before (or just after) the shoulds. Do not forget to prorate major annual or quarterly expenses! For example, if you estimate having to spend $600 on car repairs over the course of the year, you should budget $50/month for that. The hardest part will be controlling your wants. They should be allocated last, but in practice often expand to consume more and more income -- which is how we get into trouble.

"Allowance" Tip: This is how we control what we spend on "wants". We split "wants" into short term and mid-term expenses.

• Short-Term Expenses: We each take a cash allowance each week. Friday is money day, and we hit the ATM or the money drawer at home and put cash in our wallets. This ensures that if we want to we can do something fun every weekend. Back in college this was a small amount. As we both work now, this amount has increased.
• Mid-Term Expenses: We keep a whiteboard on the fridge split into a few buckets -- "His, Hers, Ours, Vices, Local Vacations." Every Friday, we add a set amount of money to each category on the whiteboard. Over time, this builds up and you can go buy something bigger and cross money off the whiteboard. You can also buy something with a credit card (say, online) and cross money off the whiteboard. If you don't spend your weekly cash allowance then you add some to the whiteboard. It is a tangible way to see your savings add up every week.

This may seem a little control-freakish, but it is highly effective for controlling your spending. The key is using cash. If you run out of cash, you can't cheat and swipe your card. You do without until the next money day.

STEP #3: USE YOUR SAVED CASH FLOW TO ESTABLISH A 3-MONTH EMERGENCY FUND

Now that you have freed up some cash every month, establish an emergency fund. I suggest keeping no more than 1-month on hand in cash, and the rest in a safe checking or savings account (not a risky investment). To figure out what a month of expenses is, take all your "Musts" and "Shoulds" above and add at least 10%.

You need to immediately establish a cash reserve because otherwise the next minor emergency will wipe out your progress and force you to run up bills on credit. Minor things will happen: car repairs, an unexpected trip to a funeral or wedding, etc.

STEP #4: GET YOUR INSURANCE UNDER CONTROL

Carefully review your insurance. Ensure that you have adequate coverage for you, your family, and your assets. This is probably worthy of a post of its own. Basically, you should make sure that you have auto, renter's (or homeowner's), health, and life insurance. You may be able to skimp on life insurance if you have no kids. Just like the emergency fund protects you from being wiped out by a minor emergency, the insurance keeps you from being cleaned out by a major catastrophe.

At a minimum, you need to have catastrophic coverage. If you have a three month's emergency fund, then the deductible on your policies should probably not be much more than that.

Argueably, this could be step #3. You may want to do this simultaneously with establishing your first initial savings.

STEP #5: DEAL WITH HIGH INTEREST CONSUMER CREDIT

Now take your monthly cash surplus and start throwing it at your consumer debt. Start with the highest interest rate account and work from there.

• CREDIT CARD #1 @ 23.99%: $2000
• CREDIT CARD #2 @11.00%: $500
• CAR LOAN @ 4.99%: $10,000
• STUDENT LOAN @ 5.5%: $7000

In this example, I'd start with Credit Card #1. Get rid of that 24% loan ASAP! Credit card #2 would be next. Then, I'd probably tackle the car loan as there may be tax benefits to retaining a student loan.

You may be able to get the rate lowered. Call and ask -- it cannot hurt. Military members may be entitled to lower interest rates under the SSCRA for debt they held prior to joining. You may also be able to consolidate the loans under one lower interest rate. For example, if you can take out a $2500 personal loan from your bank for 9%, then you can pay off both credit cards and consolidate the debt at 9%. You may also be able to use a 0% balance transfer for 12 months offer with a card.

STEP #6: EXPAND YOUR EMERGENCY FUND TO 6-12 MONTHS AND IMPROVE YOUR INSURANCE

Now that your debt is gone, start socking away money and make a 6-12 month emergency fund. How big should your emergency fund be? Here's a rule of thumb I've heard:
Your Annual Income / $10,000 + 2 = # of months in emergency fund

So if you pull down $60K/year you need an 8 month emergency fund. Obviously tailor to individual circumstances -- if you have a very secure job you may be able to skimp.

As you do this, revisit your insurance. You actually have assets now (savings) so you may need to increase your liability protection. You can also afford to raise your deductible if it makes sense to do so.

STEP #7: CONGRATULATIONS! You have gotten your shit out of the street, stopped the bleeding, and broken the cycle of debt.

Now is where you reassess. Go back to step #1 and run through the program again. Check your math. Make sure you didn't miss anything. Tweak your budget based on actual expenses.

• Stay strong with controlling the "wants." You should reward yourself for reaching this goal, but don't go blow your emergency fund on a week in Vegas.
• If you get a raise at work, a good rule of thumb is to split it: 1/2 to your monthly savings, 1/4 to "wants," and the rest to increasing musts/shoulds.
• Work towards being a one-income family. Set things up so that you can cover all of your musts/shoulds off of one spouse's income, and use the second income to feed your savings. All of a sudden, you will have tremendously more options.
  

Next, we'll take about some short and midterm strategies to make your emergency fund work harder for you.