Chapter 2: Establish a Healthy Foundation
The key to being able to save is to spend less than you earn. If your income is $1,700 a month and your expenses are $1,800, you will be worried about paying your bills, not saving. To figure out if you are spending less than you are earning, use the Budget Worksheet to list what your current expenses and income are. To determine a monthly amount for periodic income or expenses, calculate the per year amount and divide by 12.
Once you have completed your budget, total up your expenses and subtract them from your income. If your expenses are less than your income, great! If not, look over your plan and think about what changes you can make to improve your cash flow. Can you bring your lunch to work instead of buy it? Nix the land-line and just use your cell-phone? Give up your tap dancing lessons? Be honest about what is truly a necessity and what can be reduced, postponed, or cut out completely. Put any adjustments you plan to make the Goal Per Month column of the budget.
In most cases, the interest charged on credit cards and personal loans exceeds the interest earned from investments. If you owe $10,000 on a credit card with a 20% annual percentage rate, it makes more financial sense to direct your extra cash toward that than a bond with a 4% return. Once you pay off your debt, then you can dedicate your attention to investing. One caveat – you should always have an emergency fund containing at least three to six months worth of essential living expenses, even if you have debt. (This allows you to pay your bills without relying on credit if the unexpected happens.) If you have less in savings currently, at least a portion of your spare cash should go toward building an emergency fund.
Setting goals is crucial to figuring out how much you need to save to get what you want. It is also a good motivator to save. Let’s be honest – going out to eat at a nice restaurant is more fun than buying stocks. But if you know that money is going toward a fabulous vacation or a down payment on a house, it will be easier to tuck it away and pop a frozen pizza in the oven.
Use the Financial Goals Worksheet to list your goals. Financial goals should be specific and measurable. For example, a desire to be rich is not a goal, but a desire to have $300,000 saved in twenty years for retirement is. There are three basic types of goals: short-term (achieved in under a year), mid-term (achieved in one to five years), and long-term (achieved in more than five years). Whether a goal is short-term, mid-term, or long-term can influence where you put your savings (discussed more later).
The easiest way to determine how much you need to set aside each month is divide the current cost by the number of months until your achievement date. So if you want a $1,200 laptop in 12 months, you should set aside $1,200/12 = $100 a month. However, doing the calculation this way ignores inflation and the return that you earn on your savings. Inflation and return don’t have much of an influence on goals that will be achieved in the immediate future, but you may want to take them into consideration for long-term goals. A financial expert may be able help you come up with figures or you can use your best guess. You can use the “How much should I save each month?” calculator to calculate how much you should save each month figuring in the expected rate of return. (In the “Savings goal” field, enter what you expect the goal to cost at the achievement date.)
After you determine how much you need to save each month for your goals, you should add it to your budget. If it puts you in the red, go back to the drawing board and consider if you can make any further reductions in expenses. If not, consider if any goals can be adjusted. Is there a cheaper alternative available (e.g., a local amusement park instead of Disney World)? Can you extend the timeframe? Are there any goals that are less important that can be dropped? Maybe you would really love to buy a $5,000 garden gnome to put in your front lawn, but having enough money for retirement is a bigger priority.