Trying to understand personal finance can be intimidating – especially when you’re just starting to manage your own money. Sometimes, it seems like all you can do just to pay your rent every month – let alone worry about budgeting or retirement savings. And with so many ways to approach your finances and so much information out there, it can be overwhelming. But in order to get started off on the right foot, it’s especially important for millennials to understand the basics.
While personal finance is a complex topic, there are four important things you should focus on as you delve into managing your money – possibly for the first time. These four things are budgeting, savings, debt, and insurance.
The cornerstone of any good financial plan is budgeting. Without a budget, you can’t account for how much money you’re making, spending, or saving – or make sure you’re staying on track to reach your goals.
Making a budget basically requires adding up your income, allocating funds for each expense, and figuring out how much you have left over to save – and using that budget to help keep your spending on track.
Your income includes your take-home pay from your job, monetary gifts, tips, and bonuses. To create your budget, you should subtract your savings and expenses from your total income until every dollar has been accounted for.
Katie Christy, the founder of Activate Your Talent, recommends going with a zero-sum budget. “Work to distribute every penny of your income. Some people tend to want to leave “fun money” in their budget but this ends up creating a laissez-faire approach to finances,” states Christy.
You can avoid a laissez-faire approach to your money by preemptively including things like entertainment and shopping in your budget, rather than just leaving it up to chance. This will help you learn to save money for expenses and things you want to do and buy – and avoid accumulating debt to finance things you didn’t account for in your budget.
There are many tools out there to help with budgeting – some people use apps like Mint or You Need a Budget to help them track their spending and saving, while others use a simple Excel sheet or Google Doc. Choose whatever works best for you and will help you stick with it.
Important tips to remember when creating a budget
- Take note of the cycle of each of your pay periods and use this to organize your budgets.
- Subtract your savings using your savings goals as a guide. If you want to save $2,000 over the next year, divide your goal up by your total number of pay periods for the year. This will give you the amount you need to save each pay period to reach your goal.
- If you’re paid bi-weekly, you’ll want to make sure you are budgeting accordingly for fixed expenses such as housing. If your rent is $800, you could budget the entire expense using one paycheck. However, we recommend putting aside $400 each pay period to help balance your fixed expenses with your discretionary spending. This is typically referred to as bi-weekly budgeting.
Savings are essential in creating long-term wealth. Your budget should include savings for short-term (think vacations and holiday shopping) and long-term (buying a house or car) goals, as well as retirement.
The easiest way to save is by automatically contributing to an employer sponsored 401(k), if available, as well as a personal saving accounts. You can set up automatic contributions through your employer or bank. If your employer doesn’t have an employer sponsored 401(k) plan, you can contribute money to an Individual Retirement Account (IRA).
Melinda Kibler, Certified Financial Planner, and portfolio manager with Palisades Hudson Financial Group, recommends contributing money to a Roth IRA rather than a Traditional IRA because your contributions will be made after taxes. This means your earnings will grow tax-free, and you won’t pay taxes on distributions during retirement.
“Your starting goal should be to save at least ten percent of your paycheck for cash savings, and another ten percent for retirement savings,” says Kibler.
Eric J. Shaefer, Wealth Advisor at Ever May Wealth advises millennials to begin saving early, because “compound interest is one of the most powerful financial concepts out there.”
“Mathematically, you will have to save around twice as much annually to meet the same retirement portfolio balance if you start saving at 35 instead of 25. Saving and investing has a snowball effect, and the longer you wait the harder it will be to get into healthy saving habits or play catch-up,” Shaefer explains.
Your cash savings should include six to twelve months for emergencies. Without an emergency fund, you may find yourself strapped for cash if you have a medical emergency, lose your job, become disabled, or lose property due to a catastrophic event.
Emergency savings are usually kept in a separate savings vehicle, like a money market account. It’s important that these funds are semi-accessible and liquid, so you can quickly obtain them during an emergency.
While building your savings, track your net worth by subtracting the amount of savings (assets) from your total amount of debt (liabilities). As your savings grow and your debt decreases, your net worth will increase. This is a positive indicator that you’re properly managing your finances.
While most people want to stay out of debt, it’s unavoidable in some cases. And in some cases, things you may have been taught to avoid – like credit cards – are actually necessary to build a healthy financial future. However, it’s important to be smart about debt and credit.
Today, many millennials leave college with a substantial amount of student loan debt. While many could see this as a burden, Alex Snider, Director of Communications at Bennington College, encourages new graduates to embrace them – or at least know how to handle them.
Snider advises graduates, “You already took them – they are yours and they aren’t going anywhere. Take advantage of the income-based repayment options through your loan servicer to make the monthly payment reasonable for you and your budget.”
If you can afford to repay them using the standard repayment plan, that’s even better. You’ll reduce the length of time you’re paying on your debt, and you’ll also save more on interest paid towards your loan.
While managing student loans, it’s of equal importance to deliberately and responsibly build your credit. You can do this several ways. First, you can make consistent payments on your student loans. Second, you can use a credit card to make a recurring small purchase each month and then pay the balance off in full.
David Bakke from Money Crashers advises young adults, “If they can’t afford to pay for a purchase by the time the bill comes in, then they just can’t afford it. They’re better off saving their money until they can make that happen.”
Never charge more than you can afford. If you already have a significant amount of credit card debt, organize your debt from highest to lowest interest rate and attack the debt with the highest interest rate first. The longer you pay on a credit card with a higher interest rate, the more you will pay in the long-term.
Important tips to remember when building credit
- Be aware of your credit utilization ratio. If you have two credit cards, each with a $500 credit limit, and you borrowed $100 on one of the cards, your total credit utilization ratio would be 10 percent ($100 – amount borrowed – divided by $1000 – amount available). Creditors prefer this number to be less than 35 percent.
- Make smart decisions when opening accounts — choose the best credit card for building credit that you can qualify for. You’ll reduce your interest payments and potentially start racking up rewards.
- Be aware of your debt to income ratio. Lenders calculate this number by dividing your debt by your total monthly income. This number is used to determine your ability to manage your payments.
- Last, remember that your credit history makes up 15 percent of your credit history. Once you’ve paid off a credit card, it may not be in your best interest to close this account, since it could shorten the length of your credit history and negatively impact your credit score.
It’s easy to overlook insurance as an important component of your financial plan, but it’s an essential one. “Good insurance planning is the foundation for all planning,” says Micah Charyn, Vice President and Financial Advisor at FTB Advisors in Nashville, Tennessee.
You can protect your health and wealth by making sure you have the following types of insurance: disability, health, life, and renters or homeowners insurance.
If you’re hurt on the job or become ill and are unable to work, your finances could suffer due to a loss of income. The best way to protect yourself from these types of mishap is to purchase disability insurance, if it’s not offered by your employer. Disability insurance will replace a portion of your income if you’re out of work due to a covered loss.
You should also have adequate health insurance. A good health insurance plan includes coverage for wellness visits, diagnostic tests, sick visits, surgery, and hospitalization. If you choose a high-deductible plan to save on monthly premium, you should thoroughly research available options for a health savings account to supplement your plan.
Homeowner’s and renter’s insurance
For homeowners, a homeowner’s policy protects you from losses against your property. Types of covered losses include fire, burglary, and certain acts of nature. These types of policies also provide liability protection in the event someone is injured on your property or if you’re found responsible for damages to someone else’s property. Renter’s insurance provides coverage for a renter’s belongings and liability only.
Last, it’s important to have life insurance. Regardless of your marital status, if you have debt, children, or other financial obligations, having a life insurance policy allows your family to fulfill certain obligations on your behalf such as paying down debt or setting up trusts for your children. It also prevents them from going into debt to provide a proper burial.
Let’s recap the four essential components you need to understand about personal finance:
- Budget: You need to establish a budget. Your budget establishes a plan for spending, saving, and debt repayment.
- Saving: Start saving with two major goals: creating an emergency fund and building your retirement savings.
- Debt: If you have any debt, pay it off as soon as possible and then focus on building your credit responsibly.
- Insurance: Your personal finance plan will be incomplete if you aren’t properly insured. Make sure you research available options for health coverage, disability coverage, life insurance, and property insurance.
Personal Finance Terms & Definitions
Debt to Income Ratio: The total amount of debt divided by gross monthly income. Lenders use your debt to income ratio to determine your ability to manage payments on the amount of money you have borrowed.
Individual Retirement Account (IRA): An investment vehicle that allows you to save for retirement. There are two types of IRA’s — Traditional and Roth IRA.
- A Traditional IRA is a tax-deferred investment account, where you only pay taxes when you withdraw at retirement.
- A Roth IRA is not a tax deferred account. Savings are contributed after tax and your money grows tax-free.
Savings Account: An account held at a bank that accrues interest.
Credit Score: A numerical summary that creditors use to determine a person’s creditworthiness. The most common type of credit score is known as a FICO (Fair Isaac Corporation) credit score.
401k: An employer-sponsored retirement plan where contributions are made from an individual’s paycheck before taxes.
Credit Utilization Ratio: Calculated by dividing the total amount of credit borrowed by the total amount of credit available on all lines of credit.
Interest Rate: The amount charged to borrowers on loans or lines of credit. This number is calculated as a percentage of the total amount borrowed (principal).
Principal: The initial amount borrowed.
Term Life Insurance: Payment of a death benefit for the insured if death occurs during the term specified in the policy.
Compound Interest: Interest added to the principal balance and any accumulated interested.
Annual Percentage Rate (APR): The amount of interest paid on the total amount borrowed annually.
Disability Insurance: A policy that replaces a certain percentage of your income in the event of you being unable to work due to a disability covered in the policy.
Net Worth: Calculated by subtracting your total liabilities (debt) from the total amount of assets you have. If you own a home outright and have no mortgage, this is an asset. You would subtract your total debt owed from the value of your asset.
Homeowners Insurance: Provides coverage for damage that may occur against property and also provides liability coverage for personal injury and damages to other’s property.
Renters Insurance: Provides coverage for the protection of a tenant’s property. This type of coverage protects against fire, theft, and vandalism. It also provides liability protection; however, it does not protect the dwelling or building.
Health Savings Account: A type of savings account used in conjunction with a high-deductible health plan. With this account, you are allowed to save money tax-free to use for medical expenses.