Building the Foundation for a Solid Financial Plan
July 30, 2014 | Your Finances
Building a financial plan is a lot like building a house: Both need a strong foundation to support your needs and last you a lifetime. Whether you’re just starting out or revisiting your finances after a family or lifestyle change, these four steps can help you lay the cornerstones of a solid financial plan:
1. Understand Your Cash Flow. If you get to the end of the month and wonder, “Where did all the money go?” you’re not alone. It can be helpful to write down what you spend your money on for a couple of months, then compare how you’re doing to the following rule of thumb: 20-60-20. Your monthly expenses should fall into these percentages:
- 20% on saving and investing. Saving and investing includes setting aside money for emergencies, investing money for your retirement, as well as saving and investing for larger expenses that fall in between.
- 60% on essential expenses. Housing, transportation, food, health care and the cost of raising your kids are all considered essential. It can be difficult to quickly change essential expenses, but if your essential expenses are more than 60 percent, you might consider things like buying or renting a less expensive home or buying a more fuel-efficient car.
- 20% on discretionary expenses. Household and personal expenses, such as entertainment, clothing, dining out and personal care, should add up to 20 percent of your monthly take-home pay. Many of these expenses are “wants” rather than “needs,” so this is where you might cut first if you are spending more than you make.
2. Develop a Plan to Save and Invest. The key to achieving your financial goals is having a plan for both saving (setting aside money for short-term needs in a safe account in which there is no risk of losing your money) and investing (putting your money in something like a mutual fund or stocks, which carry the risk that you could lose value with the potential for a greater gain over time). You’ll need a mix of both savings and investment accounts, starting with these two:
- Emergency fund. In the event of a financial setback, illness or unexpected expense, you’ll want an emergency fund—enough to cover three to six months of expenses—in a savings account or other safe account that’s easily accessed within three to five days without penalty.
- 401(k) or other retirement plan. If you have a retirement plan at work that features an employer match, take advantage of that extra money by contributing at least up to the point where the match ends. If you don’t have access to a plan at work, open your own IRA with automatic deposits from your paycheck.
Once you have those two accounts in place, you’ll be ready to save and invest for other goals, including short- and mid-term needs, college funding for your children and additional money for retirement.
3. Manage Debt Strategically. Not all debt is created equal. Some debt, like a home mortgage, offers tax advantages and helps you pay for an essential expense, a place to live. “Bad” debt is any debt that carries a high interest rate, doesn’t offer tax advantages and goes toward a nonessential purpose or purchase. Of course, you have to make the required payments on all of your debt, but strategic management means that you make extra payments to pay off bad debt before paying off good debt. Make payments in this order:
- High interest rate credit cards. If you make just the minimum payment on your credit card bill, it could take years to pay it off and cost you as much as twice the original purchase price for an item. Pay off this debt as quickly as possible.
- Nondeductible debt. Once you’re able to pay off your credit card balance each month, concentrate on nondeductible debt, such as car payments or personal loans. Interest on these items is not tax deductible, and you may save interest costs if you pay them off early.
- Deductible debt. The last type of debt to pay off is deductible debt, such as a mortgage, home equity loan or qualified student loan, that may offer tax advantages (within certain income and mortgage limits). Check with your tax advisor or financial professional first—there may be situations where you can invest that extra cash each month and earn a better return than the interest rate you are paying on the loan.
4. Protect your assets and income. Your earning potential is your most important asset. When you’re young, disability and death may be the last thing on your mind—but actually, that’s when it’s most important to protect your family against the risk of losing your lifetime earnings. Make sure you are covered by these policies:
- Disability insurance. You’re nearly twice as likely to be injured or disabled by illness than to die during your working years.1 Disability insurance can help ensure you’re able to maintain your standard of living if you have an accident or become too sick to work.
- Life insurance. Life insurance protects your survivors in the event you die prematurely. In addition to the death benefit, permanent life insurance policies accumulate cash value. That’s money that you could eventually access for emergencies or opportunities like an unexpected house repair or college. If you no longer need the full death benefit, you could also eventually use the cash value to supplement your retirement.
- Property/casualty insurance. Also called liability insurance, property/casualty protects you in the event you are legally liable for injuries to another person or damage to their property in an accident. It also protects you if you are injured by someone with inadequate or no insurance.
These steps can help you on the path to financial security. For more detailed information on financial planning, including sample spending and saving plans, read the Northwestern Mutual white paper, Building the Foundation for a Solid Financial Plan.
1Society of Actuaries 2013 IDI Valuation Table; 2008 Valuation Basic Table.
No investment strategy can guarantee a profit or protect against a loss.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth.