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Part 3: Spend less than you earn. This is the basic financial principle that, if followed, will help you prosper, and if ignored, will send you into a spiral of debt.
This should come as no surprise to Consumerism Commentary readers or anyone who has spent time reading anything relating to basic money management advice.
Once you’ve decided to improve your financial condition and spent some time tracking your spending, you may have come to the conclusion that your situation declines each month because you’re allowing more money out the door than what’s coming in.
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Spending more than you earn isn’t feasible for the long term. However, if looking at finances from month to month, even those fully in control of finances will have some instances in which monthly cash flow is negative. Variation is possible over short periods if savings if accessible or debt is available.
Over longer periods, the variation should smooth out. The only way build your wealth over the long term outside of investments is to keep your spending lower than your income after averaging out monthly variations.
Certain life events may require large outlays in the short term, like buying and furnishing your first home or starting your first professional job. While there are ways to save money when navigating these events, it’s not uncommon for spending to exceed income for a short time.
If after analyzing your current finances you see that your savings is decreasing or your debt is increasing due to negative cash flow, here is how to approach the point of reversing that trend.
Make a psychological adjustment. “Knowing is half the battle.” If you are losing ground month after month, laying out your income and expenses on a spreadsheet should give you a clear indication of the situation.
This might not be a strong enough wake-up call, especially if you have savings or available debt, but both of these run out. Living above your means is not sustainable indefinitely as your predictions should show.
You’ve already made the commitment to improving your finances, and in order to succeed you must spend less than you earn, whether from a job or your investments.
For some people, changing a state of mind is more difficult than it is for others. Whether it’s a lack of motivation or a lack of faith, keep this in mind: Other people in worse conditions have succeeded.
No matter how difficult your financial situation is right now, many people with worse problems have been able to adjust their attitude and behavior. This dedication to change is necessary for stabilizing finances. Earlier this year, readers of the blog Get Rich Slowly shared financial success stories.
Reading through the comments, it’s easy to see how people in a variety of conditions were able to get past the present and improve the future. If they can, so can you.
Once you’ve made the psychological adjustment, continue with striving to spend less than you earn. Let’s stop to look at this idea from a mathematical standpoint. While there is more to money than math, the numbers form the basis of any financial decision, so this concept should always be in the back of your mind.
Net income = Income – Expense
If Income is greater than Expense, Net Income is positive, and you have a positive cash flow. If Expense is greater than Income, Net Income is negative, and you have a negative cash flow (a loss).
There are two mathematical solutions to a negative cash flow. You can either increase income or decrease expenses. For many people decreasing expenses is the easier option.
Many people have a steady income that may not appear to be flexible. Even if income is not flexible, it may take more effort to earn an extra $200 per month after taxes than it would to save an extra $200 month.
So we’ll consider saving money first. While I’m briefly discussing these categories, each one deserves a full article just to review all the available options for saving money.
Before we get to the details, consider adopting a philosophy of frugality. Some people see this as something with negative connotations, like “cheap” or “penny-pinching,” but there are ways to be smart about being frugal.
Frugality is simply reducing your desires to match your needs and making purchasing decisions economically. I try to find a balance with my approach to frugality, but needs may outweigh the concept of balance.
If you’ve estimated your expenses in Part 1-C, you’ve seen how to categorize your spending as non-discretionary or necessary and discretionary. The most obvious choice for cutting your expenses is by evaluating the necessity of your discretionary expenses.
Here are a few expenses I would categorize as unnecessary and some suggestions for reduction or elimination. Keep in mind that everyone’s situation is unique and you may prioritize your life differently than someone else.
Take these suggestions but make your own call, but keep the goal of spending less than you earn in mind. Take a stab at these changes, if only temporarily to see how they work for you.
Cable television. “Cable” (whether from the cable company or the telephone company) or satellite television is usually the first bus stop on the route to financial well-being. I like to be entertained as much as anyone, but if I had to,
this would be the first service to go. In fact, while I was first on the road to improving my finances, I reduced my cable television service from $80 or $100 a month to just $13 per month, allowing me to receive the most basic service to keep my internet service valid). There are a number of replacements for cable that you could consider.
Get your entertainment in the mail. Netflix allows you to receive DVDs of your favorite television shows through the mail. While you won’t be watching the shows at the same time as those who have cable, you will still experience an equivalent entertainment value, if only later. Netflix plans start at only $4.99 per month, and coupons for a free first month abound.
Over-the-air television signals are free. Unless you are in the United Kingdom, television programming is broadcast over the air and received by land-based, home-mounted antennae for free.
In fact, some stations broadcast in high definition, so despite retailer’s marketing claiming the contrary, you do not need cable or satellite service to receive digital or high-definition broadcasts.
In fact, over-the-air high-definition broadcasts look and sound better than cable and satellite broadcasts because the signal is not compressed or compressed less.
The cable companies want to provide a vast selection of channels, but in order to fit them all into the signal, they are highly compressed, resulting in blocky pictures in some cases. Over-the-air broadcasts do not suffer from this problem nearly as much.
Vacations. One advantage in living in a “rich” country is the ability to travel for pleasure, whether within the same country or abroad. While breaks from work are mentally beneficial, they can be financially damaging. Here are some suggestions for gaining the mental benefits of a vacation without the expense.
Don’t travel as far. Airfare and lodging add up in you assessment of yearly expenses, and it can be one of the largest on your books. Rather than going to France, visit Montréal, the 10th cleanest city in the world (according to Forbes Magazine). Even better, stay local. Find a nice hotel in your area and discover their amenities.
Take it down a notch. Living close to New York City, I have access to the some of the best arts in the world. Broadway has the best theatrical shows and the New York Philharmonic is the premier orchestra.
Both of these experiences are the finest in the world, but they are expensive. To save money, opt for local theater and music. The performances may not be world class, but the events will be performed by people who are very passionate about their work.
Also, rather than seeing the New York Philharmonic in a formal venue, spend an evening with them in Central Park (or in the other boroughs or New Jersey) for a free concert during the summer. (I’ve been volunteering for the New York Philharmonic’s Concerts in the Parks for the past several years.)
Charity. Charitable giving is a controversial expense. Many people in this country are brought up with the suggestion that it is a requirement to give 10% of your income to those who are less fortunate.
This is a fantastic idea if you can afford it. This is a matter of prioritization, and for some people, charity is a non-negotiable expense. If you’re scraping the bottom of the barrel in order to feed your children, I would start to question the validity of this approach.
The best way to save money in this category while still providing help to those who need it is to donate your time and effort rather than money.
The Expensive Coffee-Related Drink Factor. Other people call this the Latte Factor®, but that term is a registered trademark. There is something to be said about changing a behavior that costs $5 a day, $25 a week, or $1,250 a year, as long as you don’t consider the job done and forget about saving money with your larger, infrequent decisions.
You can cut back all you want on fancy drinks but if you still buy a house you can’t afford or a car that’s not financially practical, you’ve just undone any savings you may have gained by eliminating something that make you pleasant to be around. Here’s more about the ECRD Factor.
If you’ve eliminated as much as possible from your discretionary expenses, take a look at how you could save money while paying for the necessary monthly expenses.
Transportation. Consider car-pooling to work, school, or after-school activities for your children. If it’s time to buy a new car, buy one that’s more fuel efficient. If it’s possible, consider working from home more often.
Food and groceries. Evaluate generic or store-brand food to determine whether you could save money while still eating healthfully and enjoyably.
Insurance. Review your coverage. With automobile or homeowner’s (renter’s) insurance, you may be able to raise your deductible in exchange for lower premiums if you have savings to cover your deductibles. Shop around and you might find lower rates for the same level of coverage, but keep in mind that you want to work with a company that won’t deny your claims.
Rent. If you rent an apartment, consider taking on a roommate or moving to a different location. When I was struggling financially several years ago, I had a few options available.
First, I lived with my father for a few months as I looked for and accepted a new job. I was lucky to have this option available, and I took advantage of it. I soon moved out to a low-rent apartment in a bad neighborhood. It was worth a try, but I moved out soon afterward. My next stop was a three-bedroom apartment which I shared with three other people. It was a tight fit, but my rent was less than $350 per month.
Utilities. Optimize your thermostat usage by using a timer and setting the heat for a lower temperature than you normally would and the air conditional for a higher temperature.
Turn of all the lights when you’re not in a room and switch to compact fluorescent light bulbs. Ensure your windows and external doors are sealed and close your internal doors.
Use power strips for your electronic equipment because otherwise they will draw power even when they or switched off. Drop your land-line telephone or your cell phone.
The other side of the equation is income. As I mentioned above, it’s usually harder to increase your income than it would be to decrease your spending, but here are some suggestions.
Maximize your income at your job. If you deserve a raise, ask for one. If not, determine what is necessary to earn a raise or a promotion and make it happen. Do your peers with similar jobs, experience, and education make more money at other companies? Consider shopping around for a new job where you can be paid more competitively.
Take a second job. This isn’t a suggestion for everyone, but a number of people I know have side jobs. A former coworker of mine wanted some additional money, so she became a bartender (not pictured here) during nights and weekends.
She said the tips she received increased her income by $500 each week (and she may have been paid under the table). If you’re a technical-minded person, consider consulting during your off hours. You may find that you like this type of work and have the ability to earn more by consulting full-time. This blog is my second job.
Sell your stuff. Whether you hold a yard sale or sell your belongings on Amazon.com or eBay, you can probably earn some money for a variety of unused items around your house. I sold a few of my old college text books eight years after I graduated and earned several hundred dollars.
Each one of these options deserves an entire article because there are so many ways to save money on expenses and to increase your income.
The goal is to spend less than you earn, and any way you can make that happen is a good choice. If you have a positive cash flow, over time you will improve your financial condition. This is, of course, ignoring the effect of the stock market which is an entirely different topic.
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Part 4: Use high-yield savings accounts. Everyone needs to keep some cash on hand, so why not make that cash earn as much as possible while still being available to you?
If you’re on your way to spending less than you earn, then you’re going to need a good place to put your excess income. Even before setting savings goals and before establishing an emergency fund, it’s best to let your cash earn as much interest as possible while staying somewhat accessible. High-yield savings accounts are the best options.
Typical savings accounts at most banks pay an interest rate well below 1%. With conservative estimates of inflation running 3% to 4%, you’re losing purchasing power quickly by leaving your money in these accounts. In the last several years, internet banks paved the way for higher interest rates.
Theoretically, these banks without branches could afford to pay higher rates because the companies lacked the expenses associated with owning a network of branches on street corners or in strip malls.
More recently, traditional brick-and-mortar banks added more accessible high-yield savings accounts to compete with these offerings.
Interest rates have fluctuated over the past few years and we’re currently at one of the low points. Great interest rates are harder to find, but there are a few quality savings accounts offering 4% or close to it.
While you may barely beat inflation at this rate, the purpose of a savings account is not long-term investment. You want to cash available to you within a day or two. All it takes to withdraw your cash is perhaps an online transfer and a visit to an ATM.
You shouldn’t just chose the savings account with the highest interest rate. Banks offer high interest rates because they want to compete for your deposits.
If any particular bank is in the midst of a capital crisis — if they don’t have enough cash on hand to pay their expenses and liabilities — they will raise rates to attract more customers.
For example, earlier this year, Washington Mutual raised rates several times and was frequently at the top of the list of interest rates. The purpose of this plan was to receive more cash. In the end, Washington Mutual failed and was bought by JP Morgan Chase.
Despite turmoil through bank failures, mergers, and acquisitions, there is very little risk in savings accounts. The FDIC insures these deposits on behalf of the banking industry.
As long as you stay within the coverage limits, you should be able to access your money even in the event of your bank going out of business or being taken over by another bank. There may be a delay in your ability to access the money, but that is not typical
I have two recommendations for high-yield savings accounts. I am a new customer and new fan of FNBO Direct, the online division of the First National Bank of Omaha.
I’m not the only fan of this account. Recently, Kiplinger Magazine honored FNBO Direct as the “best online savings account.” As of today, the online savings account offers a 3.25% APY. Since opening my FNBO Direct account in September, my experience with FNBO Direct has been smooth.
My other recommendation is ING Direct. With the Orange Savings Account’s 2.75% APY, this is not the highest rate you can find.
ING Direct was one of the first banks to popularize the idea of branchless banking, and they have historically offered great interest rates.
All reports indicate that customer service is fantastic and they have one of the best websites for navigating your accounts. It’s also very easy to organize your money at ING Direct into different labeled subaccounts. With ING Direct you can earn up to $525 in bonus interest my participating fully in their referral program.
Last Friday, I wrote about newcomers to the high-yield party, including Venture Bank Direct, ShoreBank, and DollarSavingsDirect. I also maintain an index of the popular high-yield savings accounts, organized by interest yield on the first $1 of deposit.
The list was updated last night to include the rate changes from the past few weeks, and there have been several.
The high-yield savings account is an important piece of healthy finances and it will come into play as someone further develops money management acumen. Here are six tips for optimizing your savings:
Open the high-yield account. It will take only minutes to be approved, but funding your account electronically may take several days.
Keep your change. Use a jar to collect your excess coins every day and take the jar to the bank.
Automate your savings. Set up Direct Deposit for your paycheck so you’re saving first, withdrawing for expense later.
Divert small, unnecessary daily expenses to savings. If you spend $10 on two gourmet coffee drinks each morning, switch to one $2 Dunkin’ Donuts regular coffee and deposit the $40 you save each week into your savings account.
Hide your savings from yourself. Try to forget that you have money stashed away earning interest and survive without it.
Make your raise invisible. If you receive a 3% increase in your salary, increase the amount you leave in savings each month.
If you do things right, the money in your high-yield savings account should grow each month. It feels good to be in control of savings.
- See more at: http://www.consumerismcommentary.com/take-control-of-your-finances-part-4-use-high-yield-savings-accounts/#sthash.W3W4TuFh.dpuf
Part 5: Build a better budget. Budgeting is the third rail of money management — no one wants to touch it, but it provides the power to move you from one station to the next.
It’s no secret that budgeting is a chore. Although this piece of personal finance carries an ugly reputation, even a simple form of budgeting will help you achieve more towards your goal of taking control of your finances.
Despite the negativity surrounding budgets in the news — the economic slide is affecting corporate and government budgets and people are depressed everywhere — personal budgeting doesn’t have to be an ugly process.
Why develop a budget? The purpose of budgeting is not to force someone into spending less than a certain amount of money towards a particular category. A budget should be more like a guide.
Yes, you can set aside money for a certain type of expense, but if you find you need more, you can “borrow” from another category or future time in which you expect to spend less.
This borrowing, like debt, can get out of hand, so it should be limited as much as possible. Keep in mind that budgeting is flexible.
The best way to visualize a budget, particularly if you pay all your expenses with cash, is to use a system of envelopes. To simplify the visualization even further, let’s assume you receive your income on Day 1 of each month, and you must use that income throughout the month until your next paycheck on Day 1 of the following month.
When you receive your income, you take the cash left after paying income taxes and place it into envelopes. On the outside of each envelope, write the name of a spending category.
You should have envelopes for rent or mortgage, insurance, food, and utilities. Also consider budgeting for transportation, household, debt repayments, entertainment, and charity.
To get a good idea of where you spend your money, take a look at your expenses, which you track every month. Your most frequent spending categories should determine the labels for the envelopes.
Use the data to determine the amount of income you require in each category each month. This is the amount of cash you should place in the envelope.
Do not neglect infrequent expenses. You may have certain obligations that are not paid monthly, like property taxes. If you pay $1,200 every six months for property taxes, consider your monthly budget to be one-sixth, or $200. Then left that money accumulate in the envelope for half a year until it is time to pay the bill.
Do you have an envelope for savings? You should. Consider setting this envelope apart from the others, perhaps in front so you will be reminded that it is one of the most important destinations for your cash.
Everything not distributed to an expense envelope can be placed into the savings envelope. From here you can take as much as possible to the bank for deposit, invest some of it, and spend a small portion.
Now that you’ve set a budget based on your past or current spending, see if you can find a few places to cut back. Can you reduce your budget by 10%? You may find that this is not as hard as it seems, particularly if you have excess cash to spend on wants rather than needs.
Start cutting back with your wants, but also look at your needs to see if they can be reduced. Once you’re familiar with using your budget, you can focus on the future rather than your past spending habits.
When you pay expenses by check, credit card, or debit card, you may find that it’s difficult to effectively use physical envelopes to manage your budget. Although placing cash into envelopes won’t work for everyone, the metaphor can be extended to software. Here are some of the popular choices:
Mvelopes is a website that lets you manage your personal finances online. The site focuses on your budget using a virtual envelope system similar to what I’ve described. Fee: $7.90 or more per month.
You Need a Budget is a tool you can download to help you organize your budget. Fee: $12 to $50 to download.
Intuit Quicken has a budgeting system included but many people find the feature difficult to use. Fee: $45 or more to download with this link (regularly $60 or more).
PearBudget is another web-based option that follows the envelope system. Fee: $3 per month.
If nothing else, use the $0.10 option: a pencil and paper. Writing down your budget will help you stick to it, whether you use paper or computer software.
I started my first budget with a pencil and paper even though I was inclined towards computers. I was in a transition phase in my life, trying to get myself into financial shape for the first time.
After working for a few years out of college, I left my low-paying, high-expense non-profit job and moved back in with family for about four months. I worked out a plan and a budget, found a new job, and by the time I moved out I was in control.
Money was still tight, so I stuck close to my budget for a while.
As you see more financial success as a result of spending less and earning more, you may be tempted to move away from your budget.
Despite other advice suggesting to always stick to a budget, it’s a good idea to focus less on the categorization and limitation of your expenses as the need decreases
By the time you are sufficiently saving and investing money every month, the energy you spend working with a budget could probably be better spent on other activities.
But it doesn’t hurt to check in with a budget once in a while. It has been suggested that more confident personal money managers will succeed better with an annual budget. Always keep tabs on your spending, and evaluate the trends, but don’t tie yourself down.
Budgeting, even in the early stages, should not be seen as a burden. Here are some tips to make budgeting easier.
Consider the 60% rule. I’m not a fan of rules, but sometimes a guideline can help get you started on the right path. As an individual, you can decide what’s right for you, but sometimes an example helps.
The 60% rule suggests that the first 60% of your gross income (before income taxes are taken out) should be designated for your non-discretionary, essential expenses, like housing, food, clothing, and taxes.
The rest of the income should be split with 10% going towards savings, 10% towards retirement, and the rest for “fun,” or your discretionary expenses.
Reward yourself for staying under budget. If your budget is realistic — not too difficult nor too easy to achieve — then you should reward yourself when you spend less than you plan.
With your “fun” expenses, your spending may be variable month to month and difficult to predict. If you make a conscientious effort to spend less than you expected, perhaps by seeing fewer movies in the theater or cutting back on vacation plans, you have extra money left in your envelope (virtual or otherwise).
First, move that excess money to savings. If you don’t perceive savings to be an intrinsic reward, treat yourself to something you’d like.
Use ING Direct’s subaccount feature. Since you can split money in ING Direct’s high-yield savings account into separate buckets, you can label these subaccounts to match your budgeting categories. this lets you earn a decent interest rate while keeping your money organized.
Pay yourself first. No matter what, make sure some of your excess income is diverted to your savings. If you set up direct deposit into your checking or savings account, this will require less work.
Your savings envelope contains 100% of your income (minus income taxes) after you are paid, and from there you can distribute funds to your remaining envelopes.
Please share any budgeting advice or suggestions!
- See more at: http://www.consumerismcommentary.com/take-control-of-your-finances-part-5-build-a-better-budget/#sthash.EY0mRKn8.dpuf
PART 3 OF PART 1