A Step by Step Guide to Improve Your Personal Finance

By , on Nov 25, 2012

The past few years have not been good to many Americans — market crash, recession, high unemployment rate, underemployment, rising debt problem, etc. Invariably, our personal finances suffer as a result. In this article I’d like to present a potential step by step guide to help you restore your financial health.

5 Steps Guide

1. Recognizing the problem and having the determination to fix it

I believe self-awareness is an important first step in any endeavor. Personal finance is no different. Here are some signs that you may be in financial trouble:

  • You only pay the minimum amount due on your credit cards
  • You are not saving money toward major financial goals, such as down payment for a house, retirement, college education, etc.
  • You are borrowing to meet end needs

Does any of this describe you? Now that you recognize the problem, it’s time to put your foot down and make the commitment to fix it. It’s time to establish financial goals for yourself.

2. Understanding the basics of wealth building

Before you act, the next step is to understand the mechanics of wealth building. Wealth consists of four components: income, expenses, assets, and debt. In short, to build wealth you have to:

  1. Reduce your expenses
  2. Reduce and eliminate your debt
  3. Increase your income
  4. Increase your assets and their return rates

Basically, you want to earn more than you spend so that you have enough left over to pay off your debt. Then save and invest your money so that it works for you.

3. Reduce your expenses (frugality)

Building wealth is like trying to fill a bucket with water – you can’t fill it up if the bucket is full of holes. Your expenses are these little holes. Your first priority is to make these holes smaller, or plug them up entirely. The key objective is to spend less than you earn — or earn more than you spend — so that you have enough left over to pay down your debt and invest in your future.

A good way to start is to enter all your information into an online expense tracking tool like Mint.com. For example, Mint.com will provide you with a categorized list of expenses. Once you have this list, start from the biggest category and work your way down, because saving 10% off a $5,000 category is a $500 saving versus 10% off a $500 category is only a $50 saving.

Some of the questions you want to ask as you go through this exercise are:

  • Do I need this?
  • Is there a less expensive alternative?
  • Where can I cut costs?

Mint.com built-in “Ways to Save” feature is a great place to start. However, don’t stop there and think outside of the box. For inspiration, do web searches for “ways to save money” and “frugal ideas” (or start right here with our 50+ Frugal Tips, Ideas, and Resources).

4. Pay down your debt

At this point, you should begin to see left over money from each paycheck. The best way to use this money is to pay down your debt. There are many ways to approach this, but a good place to start is to pay down debt with the highest interest rate first.

Before you seek out debt consolidation services, you should do some research to find out what you can do on your own. One of the most respected debt elimination guru today is Dave Ramsey. You could start by doing a web search for “Dave Ramsey” and read up on his methodology.

Perhaps with exception of your home mortgage, you should consider eliminating all your debt as soon as possible.

5. Start an emergency fund

While you are paying down your debt, don’t worry about putting cash aside for emergencies. You can always whip out your credit cards for that. This is not a very popular view, but which one would you rather do: pay off credit card debt to save money on interest…guaranteed, or put money aside in case of emergency? I think Suze Orman also said the same thing in her book: The Money Book for the Young, Fabulous & Broke.

However, once your debt has been eliminated, you should immediately start an emergency fund.

Again, there are a lot of opinions on how big the emergency fund should be. For our purpose, saving enough to cover three months worth of expenses would be a great start.

The Next Steps

At this point, you are no longer in debt and you have a sizable emergency fund – congratulation! Now you have the financial flexibility to do many things without worrying about how you’ll put food on the table, or how to overcome the next emergency.

To complete our journey, here are three things to do (in any order or simultaneously):

  • Increase your income potential – This includes improving your skills to position yourself for a better job or a promotion, taking on a second job, and finding other ways to supplement your primary income.
  • Save for short-term goals – Instead of borrowing to buy things that you want, at this point you should think about saving for them. High-yield online saving account and certificate of deposits are some of the best way to grow your money and preserve your capital to meet short-term goals. Some of these goals include saving money for your first home, your college tuition, and business start-up fund.
  • Invest for long-term goals – Money meant for longer-term goals such as savings for your retirement and college savings for your children, should be invested. It would be difficult to address this complex topic here, but a great strategy is to invest in a globally diversified investment portfolio consists of low cost passively managed funds that reflect your risk tolerance level and investment time horizon.

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I write about things that have (and haven't) worked to improve my family's financial situation. What works for me may or may not work for you, and you should always consult a financial advisor before making important financial decisions.

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