A Foolproof Guide to Personal Financial Planning
According to the National Institute of Retirement Security (NIRS), 95% of millennials save less than the recommended amount every month.
Forbes has indicated that 63% of Americans don’t have enough to handle a $500 emergency.
CNBC has reported that nearly 34% of Americans have $0 in savings.
These statistics indicate the importance of educating people on personal financial planning.
Check if you have been underdoing the following experiences in day-to-day life.
· “I end up having no money at the end of every month.”
· “I don’t know where my money is going.”
· “I am taking credit from my friends for day-to-day expenses during the last week of every month.”
Sounds like you? Then, you need to understand the importance of personal financial planning.
Everything in your life needs a plan. A plan is a course of action that helps in achieving an end-objective.
Money is an integral part of day-to-day life. Money, if used properly, can help you build assets and change lifestyles. If misused, it can break your life. Achieving long-term financial goals is a distant dream if you don’t have a financial plan in place.
What is Personal Financial Planning?
Personal Financial Planning is a process of creating a framework for achieving the future financial goals of an individual.
Every individual has several short-term and long-term financial goals.
Short-Term Financial Goals
1. Purchasing a dream car within 2 years from now
2. Going for a vacation along with family to a foreign country within the next 12 months
Long-Term Financial Goals
1. Creating a corpus of $200K for a two-year-old child’s higher education by the time she attains 17 years of age.
2. Creating a corpus of $500K for a 30-year-old’s retirement by the time he attains 60 years of age.
The timeframe is the factor that determines whether a financial goal is short-term or long-term. People use different timeframes to differentiate between short-term and long-term goals. For me, any goal to be accomplished within 2 years is a short-term goal. The rest are long-term goals.
Financial planning is the process of organizing finances. The financial plan enables you to track the cash flows, cut down unnecessary expenses, identify suitable investment channels, and do goal-based investing.
Why personal financial planning is important?
Personal financial planning is important because it brings financial discipline to your life. Financial planning enables you to control expenses, streamline investments and build assets.
Personal Financial Planning helps to Estimate Earnings Required
You may have a lot of financial goals. Without saving and investing a certain amount of money to each goal every month, you will not reach financial goals. Financial planning enables you to reverse engineer the investing process and determine the amount of money you need to earn each month.
For instance, I am a 30 years old individual with the following short-term and long-term goals.
1. To create a retirement fund of $1 Million by the time I reach 60 years of age.
2. To create a higher education fund of $200K for my 2-year-old daughter by the time she attains 17 years of age.
3. To create a marriage fund of $200 for my 2-year-old daughter by the time she attains 23 years of age.
4. To purchase my dream car worth $50,000 in the next 60 months.
5. To purchase my second dream car worth $50,000 in the next 60 months.
6. To create a vacation fund of $50K in the next 120 months.
7. To create a vacation fund-2 of $50K in the next 180 months.
8. To purchase a dream home worth $400K in the next 120 months without a home loan.
In addition to these, I may have to allocate money for day-to-day expenses like food, clothes, rent, child school education, term insurance, and health insurance.
Now, check out how much I should earn for the next 30 years to achieve these goals. I assume that the basic expenses increase at a 2% annual inflation rate. I have also assumed that the money for each goal is invested in index funds to receive returns at 7% CAGR.
The last column of the table showcases how much I need to earn each year to achieve my financial goals. For instance, I should invest $750 every month in index funds ($9000 a year) to accumulate a corpus of $50K within 5 years. So, financial planning helps you to determine how much you need to earn to achieve financial goals.
Personal Financial Planning Helps to Track Expenses
You may earn $100K per annum but be broke at the end of the month if you don’t have a proper financial plan. As much as you focus on earning money, you should focus on tracking expenses. Personal financial planning ensures you note down each expense that you make on a day-to-day basis. It encourages you to cut down the unnecessary expenses.
One does not need to let go of the desired standard of living when tracking and cutting down unnecessary expenses. This activity helps you understand where most of your money is being spent. It helps you to understand your unknown yet common spending habits. For instance, ordering food over 10 times a month from an expensive hotel when you can prepare food in your kitchen at home could be an unnecessary expense. However, it depends on the priorities. For a working couple who don’t have time to make their food, ordering food from an outside hotel is a good idea.
I suggest you identify your priorities and check if you are spending more money on activities of lesser priority. An example of lesser priority activity could be an automatic renewal of Paid Membership for a particular service that you don’t regularly use. You can identify your negative spending behavior by tracking expenses for a couple of months.
You can use a pen and paper to note down the expenses. Several mobile applications are available to help to track the expenses. Irrespective of what method you use, ensure that every penny spent is recorded. Make sure you involve your spouse well in tracking the day-to-day expenses for better results.
Family Security
It is your responsibility to provide secure life to your family members. Financial planning enables you to have proper insurance coverage for you and your family. According to LIMRA’s Insurance Barometer Study 2020, only 54 percent of adults in the United States were covered by some type of life insurance. According to the survey conducted by MoneySupermarket, up to 60 percent of adults in the United Kingdom don’t have any form of life insurance. Lack of financial planning is a reason for lower insurance coverage across the world. Since insurance (both medical and term insurance) is an important component of financial planning, people with financial plans will attain better family security.
Increase in Savings
Money is the seed to make more money. Investments that generate passive income need seed capital. For instance, you need money to purchase real estate that generates rent every money. You need money to purchase shares of an organization that over a period of time appreciates in terms of value and generates yearly dividends. You cannot make investments and income-generating assets without having money in hand. For a salaried employee, this money would come from regular savings every month.
One can save money without having a financial plan. But, the efficiency of the savings process would increase when a financial plan is in place. Since personal financial planning enables you to track your expenses consciously and cut down unnecessary expenses, the savings rate would go up automatically. So, you should create a financial plan to increase the savings rate.
Peace of Mind in Emergencies
Emergencies struck at least once or twice in everybody’s life. A sudden job loss could be an emergency that puts you under stress if you don’t have an emergency fund that covers at least 12 months of your expenses. A health emergency of a family member can eat all your savings and investments if you don’t have adequate health cover.
Personal financial planning increases your peace of mind by encouraging you to create an emergency fund and take adequate medical and term life insurance before making investments into income-generating assets.
What are the steps involved in Personal Financial Planning?
Here are five steps of the personal financial planning process.
Step-1: Review Current Financial Situation
The review focuses on gaining in-depth insights on monthly income, expenses, current assets, fixed assets, short-term obligations, and long-term liabilities. Certified Financial Planners give an exhaustive questionnaire that collects information on an individual’s current financial circumstances. The individual may also need to answer questions related to future earning potential and risk tolerance level. The questionnaire would also focus on identifying savings rate, desired retirement age, eligibility to social security schemes, and dependents’ needs.
Step-2: Establish Short-Term and Long-Term Goals
An individual can have big dreams and goals. However, these goals might not be realistic considering his existing earnings and future earning potential. This step focuses on establishing realistic short-term and long-term goals by using SMART Criteria.
SMART — Specific, Measurable, Attainable, Relevant, and Time-Bound.
Goals vary from one individual to another.
· A person at 22 years of age might want to save $50K within the next five years for her marriage.
· A person at 32 years of age might want to save $200K within the next fifteen years for his child’s marriage.
The financial goals can also include a luxury car, dream house, and foreign vacation.
Proper analysis of the current financial situation and future earning potential would help to determine realistic goals.
Step-3: Analysing Current Financial Planning Process
This step focuses on analyzing the existing savings rate, monthly allocations to investments, insurance coverage, and day-to-day expenses. The following process would help in analyzing the current course of action.
Monthly Income:
Debt:
Emergency Fund:
You’ll be able to understand how much, on average, you are allocating to each component by drawing a table like this. Recording the allocations of 3 months would be sufficient.
Step-4: Prepare New Personal Financial Planning Process
The first component in this new personal financial planning is — HEALTH and TERM INSURANCE. If you don’t have health and term insurance yet, you should take adequate health and term insurance policies for yourself and your dependents. Your financial planning comes to standstill until you (your family) are not covered adequately.
The second component is — EMERGENCY FUND. I suggest you have an emergency fund covering at least 12 months of your expenses, which include your EMIs. Stop all investments until you create an emergency fund, covering expenses of 12 months.
The third component is — CLEAR DEBTS. I am not talking about your Home Loan and Car Loan for which you are paying EMIs. I am talking about the debts you got from banks, non-banking financial institutions, independent creditors, relatives, and friends for higher interest rates. Clear all your high-interest-bearing debts before start making investments.
In this step, you should make amendments to the existing plan or prepare a new plan. The new allocations should practically help you achieve the financial goals you have developed in step-2. You would come up with fresh allocations for day-to-day expenses based on the analysis you did in step-3. You cut down unnecessary expenses and convert them into investments.
I strongly suggest you prepare a goal-based financial plan. A goal-based financial plan enables you to allocate a certain amount to each goal every month and invest it somewhere (shares, mutual funds, or real estate) based on the timeline of the goal and your risk appetite. This is called a Systematic Investment Plan.
People with a high-risk appetite can invest money in shares or equity mutual funds. These investment vehicles are a bit volatile but give high returns. People with less risk appetite should invest money in debt mutual funds. The timeframe would also play a major role in choosing an investment vehicle. The longer-duration goals like retirement corpus and kid’s education fund would allow you to invest money in equity markets. Don’t invest money in equities for shorter-duration goals (below 2 years) as the equity market can be volatile in the short term.
Step-5: Close Monitoring and Revising the Plan
We are human beings and our goals evolve over a period. An individual who earns $60K might earn $100K next year. When the income increases, you may add more financial goals and increase the allocations for existing goals.
You can always tweak the financial plan based on your priorities. The aims of financial planning are to reduce unnecessary expenses, increase the savings rate and invest the savings into the right investment vehicles.
Final Word
Personal financial planning helps to track your expenses, cut down unnecessary costs, increase the savings rate, invest the savings to achieve financial goals.
