One mistake that most beginners make when trying to figure out how to manage their money is thinking that personal finance is just all about investing. However, they don't realize that before you can even grow money, you'll need to build a solid foundation to support this growth. You'll find a lot of resources all over the internet, and these can be overwhelming, especially for a beginner. Personal finance does not need to be complicated. Let me simplify this in five steps (should be in sequence!):
Assessment
Clear any expensive debt
Build emergency fund
Build protection
Growth
Assessment
Determine your current financial status. This activity may make you uncomfortable because it will make you introspect your financial decisions, so far. I've seen people realize they have been living way above their means during assessment, and one may feel bad about it. But, you won't be able to fix anything if you don't acknowledge the problem.
Here are suggested steps to take the assessment:
#1 Record your monthly cash flow - list all your known sources of income and how much you are getting from each. Get the sum. If you have a business, take your worst case. For those who are employed, take your net salary (that's minus all the taxes and government contributions).
Sample:
Maria has a net salary of 50,000/month and gets 20,000/month from her side hustles. Her total cashflow is 70,000/month.
#2 List your expenses and liabilities - jot down how much you are spending on monthly bills, groceries, tuition fees, eating out and take aways, leisure, etc. You also need to list your monthly commitments like insurance, home and car amortizations.
Sample:
Maria's expenses are as follows--
Groceries - 2,000
Condo dues - 2,000
Water - 600
Electricity - 3,000
Leisure - 3,000
Condo mortgage - 20,000
Car loan - 15,000
Gas - 4,000
Total - 49,600
#3 Calculate your debt to income ratio - credit card debts, home and car loans, etc. This is usually used by banks to determine whether you would be able to "afford" a mortgage or a loan with them. This illustrates your ability to pay your debts. Use the formula: (Total debts ÷ Total Income)*100.
Sample:
Maria's total net monthly income is 70,000
Maria is paying 20,000 for her Condo and 15,000 for her car.
35,000 ÷ 70,000 = 0.5 * 100 = 50%
A low ratio according to financial advisors is around 10-20%.
A high ratio is above 30%, because that means you are probably spending the majority of your income on paying off debt. If you are in this realm, do not add more debt and work on either increasing your income OR making a plan on clearing your debts.
For this example, Maria has a high debt-to-income ratio, which should signal her that she is spending too much of her income in debts. She's most likely one emergency away from incurring more debts in the event that she fails to pay in a month.
#4 Calculate your total savings per month - this is as simple as: Total Income (#1) - Total Expenses and Liabilities.
Sample:
Maria is able to save ~21,400 of her income every month after paying all her bills and day to day expenses.
70,000 - 49,600 = 21,400
Clear any Expensive Debt
Expensive Debt are those that have high interest rates, such as credit cards. Credit cards in PH are usually at 2% monthly interest rates, bringing it to 24% p.a. The notorious 5-6 is, technically, at 20%. Due to the high interest rates, it is easy to go into more debt if you don't pay this off as fast as you can.
Sample:
If you have 50,000 in credit card debts and leave it there for 3-months without any payment:
50,000*0.02 = 1,000 (month 1)
(51,000 + 1,000 hypothetical late payment charge)*0.02 = 1040 (month 2)
(53,040 + 1,000 hypothetical late payment charge)*0.02 = 1080 (month 3)
Total Credit Card debt in month 3 = 55,120
Your credit card debt just ballooned to another 5,000!
Steps on clearing debt:
Stop adding more debt. If you have been just paying off the minimum monthly payments, there's a high chance that you're having a hard time paying off the debt. Cut your credit card and close down your account.
You can use different strategies. One strategy is Dave Ramsey's Snowball strategy, which is paying off the smallest debts first and gaining momentum to paying off the largest ones.
If you have multiple credit cards, you can ask for a transfer to one credit and negotiate a payment scheme with the bank that works for you.
Build Emergency Fund
You can also build this in parallel to paying off debts. You can use your monthly savings money you were able to calculate to build this. Emergency funds keep you afloat when unexpected mishaps happen such as losing your job, medical emergencies, immediate home repairs etc. These unexpected events can be stressful and costly. It gives you security at times of financial distress and reduces the need to withdraw from high-debt options such as resorting to credit cards or undermine your future security by tapping from your investments. You can read here on how you can better build this fund.
Sample:
Maria can save 21,400/month
She decides to build 3 months worth of monthly income as emergency fund. This means she needs 210,000 (70,000 monthly income X 3months).
She will complete her emergency fund in 10 months with her current savings rate (210,000 target EF / 21,400 savings rate = 9.8 months).
Build Protection
After you've built your Emergency fund and kept debts at a manageable state, the next step is to protect your income and fund. This is important, especially for breadwinners and those with dependents. Protection means if something happens to you like untimely passing away or needing to be hospitalized for a critical illness, god forbid, your dependents will still be able to carry on with their lives without any financial burden. Health care is very costly and can drain all your savings easily.
This is where insurance comes from. There are also different kinds of insurance: Medical, Health and Life Insurance. Medical Insurance supports your hospitalizations, out-patient procedures, etc. depending on your policy. One example of this are the HMOs you get as a benefit from your company. Health Insurance are those that are focused on Critical Illness, hospital Income, etc. You will be able to get a lump sum out when you declare that you have been diagnosed by an illness covered on your policy. Then, you would be able to afford your hospital bills and focus on recovery. Examples of these are AIA's Critical Protect, AXA's HealthMax and Sun Fit and Well Advantage. And lastly, Life Insurance puts a lump sum on your life. When you pass away because of an illness or an accident, your beneficiaries will get a lump sum. I won't be discussing these three in detail. There are different flavors of insurance in the market, but it's best to determine your need first before talking to insurance agents.
Growth (Investing)
You may be wondering why this is at the bottom of the sequence. The main reason for that is growth has another element: time. If you don't have any of those we have discussed above before investing, you are one step away from losing money. Why?
If you put your money straight to investing without emergency funds, during an "emergency", you won't have any liquid cash with you. You will then need to withdraw from your investments. Due to the nature of investments where it'll need time to grow, you may be prematurely taking it out at the wrong time, such as a market depression. For example, you may need to pull out your investments when the value is 20% down.
One thing you may have built while doing steps 1-3 is discipline. Some people who run straight to investing without discipline is prone to the Fear Of Missing Out (FOMO). I've seen people use their credit cards to "invest" on a hyped financial instrument. That's adding debt and if you lost money in your "investing", then that's double the damage.
There are different investing strategies and different people will have their own appetite on how they want to grow their money. I've discussed a few, and check out my FIRE posts if you are interested to know where I have been putting my own money.
Talking about money is uncomfortable, but that's probably because we don't want to admit to ourselves that there is a problem. But until we acknowledge that there is a problem, we will never be able to improve and solve anything. I hope this gives you some guidance on your way to financial independence. Happy Sunday and stay safe, everyone! :-)
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