Long ago, I found a twitter quote that helped me understand why it is important to have a solid financial foundation.
“If you can’t manage $1,000, you can’t manage $10,000.
You don’t suddenly learn how to manage money by amassing more of it. That is why a lot of lottery winners lose it all.
Financial literacy is not a side effect of wealth. Wealth is a side effect of financial literacy.”
My goal within the blog post is to help you understand the importance of a budget, dive into the mechanics of credit, and explore ways to pay off debt. Hopefully by the end, I’ve given you some of the blocks to build a solid foundation for financial success.
Budgeting 101
To start, the reasons and benefits on why you should budget is to maximize assets and minimize debt. I’ve broken down this into a simple 4 step-by-step guide to help you nail down the basics of budgeting:
Step 1: Calculating Monthly Income
To figure out your monthly income boils down to how you are paid. If you are paid bi-weekly (every 2 weeks), multiply your take home pay for one paycheck by the number of paychecks in a year: 26. Then divide this number by 12 to get your monthly income.
If you are paid weekly, take your weekly pay, and multiply it by the number of weeks in a year: 52. Then divide this number by 12 to get your monthly income.
Step 2: Calculating Your Monthly Expenses
In this step you will list out all your monthly expenses and determine if they fall within a fixed expense or variable expense.
For fixed expenses, some examples are mortgage/rent, car payments, car insurance, health insurance, utility bills, internet, TV, and cell phone bill. These are all expense where you pay a set dollar amount every month.
As for variable expenses, notable examples are travel, dining out, groceries, gifts, and entertainment.
As you complete this exercise, did anything surprise you on how much you are spending on various expense?
Step 3: Develop a Spending Plan
To develop a spending plan that you can work off your income, I encourage you to utilize the 50/30/20 Rule. This rule boils down to using 50% of your income towards NEEDs (rent, food, debt repayments), 30% towards WANTS (trips, entertainment, gifts), and 20% towards SAVINGS (emergency fund, home, retirement).
Keep in mind that is a general rule to start with and not a rule that needs to be followed to the tee. This rule can be a great template to start with to help build a budget that you can follow through with.
Step 4: Minimize Expenses
Now you will take what you have noted within step 2 of calculating your expense within fixed and variable categories and compare it to your spending plan. The goal is to compare your standard of living with the reality and expectations of your budget. You will need to find ways to increase and decrease expenses to fit your spending plan.
Your goal is to have your spending align with your values.
Credit As A Consumer
Credit is a financial tool that effects everyone. From leasing a car to buying a home with a mortgage, credit plays a huge factor. Credit is the ability to borrow money under the agreement that you’ll repay the debt later.
The 2 main types of credit that most are familiar with are revolving credit (think of credit cards) and installment credit (auto loans and mortgages).
A big question we get that pertains to credit is what a credit report is. A credit report is a financial record containing information about an individual’s history of borrowing and repaying debt. By law, all Americans are entitled to one free copy of their credit report every 12 months through AnnualCreditReport.com. This is also used to calculate your credit score (more on that later).
I highly encourage you to download your credit report to protect your credit history from errors and help you spot signs of identity theft.
Now on the topic of credit scores, you might have heard of the FICO Score or VantageScore. These are some of the most popular credit scores that lenders use to show how “risky” you can possibly be as a customer. The range of credit scores usually fall within the range of 300 to 850. The higher the number, the less “risky” you are. This tells the lender how likely you are to pay back what you owe.
Lastly, I do want to point out major factors that affect credit scores. They are the amounts that are owed, payment history, types of credit account you have open, length of credit history, and how many new credits account you have open.
Paying Off Debt
Debt.org had ran studies and has shown that 77% of American households have at least some types of debt. Debt can be in the for of mortgages, credit cards, auto loans, and more. Keep in mind not all debt is considered bad. Some debt can be used to grow wealth. But what is surprising is that at the end of 2022, American household debt hit a record of $16.9 trillion dollars according to the Federal Reserve. That is a lot of zeros.
There are many ways to pay off debt. In the blog post we won’t be going over balance transfer credit cards, debt consolidation programs, or debt repayment plans. We will be going over 2 other effective ways to pay off debt: Avalanche method and Snowball method.
The Avalanche method of paying off debt can be boiled down to 5 steps:
- List all debts with the highest interest rate to the smallest interest rate.
- Make minimum payments on all your debts except the highest interest rate.
- Throw as much extra money as you can on that one until it’s gone.
- Take what you were spending on your highest interest debt and add that to your payment on the next-highest interest debt until it’s gone too.
- Repeat until each debt is paid in full and your completely debt-free!
This process not only reduces the amount of total interest a person can pay over time, but also the time it takes to get out of debt. This is great for budget-oriented people. However, this requires a lot of discipline and commitment.
As for the Snowball method, it too can be summarized into 5 steps:
- List all debts smallest to largest (regardless of interest rate)
- Make minimum payments on all your debts except the smallest debt.
- Throw as much extra money as you can on your smallest debt until it’s gone.
- Take what you were spending on your smallest debt and add that to your payment on the next-smallest debt until it’s gone too.
- Repeat until each debt is paid in full and your completely debt-free!
This process is great to build motivation by settling debts faster. But, throughout the process, it can take longer to become debt free and will not reduce the amount of interest paid than the debt avalanche method.
Between the two methods, there is no best way to pay off the debt. Everyone is different and each will need to find what works best.
After putting the pieces together, having the appropriate budget enables you to purposefully allocate and manage your expenses. With an understanding of how credit works, you can leverage it to your advantage and manage a healthy score. Lastly, effective debt management is crucial to prevent it from consuming you. For any questions, CLICK HERE to set a meeting up and get you back on track with your finances!