Can you imagine driving to a new destination without a map or directions on how to get there? The chances of you reaching your destination would be close to zero. Well, this is what people do when they go about their daily lives without a financial plan.
A lack of financial planning may be why most workers over 40 don’t have enough savings to retire. But what exactly is financial planning and how does one go about it? Keep reading for the complete guide to financial planning.
What Is Financial Planning?
Financial planning is a major life skill that everyone should master before they turn 18. Adults need the financial means to pay for their basic needs as well as savings to cover emergencies. Unfortunately, many of us go through life never learning key financial principles so we struggle to live life on our terms.
Financial planning is all the activities that go into managing your personal finances. A good financial plan evaluates the current state of your finances and works out how to achieve your financial goals. The plan helps you make sound financial decisions that will secure both your current and future financial situations.
A financial plan is a must if you are mid-way into your career and expect to retire in the next 10 to 15 years. Households with a written financial plan are more than 2.5 times likely to save enough for their retirement. So a financial plan may be the key factor that ensures you have a good life post-retirement.
The Elements of a Financial Plan
A financial plan should reveal all aspects of your financial portfolio. This is so you can have a good picture of your financial standing. There are four critical components you should be tracking:
- Income and savings
- Assets and liabilities
- Risk management
- Retirement outlook
You should set monthly and annual goals for each of these four areas and check your progress each month. Let’s look at each element in more detail.
Savings and Investments
Your savings and investments are the keys to securing your financial future. The focus in this area should be to maximize your household income and savings rate. One way to increase your income would be by upskilling yourself to increase your take-home salary. You could also work several jobs or start a side hustle business.
Your savings rate calculates the percentage of your monthly income that gets saved or invested. The higher the percentage the better, but you should aim to save at least 10% of your gross household income. The amount each household should save depends on their lifestyle and retirement goals.
In case you’re falling short of your savings rates you’ll need to find ways of increasing your income or reducing your monthly expenses. Setting a household budget will help you reduce your expenses to reach your savings and investments goals.
As part of your savings plan ensure that you have an emergency fund of liquid assets covering at least 3-6 months of your household expenses. This could be cash saved in an interest-bearing savings account that you can withdraw quickly without loss of principal in case of an emergency.
Assets and Liabilities
The second area you should track is your net worth. This is calculated by adding up the value of your assets like cash, stocks, and properties. You then deduct your liabilities like credit card debt and mortgages. The goal is for your net worth to increase over time as you pay down your debt and your investments compound.
Something else to consider in this area is your debt-to-income ratio. Many people go bankrupt because they take loans or mortgages that they are unable to pay for. Before taking on a mortgage or credit card debt, check your debt-to-income ratio (the percentage of your income that will be used to pay your debts).
This will help you see whether your monthly income can cover the minimum monthly payments of your debt. Try and keep your debt low. This will leave you with more disposable income to put towards your savings and investments.
Risk Management
Another important element of your financial plan should be how to reduce your financial risks. Life insurance coverage is a must if you have dependents. The insurance will provide your dependents with a financial cushion that will cover their basic needs if something happens to you.
You can also take out disability insurance coverage that will provide a substitute income in case you are unable to work due to illness or injury. Some employers provide this as an employee benefit as well. Other standard insurance coverage you should have includes auto insurance, health insurance, and homeowners’ insurance.
Another important task you must complete under this section is estate planning. The only sure thing in life is death, so be sure to have a will that specifies how your assets should be divided when you die. You must also write clear directives on guardianship nominations, health care directives, and final disposition instructions. If you want to control how your assets are distributed while keeping your wishes private, you should consider implementing a trust as well.
Retirement Goals
The final element of your financial plan is your retirement planning. You need to figure out how much you need to save for retirement and if you are on track to save enough before you plan to quit working. This targeted savings will be determined by what you need for your day-to-day living expenses plus any large, occassional expenses like the purchase of a car as well as any one-time goals like a large anniversary trip.
Once you have your retirement goals set you can establish how much you would need to save each month to cover these goals. In some cases, one may find it impossible to save enough to meet all these initial retirement goals. So you may need to adjust your desired retirement lifestyle or find ways to earn more money.
Start Financial Planning Today
Living life without a big picture idea of what your financial goals are is a recipe for disaster. It is never too late to learn what is financial planning and start today. So use the information above to start your plan.
You can also seek the guidance of a qualified financial professional to create your plan. Contact us for more information on how to create the best plan for your financial independence.