"A journey of a thousand miles begins with a single step" - Lao Tzu (Chinese philosopher)
With the previous post, "The Basics for Prosperity", I outlined the financial landscape that we will navigate during our lives and the financial foundation that we need to put in place to have peace of mind.
Some of the comments on the post was very insightful and on point but my impression is that you are slightly impatient. (I write this tongue in cheek) A few of you pointed out that part of the basics for prosperity must include investing. I completely agree! It is essential! Investing is a crucial part of the 1st, 2nd, 3rd and 4th quadrants of our financial life. It is the secret sauce.
However, let's not jump too far ahead of ourselves. We are still laying the foundation to build on. It is no use having walls and windows without a solid foundation.
My assumption, if you are here, is that you will like a practical step by step guide on how to achieve financial freedom.
If that is the case, then your very 1st step should be to know where your money comes from and where it is going.
So, lets address an issue that all of us know is important, but very few of us is doing.
Budgeting!
Ever heard of Net zero Budgeting?
Net zero budgeting is a method of structuring your budget in such a way that you have a net zero balance, i.e. your income and expenses match each other.
Here is an example: (Its very basic, and I made up the numbers to illustrate the concept).
NET ZERO BUDGET | |
|---|---|
Total Monthly Income | 10000.00 |
Morgage / Rent | 3000.00 |
Utilities | 700.00 |
Groceries | 1200.00 |
Petrol/Commute | 600.00 |
Entertainment | 650.00 |
Insurance | 350.00 |
Retirement Savings | 1000.00 |
Emergency Fund | 500.00 |
Charity | 250.00 |
Phone Bill | 450.00 |
Loans | 850.00 |
Miscellaneous | 450.00 |
Balance | 0.00 |
There are several advantages with this method of budgeting versus the traditional method where we only track our expenses over time.
Net zero budgeting brings clarity and awareness about how and where we want to spend our money. It is based on conscious decisions that we need to evaluate all the time. We allocate our money to specific parts of our lives.
It also allows for customization. For example, if you want to allocate more towards your emergency fund, you might decide to allocate less to your entertainment budget. The net result should still be zero.
It also helps you to focus on the reason behind your spending decisions. It aligns spending with specific objectives. You will notice in the example above, that you include your savings and investments into your budget, you treat your retirement savings as an expense. This shows you very clearly how much of your income goes to future you versus current you.
The biggest advantage, from personal experience, is that it really showed me my priorities. It was a little bit uncomfortable to be honest with myself in the beginning, but it's a decision I would never regret.
The biggest disadvantage of net zero budgeting is that it is inflexible and rigid, especially when unexpected expenses arise. So, it's important to build that redundancy into your budget.
This brings me to the 2nd topic for today:
Emergency Funds!
There are different definitions for emergency funds.
I tend to think of it on a scale of bare minimum to fully stocked. 3 months of your income being the bare minimum and 6 months being fully stocked. More than 6 months is fantastic, but then we are getting into the area of unproductive money. Always remember, your money is a tool that either works for you or against you - your choice.
Here is a thought. Emergency funds should not be your credit card or an overdraft facility or a personal loan. It is also not your family or friends. It is not an emergency loan against your home equity or any other form of savings. An emergency fund is an asset that earns you a small interest rate when not used. It is not a liability.........well, it should not be.
Another very important aspect of an emergency fund is that it is liquid. (immediately available when needed). So, probably a separate bank account that is not your everyday expenses account.
Here is a practical idea on how to administer your emergency fund. The probability that you will need an amount equivalent to 6 months income in one go, is remote.
Rather than having the entire amount in one separate bank account somewhere, why not keep 1 months' worth of income in that account that you can access immediately and the other 5 moths in a 30day fixed deposit that provides a small interest rate and requires only 24hours notice before you can access your money?
Ok, but what if you don't have an emergency fund and have to build it from scratch? This is where a tool like net zero budgeting comes in very handy, because you can allocate part of your budget every month to this specific goal.
Be honest, after the floods that we experienced a month ago, how many of you needed an emergency fund, but instead tapped your credit cards or a loan facility?
Let' talk about debts:
If you are in a situation where you don't have an emergency fund, but you also have debts to pay, which is the more important priority? Personal opinion - pay your debts first. There are so many benefits from not debt in your life (emotional, psychological, cash flow, savings). You will not only save on the interest payments but will suddenly have extra cash available that you can allocate in your budget towards your emergency fund.
Let's talk about the order in which it is most beneficial for you to pay your debts:
Credit Cards - interest rates vary from institution to institution, but are usually north of 20%
Personal Loans and overdrafts - interest rates on this are usually in the teens.
Car loans - It's a bad idea to purchase a car with a 60 month or longer loan at a rate of anywhere between 7 - 15%. You are adding hundreds of thousands to the price of that car.
Furniture and appliances loans - Seriously, do I need to say anything about this?
Home loans - usually the lowest interest rate but be careful even here. Even with a low rate, with a loan of 20 - 25 years the interest payments add up. If possible (affordable), try not to take out a home loan for longer than 10 years. (I'm not referring to investment properties here, that a topic for another day. We are talking here about a primary residence in which you live and raise your family).
You will notice that the priority of repayment of debts, depends on the interest rate charged against that debt. The higher the interest rate, the higher the priority to pay it off.
Right, let's recap - practical ideas that you can implement immediately:
Know where your money is coming from and where it is going - know your budget.
Allocate some money to the wellbeing of your future self!
Allocate a part of your budget to build an emergency fund.
Pay of your debts in order of the rate of interest that is charged against it - higher interest rates should have priority.
In closing, it must be said that building an emergency fund or paying of your debts is not an overnight exercise. It will take time.
If you are living from paycheck to paycheck with no savings and no emergency fund you need to find a way to free up cash flow or generate additional income. This is easier said than done.
If you feel that you need help with any of this or just need a second opinion on what you are already doing, please get in touch. I would love to help.
Next week we'll talk about savings. It's a fun topic.
See you then. Take care.
Hendrik
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