We all want to save money, right? (Well, maybe not all of us, but the smart ones.) It’s just a matter of actually doing it. All too often a pesky thing called "life" gets in the way: we get too busy, a surprise gets sprung on us, it’s too confusing to go it alone without a professional financial advisor… you name it, and someone’s probably used it as an excuse for why their finances are a nightmare.
But here’s the secret: it doesn’t have to be hard.
Sure, if you wake up one day and decide today is the day you’re going to completely overhaul your financial picture, start new habits, and become a new person, then yeah, I can see how you’d be overwhelmed. What if, instead, you took things step-by-step and walked your way toward financial security, rather than trying to do it in one giant leap?
Here are five steps to get you started on the path toward a financial safety net.
Step 1: Create a budget
Easy to say, harder to do, but a budget is the first thing you need to do if you’re getting your finances under control. After all, how can you make any plans with your money if you don’t know how much you have or where it’s going?
There are a lot of ways you can break down your spending habits, but sometimes it’s best to keep it simple. If you’re looking for baby steps to creating a budget, try dividing your spending into three categories: needs, wants, and savings.
Needs are the things you absolutely have to spend money on. You’re not getting out of your rent, for example, and it’s in your best interest to get your utilities paid every month. You should also keep food near the top of your list.
Wants, as you might guess, are different than needs. Yes, you need to eat, but is going out a better choice than eating in? Are you counting Netflix as one of your utility needs? Do you really need that new pair of boots right now? No one’s saying you need to live Ebenezer Scrooge-style and hoard every coin you make, but limiting your discretionary spending can go a long way.
Then there's savings. There’s a saying in the personal finance community: "pay yourself first." Basically, take out the money you need for savings before you even think about spending it on anything else. Emergency funds, retirement, long-term goals – all of that should be taken care of. And why do it first? Because it limits the amount of money you have access to once you do start spending on other things.
Take this example: your take home pay is $3,000 a month. That’s great! But then you pay off your needs, start spending on your wants, and before you know it you’re not contributing as much as you’d like to your IRA, and your emergency fund isn’t as robust as you were planning, and so on. But if you pay yourself first and have money taken out right away (more on that in a minute), suddenly you’re starting your spending with, say, $2,000 a month – your savings are taken care of, and you know how much you have leftover to spend on everything else.
So how can you make this easier on yourself? One is by automating your finances. Have your bank transfer money at regular dates so you aren’t tempted to touch it. If you get paid on the first of the month, by the time you look at your bank account on the second or third the money has already been routed to your retirement fund and emergency account and used to pay bills. Again, what you’re left with is what you’re able to spend, and you won’t have to worry about spending money you shouldn’t.
Since it’s 2015, this article wouldn’t be complete if we didn’t mention personal finance apps. There are a ton to choose from. The most popular is Mint, and it’s robust enough for any daily budgeting needs; if you want to have a conversation about your spending, use Penny; You Need A Budget (or YNAB) is a program that provides thorough money management and habit-changing features; or, if you want to be a little more low-tech, a DIY spreadsheet can work just as well. As long as you can get something that’s easy to use and tracks your spending, it’s incredibly helpful to have a place to see your habits and make adjustments accordingly.
Step 2: Tackle your debt
Most debt has an interest rate attached to it, and if you’re paying interest that means you’re spending money that could be going toward your savings. Keep in mind that not all debt is bad; if you’re making an investment and creating value, like with education costs or mortgages, then it’s theoretically worth the cost. But bad debt – for example, credit card debt, which is projected to reach $900 billion in America by the end of the year – can carry interest rates that can cripple your ability to save.
There are two main theories to paying off debt. First is the "snowball" method, in which you pay off the debt with the smallest balance first while paying the minimum on your other debts. Once that first debt is paid, you start using that money to pay off the next largest debt, and so on until all of your debts are paid. The other school of thought is to pay off the debt with the highest interest first and move down until you are finally paying the debt with the lowest interest rate. That way you’re getting rid of the debt that’ll add up the most over time.
Both methods have their own pros and cons. Regardless of how you choose to pay off your debt, it’s crucial that you get it done, because it can be an anchor that keeps you from ever getting to where you truly need to be.
Step 3: Set up an emergency fund
Here’s a free lesson: in life, sometimes, the stuff hits the fan, you’ll be thrown a curveball, or some other metaphor will occur that means bad news for you. It’s not fair, it’s not fun, but it happens. The best thing you can do is roll with the punches, and one way to do that is with an emergency fund.
Got laid off? You have money to live off of while you get back on your feet. Car broke down? You’ve got the funds to buy a new radiator. Unexpected medical bills? You’re savvy so you have insurance, but you can also pay off whatever’s left over. That’s what your emergency fund is; it sits gaining interest, untouched but easily accessible, until it absolutely needs to be used.
So how much should be in your emergency fund? Good question! And one we don’t have the answer to! But seriously, no one has the answer – or, rather, everyone has a different answer. Vanguard suggests three to six months of expenses, and six months is a solid, attainable goal. But popular financial advisor and TV personality Suze Orman says a minimum of eight months. Other people say a year.
Besides a set amount of time, you can also decide you want to have a certain percentage of your income saved up, or even just a flat amount. It’s one of those situations where you have to decide how comfortable you are with the amount of money you’ll have access to; a year’s worth of money obviously gives you more of a cushion than three months, but it’ll also take longer to build up that reserve, and that’s money you could be using for things like investing.
You can determine the size of your emergency fund with a little simple math – six month’s worth of expenses, for example, just requires some multiplication – or use tools like HelloWallet’s Emergency Savings Calculator. Regardless of how much you put aside, remember: hands off. The new Air Jordans don’t qualify as an "emergency."
Step 4: Insurance!
Start with the basics: health, dental, and vision insurance. Health insurance is legally mandated, so your decision is sort of made for you there, but having it, along with dental and vision, takes a lot of risk off the table. Whether you’re buying it on your own or getting it through your employer, make sure you’re covered. Open Enrollment is right around the corner, which is a perfect time to assess your insurance needs.
Health insurance is a good idea for everyone, but you may need other insurance based on your situation. Renters insurance and pet insurance, for example, don’t make a lot of sense if you a) don’t rent or b) don’t have a pet, but if you do then they can go a long way in protecting you when your stuff gets stolen or Spot heads to the vet.
Then it’s time to think about long-term disability insurance and life insurance. Again, these aren’t for everyone – it depends on your financial situation, who is depending on you for income, and so on – but if you’re at a point in your life when you need either of them, don’t put it off any longer. Both life insurance and long-term disability are income-replacement insurances; they’re safety nets in that they provide money when you can’t work in the event of illness, injury, or death. This can be a real boon and get you and/or your family through a difficult stretch and cover expenses until money begins coming in again.
Step 5: Look toward retirement
Remember how you’re paying yourself first? This is where you’ll really see that pay off – literally. You won’t see the benefits of a 401(k) or IRA until your golden years, but the wait will be worth it by then. And because you have your transfers to these accounts automated so you’re making regular contributions, the only thing you have to worry about is how you’re going to spend your time as a retired millionaire!
If you have a 401(k) through your workplace, make sure you know the rules about employer matching and contribute as much as you can to take advantage of that match. Sure, it’s good to be contributing 2%, but if your employer will match up to 5% and you can swing it, why not bump that up a little? It’s what people in the industry call "free money."
One last thing about retirement savings: both IRAs and 401(k)s have contribution limits based on factors like age and income. You can check those out here, and keep them in mind when you’re deciding how much to contribute.
Setting up a financial safety net doesn’t have to be difficult – we did it in only five steps. As long as you’re aware of your spending habits and are dedicated to sticking to your plan, there’s no magic involved. The best part is, these tips are useful regardless of where you fall on the scale of financial savviness. So once you get into something a little more advanced, like investing, these five steps will make sure you have the groundwork for success.
Image: JD Hancock