Personal Finance 101

I promised practical how-to advice.  I really will but this posting is all about background.  When we speak of Personal Finance we are describing habits and attitudes related to how a person manages their money.  It’s really all about three basic principles:

1. Spend less than you earn
2. Build and maintain an emergency fund
3. Pay yourself first

Assuming your income grows at least at the rate of inflation, if you follow by these principles you will be able to maintain your adopted lifestyle indefinitely, you will have some protection in case of unexpected expenses or income interruption, and you will build up a nest egg to support you in your retirement.  This is financial security.

Personal finance principle #1: spend less than you earn

This is the fundamental concept.  It’s obvious but it’s just too important to leave unsaid.  Money in your possession is often compared to water in a well.  When you draw out a bucket of water the level in the well drops.  The water level slowly rises again as groundwater seeps in.  If you draw too much water from your well too quickly it will run dry and you may die of thirst waiting for it to fill up again.

The parallel with money, of course, is that money comes to you only so fast.  As long as you keep your expenses down to the point that you spend less than you earn, you’re not going to run out.  You’ll be able to maintain your adopted lifestyle for as long as the money keeps coming in.  You might need to control your spending and live without some desired luxuries but your well will never run dry.  The alternative is very ugly: your money will run out and your chosen lifestyle will come to a halt.

In reality, no matter how slowly you draw from it, a well’s water level can only rise so high (the water table).  Money doesn’t share that limitation.  If you spend less than you earn then you get to keep the difference, no matter how much you already have!

This first principle is great when your income and your expenses are predictable and steady.  The real world isn’t quite so simple.  The second principle is intended to help you deal with uncertainty:

Personal finance principle #2: build and maintain an emergency fund

It could happen at at time: your car breaks down or you get sick or injured and have to take unpaid time off work.  An unexpected expense or an interruption to your income can make it suddenly much more difficult, or even impossible, to spend less than you earn, at least in the short-term.  Let’s consider some typical emergency scenarios:

- your car dies and requires a tow and expensive repairs

This is a one-time hopefully infrequent expense.  It will irritate you for a few hours but you won’t spend three months worrying about how you’ll pay off your credit card (and the high interest amount).  Instead, you just pay for it out of your emergency fund and then rebuild that.  Think of the emergency fund as a miniature insurance policy.  If something goes wrong, you’ve got some money there to handle the immediate costs.  You might be a little stuck if a second thing goes wrong but you’ll be in much better shape than if you hadn’t had the fund in the first place.

- you lose your job

Clearly this is a much more serious problem.  Instead of a one-time expense leaving you with a shortfall in a single month this will drop your income to zero.  Spending less than you earn might be impossible until you find a new job.  By drawing on your emergency fund and cutting your expenses back to a bare minimum you buy yourself some time to react to the new situation.

How big should your emergency fund be?  There is no hard and fast rule.  A good place to start would be to save enough to pay your “rock bottom” living expenses for three months.  If others depend on you to provide for them (for example a spouse or children) then you would be wise to have a larger fund that could support you for a longer period.

Your emergency fund won’t replace car, home or life insurance and if you do have to dip into it, you must begin to replenish it as soon as you are able.

Your emergency fund exists to help you get through a temporary condition.  It cannot, for instance, support you in your retirement.  For all that you need to follow the third principle:

Personal Finance Principle #3: pay yourself first

One day you will retire from your job.  When you do, your employment income will drop to zero.  Your employer might offer a pension plan and you might also qualify for government retirement benefits such as Social Security.  For the most part retirement benefits are designed to provide for basic cost of living.  Furthermore, you don’t have to look very hard to find someone convinced (or trying to convince you) that Social Security will collapse for one reason or another.  As long as everything goes according to plan you should be able to live comfortably (if frugally) into old age.  What if it doesn’t?  The economic upheaval of 2008 and 2009 (and into 2010) should give you pause.

While it’s far more likely that a Social Security disaster will not take place but why gamble? Take control of your destiny.  Save for your own retirement.  If the worst happens you’ll be self-sufficient.  You won’t have to survive by eating pet food and you won’t burden your family with your care.  The worst-case scenario if things go well is your pension might get clawed back because you’ve been too successful.  That is, as the saying goes, a good problem to have.

Building your savings should be part of your plan every time you get paid.  That’s what “pay yourself” means.  When you deposit your pay from work, transfer your monthly savings amount immediately.  That’s the “first” part.  Because the money isn’t there in your bank account you use for your day to day spending you won’t be tempted to use it.  If your bank allows you to set up an automatic transfer then you can have it do the transfer for you on each payday.  That makes it even easier for you.

Start out by using the “pay yourself first” strategy to build your emergency fund.  Once you’ve built up your desired emergency fund, start transferring into your long-term savings instead.  If you have debts you will probably want to divert some of your savings into extra payments on your debts.  Making extra payments on your debts means you’ll pay them off quicker.  When you’re debt-free the amount you were paying on your debts is freed up for other things.  The sooner that happens the better.  Paying debts off early also saves you money on interest.  If you go into debt repayment overdrive, though, be sure to take a balanced approach: decide on a minimum amount to put into retirement savings and do that even while putting the rest into debt repayment.

This article has outlined the principles only.  Little has been said about how to put them into practice and almost nothing on the subject of debt and debt repayment.  I’ll begin to delve into all of this in future postings.

Further reading

A great personal finance blog I highly recommend is http://www.thesimpledollar.com.  Along with plenty of other information and advice you’ll find a truly great posting: Everything You Ever Really Needed to Know About Personal Finance on the Back of Five Business Cards.

Long Delay

Neither Tim nor I has had the time lately to post anything to the Your Dough blog.  It all comes down to time and priorities.  We had an idea for an app for the iPad and wanted to get it into the App Store for the iPad launch.  If you’re interested, the app is called The Dossier.  You can take a look at the product blog here.

I’ve got lots I want to say and intend to get back into the swing of things here shortly.

Welcome to Your Dough!

Your Dough is about personal finance.  In other words, it’s about helping you save your dough.

We’re James and Tim. We’re two thirty-something friends who grew up two blocks apart and, years later, started a company called Without Software.  You can find out more about our company here: http://www.withoutsoftware.com and about the two of us here: http://blog.yourdough.com/?page_id=2

There are lots of personal finance (often shortened to “PF”) blogs out there.  What’s special about ours?

If you read PF blogs then you already know the first rule of Personal Finance: Don’t talk about Fight Clu… er… Spend less than you earn!

That’s a nearly unbeatable catch-phrase. It’s short. It’s powerful. It’s also not at all helpful. It’s vague philosophy without practical guidance.

That’s where Your Dough comes in. We’re all about the “how-to”. And sometimes a little math geekery*.

We’ve got tons of ideas and links to pass along as we go forward.  As important, though, is the companion website we’ve created at http://yourdough.com. There you’ll find an ever growing suite of free calculators and other quick tools as well as our personal finance toolkit. You can sign up and use it immediately for free. We designed it to be used with your spouse/partner so you can always know where you stand, at least financially. The idea is to keep track of your spending (it’s really, REALLY easy) and after a month or two turn your history into a forward-looking budget. It works best if  you turn it into a bit of a game.

* We can’t promise we won’t sometimes skip the math part.