How do you approach your finances? Chances are that if you are like most people, you are focused on your day-to-day expenses. Maybe you think that the future will take care of itself. Maybe you think that money is just too complicated. Or even worse, you know you are in money trouble, but you just can’t deal with it right now.
Here’s some tough love – you can’t achieve financial goals unless you understand your current financial situation. I know it might sound scary, but it needs to be done if you want to improve your finances. After all, if you don’t know where you are starting, then you have almost no chance of ending up where you want to be.
Before starting, clear your mind and approach this process with a gentle mindset. What does a gentle mindset look like? It means not being hard on yourself and giving yourself forgiveness for past mistakes. Ban the words, “could of” and “should of”. You’re doing it now – and that’s all that matters! Here are five essential steps that you need to take to measure your financial health – no matter what your age is.
Step #1: Determine Your Net Worth
Your net worth is your assets minus liabilities. You want to end with a positive number, but if you’re starting with a negative number, that’s okay. You can improve your financial health over time. The fact that you are reading this article means that you are ready to take control of your finances.
Calculating your net worth is fairly straightforward. First, write down all your assets and their value. Assets are anything you own and include things like your house, investments and savings accounts. Next, write down all of your liabilities (anywhere you owe money). Liabilities include your mortgage, car loan, credit card debt, etc. Finally, add all your assets together and subtract your liabilities. The total is your net worth.
It’s important to track your net worth over time. I personally use an excel spreadsheet. I write down the value of all my assets and liabilities as they stand on December 31st. I can see how my net worth is trending over time (is it generally going up or down). It also gives me insights into where my net worth is changing.
Step #2: Calculate Your Debt-to-Income Ratio
The debt-to-income ratio is used to indicate if you have too much debt and if you have it under control. Most lenders and financial experts recommend to keep the ratio lower than 30%. Anything higher than 40% means that it’s time to worry.
Another important fact to know is that the debt-to-income ratio is a primary factor in your credit score. There are other factors considered, but it does impact whether you can get new credit. If your ratio is too high, you won’t be able to get new credit (i.e.: a mortgage), until you lower/pay down your debt.
Great, so now you have a quick overview. But how is the debt-to-income ratio calculated? You take the total amount of your debt payments for the month and divide it by your monthly gross income (before taxes and other deductions).
Let me show you an example. Each month, you pay a total of $2,100 in debt payments. This total comes from your mortgage ($1,400), your car loan ($300) and your credit card payment ($400). When you divide the total debt payments of $2,100 by your monthly gross income of $6,000, it gives you a debt-to-income ratio of 35% ($2,100 / $6,000 = 0.35). Since your debt-to-income ratio is higher than 30%, it’s time to start paying off some of that debt.
Step #3: Track Your Spending
It’s important to track where you are spending your money because you can’t make changes unless you know where to make changes. The three main goals of tracking your spending are 1) to spend less money than you make, 2) pay off debt and 3) save and invest your money.
You will need to track your spending on a monthly basis. Start by recording all your income (and other sources of incoming money) less all the money you spend. You can make it as detailed or as simple as you want. Most people like to track by category (housing, transportation, food, insurance, debt payments, personal spending). However, you could also track by store, which is useful for stores like Target or Walmart, where you can buy items from multiple categories. For myself, I use a blend of these two strategies. I mostly track by category, but I do have a separate line for stores like Walmart.
To fill in the categories, go through all your bank account and credit card statements. Go back at least six months to get an average of what you spend each month. Once this is complete, you can analyze your spending to see where you can reduce your spending.
Step #4: Align Your Investment Strategy
Before you start investing, you need to make sure that you have an emergency fund. As the name would suggest, this fund is only used when there is an emergency, such as being laid off from your job or unexpected medical bills. An emergency fund is a separate savings account that holds at least six months worth of expenses.
Once your emergency fund is set up, then you need to ensure that your investment strategy is aligned with your financial situation. Your investments are the stocks you hold, within your RRSP (Registered Retirement Savings Plan for Canadians), your 401k (retirement savings for Americans) or another type of investment account.
A financial planner or advisor can help you determine your investment strategy. They’ll look at factors like your risk tolerance, the number of years before you expect to retire and your current financial situation.
Step #5: Review Your Financial Goals
If you don’t know what you want, you’ll never get there. Start by identifying your short-term and long-term goals.
It’s important to write these goals down, as it’s been proven that writing down your goals will improve your chances of reaching these goals. Include in your written plan when you want the goal to be reached and how much money you will need. Think about things like paying off debt, having a wedding, buying a house and retirement.
Finally, come up with a detailed plan. Be clear about how much money will you need to save for each of these items. If you aren’t able to set aside that much money now, brainstorm different ideas of how you can reach your goals. These ideas could include earning more money, reducing your spending or even modifying your goals.
Evaluating your financial health does take time, but it is worth the effort. Simplify the process by having a strategy in place – one that allows you to cover all of the above five steps. Start by putting aside a small amount of time each month to track your spending. Then, set aside some time once or twice a year to review your overall numbers, to see if you are on track to reach your financial goals and to take action where needed.
Until my next blog post, here’s wishing you lots of joy and happiness!