How does someone go from a complete novice in money management to someone who considers themselves good with money?
On a similar level, how can someone who currently feels they’re bad with money become good?
What research has shown us is that when we set the right goals, then take action towards our goals, we change our beliefs about ourselves.
Learning how to manage your money — in other words, developing effective processes and habits of managing your income and expenses — is the next domino.
When you manage your money in a way that allows you to achieve your goals, you transition from someone who feels they’re bad with money to not only believing you’re good but having the results to prove it.
It’s this confidence that allows you to achieve both your short-term financial goals (a big win in and of itself) and to accomplish bigger and better things in the future.
The Basics of Money Management
There’s a lot more to money management and being fiscally responsible than just budgeting. Knowing where your money goes is important, but it’s just one small slice of the pie.
To become good at managing your money, there are five different steps you’ll need to go through.
- Knowing where you’re at today.
- Knowing where to put your money.
- Designing a cash flow plan.
- Managing your living expenses.
- Tracking what’s important and making adjustments when necessary.
Step #1: Know Where You Are Today (Calculate Your Net Worth)
To manage your money effectively, you need to thoroughly understand your current financial situation. The most straightforward number you can calculate that will tell you how you’re doing is your net worth.
You calculate your net worth by totaling up your assets and subtracting your liabilities.
Resource: Free Net Worth Spreadsheet Template.
If you’ve had your share of past financial mistakes, this exercise can be a bit disheartening. Shame is a word that’s often associated with this process, especially for those who have been afraid to open up their credit card statements.
If that sounds like you, keep in mind that your net worth is only a number. There’s no need to pass judgment on yourself. You are where you are today, but from today forward, your goal is to see improvements in that number — even if that means going from a negative net worth of $75,000 to negative $74,750.
Step #2: Know Where to Put Your Money
Once you know where you’re at today, the big question becomes what to do with your money. This includes managing your current assets and liabilities, as well as determining how to handle future income and debts.
Tracking Your Income and Expenses
One thing has to be true in order to see consistent increases in your net worth: you must spend less than you earn. Therefore, you’ll want to track what you earn vs. what you spend every month.
There are a number of ways you can do this.
Here’s some advice on how to approach the process, depending on your situation.
- When you’re living paycheck-to-paycheck, or on a very tight budget: If you’re consistently struggling to come up with enough money at the end of the month, it’s best to thoroughly track each and every dollar. You might try an approach like the allocated spending plan, which has you manually budget every paycheck.
- When you have solid income but also high expenses: If you’re wondering where your money goes every month, even though you seem to be making plenty of it, consider an approach like the cash envelope system. This budgeting method has you separate your expenses into different envelopes; once you go through the money in that envelope, you can’t spend a single penny more in the given category. That makes it a good approach for those with a penchant for overspending.
- When you’re living below your means. If you know you’re living below your means each month, consider a financial tracking app that allows you to easily see a snapshot of what you’re earning vs. what you spend. Instead of estimating, the right app can help you get a quick, accurate analysis of what you earned vs. what you’ve spent for any given month.
Developing Financial Goals
Here at The Ways To Wealth, we call the difference between your income and expenses “your gap.”
Managing your money well comes down to:
- Growing the gap between your income and expenses.
- Allocating what’s inside the gap towards the financial goals that are most important to you.
In other words, the goal isn’t to have a $500 gap that just sits and builds up in your checking account each month. Instead, the objective is to put this $500 towards your personal finance goals.
For some people, this may involve paying off credit card debt or student loan debt. For others, their goals might be retirement savings, saving for a car, a wedding, a house, or even all these things at the same time.
To help you set financial goals, we created an entire workbook that can walk you through the process:
Free Workbook: How to Set and Accomplish Financial Goals the Smart Way
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Step #3: Make a Cash Flow Plan
In our post on creating a financial plan, we discussed how cash flow planning is the most important aspect of financial planning.
Most people equate financial planning with managing an investment portfolio. But it’s far more important for most households to focus on cash flow planning — i.e., on deciding what to do with your income.The Ways To Wealth
It’s the proper allocation of your monthly income that’s going to drive your progress towards your financial goals.
So far, we’ve focused on what you’ll do with your money. Now it’s time to get down to the how.
Because it’s not enough to commit to the idea of building an emergency fund or saving money for retirement; you need to develop a plan for how to make that happen.
Paying Your Goals First
Let’s say your goal is to start saving more money for retirement.
The two options you’re considering are:
- Have your employer automatically deduct money from your paycheck.
- Wait until the end of the month to see how much extra money you have left over and then invest that.
If I was to place a bet on which of these strategies would lead to more money saved over time, I would go with the first option every time.
Money without a purpose tends to get spent. On the other hand, when we allocate money to our most important financial goals up-front, the small stuff always seems to work itself out.
In practice, this idea is referred to as paying yourself first.
Specifically, that means that instead of waiting until the end of the month to fund your financial goals, you pay these goals first.
And for even better results, you’ll want to automate the process.
What this automation looks like depends on what you’re trying to do. However, here are some best practices based on common financial goals.
- Building an emergency fund: Schedule an automatic transfer from your checking account to a savings account for the day after your paycheck hits the bank. For best results, keep your savings account at a different bank than your checking account, so that it’s harder to withdraw the money. One of my favorite high-interest savings accounts is offered by CIT Bank.
- Paying off debt: Create a debt snowball. For the debt with the smallest balance (not the one with the highest interest rate), set up an automatic payment that’s higher than the minimum.
- Achieving short-term saving goals (car, house, wedding, etc.): As with your emergency fund, set up a recurring transfer from your checking account to your savings account. If your bank allows you to have sub-savings accounts, you can even go as far as naming your accounts after your goals.
- Investing. Utilize a 401(K) or other employer-sponsored plan to make automatic contributions. For IRA contributions, set up a recurring transfer that goes from your checking account to your investment brokerage soon after each paycheck hits.
Step #4: Automate Your Bills
The vast majority of monthly bills, including credit card, cable, internet, cell phone, utilities and other subscriptions, should ideally be set to auto-pay.
This is a big time saver. But even more importantly, it helps you avoid late payments. And since one of the most influential factors in your credit score is on-time payments, this habit can boost your credit score significantly over time.
At the same time, this can be tricky for those living paycheck-to-paycheck. If that’s the case, here are a few tips:
- Use auto-pay to make only the minimum monthly payment. This can help you at least avoid late fees for missing payments. Ideally, you can then go in and make a bigger payment on your own.
- Sign up for a bank account that doesn’t nickel and dime you for overdraft fees. Overdraft fees alone totaled $11 billion in the U.S. in 2019. If you’re with a bank that has numerous fees, consider switching. One of our favorites, Chime, allows account holders to overdraft up to $100 without a penalty.
- Utilize notifications. Use text or email notifications to stay on top of when bills are due throughout the month, as well as when your bank account balance gets low.
Step #5: Track What’s Important and Adjust If Necessary
What’s known as Pearson’s Law states:
“When performance is measured, performance improves. When performance is measured and reported, the rate of improvement accelerates.”
For the best results, it’s important to keep continuous tabs on your financial situation over time. You want to know if progress is actually being made, as well as how much or how little.
Here are a few important areas worth tracking.
Monitor Your Credit Score and Credit Report
Most people don’t realize that your credit score can impact your financial situation by tens of thousands of dollars or more over your lifetime.
Tracking this three-digit number over time, and knowing simple steps you can take to improve it, is therefore a smart financial move.
I recommend using a site like Credit Karma that can help you get your credit score and report for free, and which offers customized tips on how to increase your number.
Track Your Net Worth
The first step in managing your money is tracking your net worth. To get the most benefit out of this exercise, however, you’ll also want to constantly monitor your net worth.
Personally, when I started to pay attention to my finances, I was tracking my net worth on a monthly basis. Over the years, the time between calculations has increased. Today, I only calculate my net worth twice a year.
Know the Day You’ll Be Debt-Free
One of the more motivating numbers to track, for those looking to pay off debt, is the exact month they’ll become debt-free.
What I like about this number is that it encompasses income, expenses and current debt, providing an overall snapshot of your situation. Best of all, it tends to be very motivating knowing that you’re X Months away from being debt-free.
Our post on how to get out of debt explains the step-by-step process for calculating this number, even giving you a free template to help you do it.
Strive For Financial Independence
If you’re in the wealth accumulation stage, consider tracking the date you’ll become financially free.
Specifically, that’s the date the income from your investments will allow you to maintain the same standard of living you enjoy now.
As with tracking your debt-free date, this number encompasses both your income and expenses, as well as your investment portfolio.
Plus, seeing that cutting $500 from your monthly expenses means you’ll reach financial independence X Months or Y Years sooner can be quite motivating.
Final Thoughts on Managing Your Money Better
Learning how to manage money is a skill. Don’t expect all systems to fire perfectly each and every week. However, if you commit to the process, you can expect to get better and better over time.
Things may be difficult at first. It doesn’t always go as planned.
When things do go wrong, stick with the fundamentals of:
- Knowing where you are today so that you can make intelligent decisions about how to improve.
- Managing your cash flow to help you accomplish your goals.
- Prioritizing your most important financial goals by paying yourself first.
- Automating as much as possible.
- Tracking what’s important so you know whether you’re making progress.
These fundamentals will help you take control of your finances and lay the foundation for a solid financial future. They can even help you live without a job, if your goal is full financial independence.