The road to financial literacy starts from where you are. There's really nowhere else you can begin.
Many consider financial literacy's endgame to be financial independence. Although that outcome is certainly important, it isn't the only reason to become financially literate.
Becoming financially literate can reduce stress and improve your quality of life. Sure, financial independence sits on the horizon as a beacon to work toward. But financial literacy does not merely make the journey possible — it can also make it easier and far more enjoyable.
How to Become Financially Literate
You start to become financially literate by assessing your present situation. That's the only way to make good financial decisions. Otherwise, how can you determine what impact the decision would have on your situation?
After assessing your current situation, define your goals.
This requires you to establish not only the financial milestones you want to meet, but also your priorities and contingency plans. Once your goals are established, determine the financial resources that you need for each goal. Here you will examine your risk-and-reward trade-off.
The final step towards financial literacy is to monitor and measure. This is your feedback loop. Changes in your situation — as well as in markets and the economy — will necessitate adjustments to your plans so that you remain on track.
Today we will limit our detailed discussion to the first element of becoming financially literate: assessing your present situation. The other steps will be addressed in the next few weeks.
Three Basic Areas
Let’s break down your current situation by analyzing three basic areas. The first area is cash flow, which consists of your income and expenses. The second area is your net worth, which is simply the sum of what you own minus what you owe. The third area is protection, which is made up of policies and benefits that keep you from going backward financially.
1. Determining Your Cash Flow
Your cash flow is the sum of your inflow (sources of income) minus your outflow (expenses and savings). To calculate your cash flow, first calculate your income. For many people this will simply be their work income. People with variable income should use their average income. Use your gross (before taxes and deductions) income.
Next calculate your outflow. Make sure to consider all expenses. Committed expenses such as your rent or mortgage and your transportation costs are generally pretty straightforward. Discretionary expenses such as entertainment may require a little more thought.
After coming up with both numbers, subtract your outflow from your inflow. Then see if the number makes sense. For example, if the number shows a positive cash flow of $500 per month, consider if this seems accurate. Does your checking or savings account balance grow by this amount? If the number seems off, try to figure out what’s missing. Also consider tracking your expenses to see if your actual numbers match your calculations.
2. Determining Your Net Worth
Your net worth is the sum of all your assets minus all your liabilities. Theoretically, this is what you would be left with if you sold everything you own and paid off all your debts.
To calculate your net worth, first add up all your assets. It may help to gather any relevant account statements first.
Investment accounts will generally be straightforward. Your account statements will show you the balance at a point in time. Use only the vested portion of your retirement accounts if you’re not completely vested.
Personal assets may be a little more difficult. Determining the value of your clothing or your kitchenware isn't necessarily easy. But it also isn't important to be precise with the value of such belongings. Spend a few minutes to make an educated guess and move on. People often find it easier to calculate the value room by room and then add up the total the amounts.
For cars, consider using a resource like Kelley Blue Book. Consulting an outside source removes any personal bias and provides a somewhat objective evaluation.
After calculating all of this, subtract the value of your liabilities from the value of your assets. This is your net worth — the total value of all you own minus your debt. Your net worth may be positive or negative.
It's common for people who are starting out or who have just graduated from college to have a negative net worth.
The number itself isn’t tremendously important, but improving it is.
3. Assessing Your Protection Programs
Any assessment of your present situation that ignores your protection planning is incomplete. Your health-, disability-, and life-insurance programs are essential parts of making sure you can reach your financial goals. Plus, your renter’s or homeowner’s policy and your auto insurance provide protection for valuable assets.
To assess your present situation, review your coverage in each area. Know your health plan’s deductibles and copays. Determine what your disability insurance will pay if you become sick or injured and are unable to work. Know how long they pay out — not just how much.
Assessing your protection involves understanding what you have and noting any apparent gaps. Addressing your protection needs will be an important aspect of each area of your overall financial planning.
Next Steps on the Road to Financial Literacy
The steps above should give you a clear picture of where you stand — a prerequisite for making informed decisions. The next step will be to determine and prioritize your goals. We will address that in next week’s installment. Have a great week, and keep being intentional with your money.