The U.S. economy stalled out in a big way in March and April of this year, as whole communities shut down to contain the spread of COVID-19. But now that stay-in-place orders are being loosened or lifted entirely, we may be headed for better economic times soon.
A shift to a more stable economy would be a welcome change, for sure. But it's also a sign to adjust your outlook on money management going forward. Most of us will shift from a defensive stance of hoarding cash for emergencies to a renewed focus on longer-term financial goals. No matter what your ideal financial future looks like, you can make big strides in that direction by following these four personal finance fundamentals.
1. Spend less than you make
Does your spending increase every time your income does? This is called lifestyle inflation, and it undermines your ability to meet your financial goals. Think back to when you first entered the workforce. You probably lived very simply in those first few years. But then, your income rose and you upgraded your living situation, bought a better car, and frequented nicer restaurants.
Improving your quality of life isn't inherently bad for your finances. The problem comes when we keep needing more. It's one thing to move from a rented room with no kitchen to a one-bedroom apartment. But it's quite another to upgrade from a big, fancy house to a bigger, fancier house. If you don't put a cap on lifestyle inflation, you can end up living paycheck to paycheck for the rest of your life.
On the other hand, capping your expenses even while your income grows creates a lot of extra cash in your budget. And that extra cash might give you the freedom to:
- Save for an early retirement
- Work fewer hours so you could get another degree
- Take an unpaid sabbatical
- Restart your career in another industry that's more meaningful to you
There's power in spending less than you make. Brainstorm how you might increase the gap between your income and your expenses. The fastest course of action is to downsize your lifestyle dramatically. You could also hold your lifestyle as is and start banking all of your future raises.
2. Have a cash emergency fund
A big cash savings balance often seems unnecessary, right up until something bad happens. And, as we've learned from the coronavirus pandemic, bad things do happen -- whether you are prepared for them or not.
Financial experts recommend having at least enough cash on hand to cover three to six months of expenses. If you are over 60, you might even target 12 months of expenses to reduce your short-term dependence on your investment portfolio.
Put a line item in your budget for emergency fund savings. If you can swing it, save 5% of your pay to that cash account. At that rate, it will take you five years to amass three months of your income. You can expedite the process by directing all cash windfalls into that account too -- things like birthday checks from Grandma, tax refunds, and bonuses from work.
3. Avoid high-rate debt
Credit cards can be useful when you're in a jam, but they also make it way too easy to over-spend. The general rule of thumb is to charge only things you can afford to pay off immediately. Said another way, if you have to roll the balance over, you can't afford it. Rolling over a balance may seem manageable at first, but revolving debt has a way of snowballing. You might fall into this dangerous logic: You have a balance already and buying this shiny, new thing hardly increases your minimum payment at all, so what's the harm?
The harm is the interest charges that can become a sizable line item in your budget. The average interest rate on a credit card is about 20% and the average credit card balance is $6,354. That equates to monthly interest charges of $102 -- a sum that could surely be put to better use elsewhere.
Say no to credit card debt, unless it's your only option. And if you do have balances, start paying them down one by one. Stay motivated by calculating how much cash you'll free up when those debts are repaid.
4. Save for the long term
Cash savings give you flexibility today, while your investment accounts give you flexibility tomorrow. For most of the us, the big, looming, long-term goal is having enough savings to support a comfortable retirement. Social Security in its current form only replaces about 40% of your working income, after all. Imagine living on less than half of what you make today. Sounds unpleasant, right?
The surest method to avoid a major lifestyle downgrade in your senior years is to save 15% of your income for 25 years or more. Invest that money in low-cost index funds inside a tax-advantaged retirement account, like an IRA or 401(k). On an annual salary of $60,000, that equates to saving $750 monthly. Invest that $750 to earn 7% annually, which is in line with the stock market's long-term growth rate, and you'll have $611,097 in 25 years. Add five years to that timeline, and the balance grows to $920,315.
About those competing financial goals
I know what you're thinking. Save 5% in an emergency fund, pay off debt, and then also save 15% in a retirement account. Is that even possible? Yes, it's possible -- but only when you spend less than you make. There are trade-offs, of course. You can't live in the fanciest place or drive the nicest car. But you will be completely in control of your finances and the master of your own future. And those outcomes can be far more satisfying than a prestigious address or a flashy ride.