In a Nutshell
Building a financial foundation is a process that takes time. It’s less about hitting a single home run than making smart decisions on a daily basis.Financial success doesn’t happen overnight, and it’s not the result of making the right choice on one major money decision.
Of course, you have to start somewhere. That’s why we’ve highlighted three key components of personal finance — building a budget, eliminating debt and investing your savings — to help you build a solid financial foundation for long-term success.
How to build a solid financial foundation
- Understand your cash flow and build a budget that works.
- Eliminate debts that drag down your financial health.
- Take your savings to the next level with the right investments.
1. Understand your cash flow and build a budget that works.
Let’s get one thing straight: “Budget” is not a bad word. And yet so many of us shy away from building our own budget for a number of reasons: It’s too boring, too restrictive, too complicated, too pointless.
That’s a problem because budgeting is perhaps the single most important tool you have when it comes to managing your personal finances.
It’s the tool that allows you to understand how much money goes in each month and how much goes out, helping you stay on track with your goals and use your money exactly how you want.
“A budget allows you to know your cash flow, which guarantees you aren’t overspending,” says Erin Lowry, author of “Broke Millennial: Stop Scraping by and Get Your Financial Life Together.” “Spending less than you earn is a cornerstone of financial health, so a budget — whether or not you call it a budget — is part of that success.”
If you’ve never made a budget before, here are some steps to get you started:
- Track your cash flow. “Sit down and write out how much you have coming in each month as well as set costs going out, like your rent, cellphone bill, student loan payments, transportation costs and utilities,” Lowry suggests. This will give you an idea of how much of your income you can use for flexible spending on nonessential items and how much you can allocate toward savings goals.
- Start automatic contributions. Setting up automatic weekly or monthly deposits from your checking to your savings account means you don’t have to think twice about saving and ensures you won’t forget to move money over. “Never skim money out of financial goals to fix overspending,” Lowry warns. Try and cut spending on nonessentials first.
- Stick to it. It’s hard but don’t fall off the wagon. “Don’t listen to the lectures about how X budget is superior to Y budget. It’s only superior when you actually stick to it,” Lowry says.
If you do get off-track, don’t quit budgeting — simply try something new until you find a system that works well for you.
You can also prevent falling off the wagon by being proactive. “Weekly money check-ins are a simple way to spot that you’ve gone off track early enough to course-correct,” Lowry says.
2. Eliminate debts that drag down your financial health.
If you have debt, allocating some of your cash flow to paying down those balances is the next step in building a strong financial foundation.
Maybe you’ve heard the phrase “good vs. bad debt” and wondered how any debt could be possibly be good.
In general, “good debt” is debt that allows you to leverage your money to gain an asset. A mortgage, for example, is debt, but it allows you to buy a home today and pay it off over decades.
In the meantime, the home addresses your basic human need for shelter. You can also use your home as an asset by renting it and earning income, or by potentially earning a greater return when you go to sell if the value appreciated over time.
Credit card debt, on the other hand, is a type of “bad debt” in the sense that it doesn’t allow you to build an asset. It’s just money you need to repay with interest.
“Getting rid of any debt with no corresponding asset is essential to financial success because it naturally increases your net worth and frees you up from cumbersome payments,” explains Katie Brewer, CFP® and founder of financial coaching service Your Richest Life.
According to a 2016 study conducted by NerdWallet, the average credit card debt per indebted American household is nearly $17,000, which may suggest that many people with balances struggle to get them under control and paid off.
Where should you start if you’re ready to pay down debt for good? Here are some first steps to help get you on track:
- Get organized. Write down all your debts that you need to pay off in one place. Note the source of the debt, the amount of the balance and the interest rate.
- Pick a payment plan. You may need to make some changes to your budget and your lifestyle as a whole to make debt freedom a real possibility. “You can either prioritize [debt repayment] by interest rate and pay off the ones with the highest interest rate first, or prioritize it by smallest balance to largest balance and pay off the smallest balance first to get the momentum going,” Brewer says.
- Take a break from your credit cards. If you struggle to pay off credit card balances, it may be a good idea to take a hiatus from your credit cards to avoid digging yourself further into a hole of debt. Brewer suggests limiting yourself to using a debit card or setting aside cash in an envelope.
3. Take your savings to the next level with the right investments.
If possible, your budget should include setting aside money for savings. To start, set a goal of creating an emergency fund that houses 3 to 6 months’ worth of expenses.
From there, you can create other specific goals you want to fund or simply aim to save a small percentage of your income for the future. You can start with just 1 percent and incrementally raise that rate over time to save more.
But there’s one big downside to having a lot of cash sitting around: It’s not doing much for you. The best savings interest rates hover around 1 to 1.25 percent. A high-yield checking account may garner more (up to 5 percent) but these accounts typically have balance caps.
It’s nice that your cash can earn a little extra money for you, but those interest rates probably won’t beat the rate of inflation over time. Also, these interest rates may be subject to change over time.
Think about it: If you put $10,000 in the bank today, it will likely be worth less than $10,000 in 30 years when adjusted for inflation. With only a 1 percent return, you’re looking at only $13,478.49 after three decades of saving.
Bottom line
Taking these three steps to build a solid financial foundation today can help you work toward long-term financial success.