The biggest mistake most people make in starting a business is that they mix personal funds with funds of the business. What a mess! So what does this have to do with personal financial planning? Everything. In a way, this rule should be applied to personal financial planning; yet most, if not all financial planners ignore it.
What I’m referring to is commingling day-to-day finances with those for later in the future. Most financial planners look at the whole picture all at once; while this is not a bad thing, it is extremely overwhelming for the person who, should we say, is not financially savvy.
We need to separate our finances into two distinct areas; we'll call them "wells." These wells should always be kept separate. The first well contains all those items we deal with on a day-to-day basis: our paycheck, our checking and savings accounts, our mortgage, our groceries, and our credit card(s). The second well is for longer term finances, such as retirement and funding for our children’s education.
We need to be concentrating on the first well; as we understand and master the first well, we'll be able to put money away for the second well, but only after mastering the first well and creating an overflow.
It's important to note the first well contains credit cards, so here’s a concept for you: credit cards are an expense. What they are not is a source of funding, which is what so many Americans think. It’s time to think again.
At the beginning of the month, (I know it may not be the first of the month when you read this, but hey, at the longest, it is only about 25 or so days away), if we take our month’s income and add it to what is already in our checking and savings accounts, then subtract all our credit card balances and all our upcoming expenses, then we have what would be left over at the end of the month if all our expenses for the month came due right now. If this number is positive, then congratulations, you are solvent. If not, then you need to start paying down your debt and reduce your expenses. Whether it’s positive or not, let’s refer to this number as our solvency number.
Once we get the solvency number positive, then we know we can meet all our expenses, including paying off our credit card, if our income were to stop at the end of the month.
Wait. What about the second well? Good question. The second well is of no concern to us until the solvency number gets above the point of covering the number of months expenses we’re comfortable with in the event we lost our job and had to take those months to find a new one. At this point we can now take money out the first well and place it into the second well for investing, which will be used later for longer term events, such as a child’s wedding, or our retirement.
Have you been commingling your wells when it comes to financial planning? Does this approach make more sense to you? Does it make it easier to get a handle on your finances by concentrating first on the day-to-day issues until you’re solvent before tackling the longer-term issues?