You become financially wealthy by mastering personal finance skills. I have used those skills to acquire cash paying assets. Currently my passive income covers 100% of my costs. Wealth in my opinion is a state where you no longer need to work paycheck to paycheck. I have put together a list of the top ten things you need to know about personal finance in order to become wealthy. You can find all those items on my road map to financial independence. Use that road map to see where you are now and what you need to do to progress. Enjoy the read.
Budgeting for personal finance is fundamental. Keeping personal budget does not only help you understand where your money goes. It also helps you in understanding if you are running an annual surplus budget. Let me share a number one best practice here. You need to take a year as your budget period to factor in expenses and revenues that happen less frequently than monthly, for example, real estate taxes, car service, various memberships, etc. Without taking a year’s view on the budget, you may think in certain months of the year that you can save. It may turn out though, that you are not saving at all. You may also find out that you keep spending more than you earn. The top 1% of people who have the highest Financial IQ use a year as their planning time horizon.
Bad debt is not only costly but can lead to serious consequences in case of loss of income. Bad debt, if not managed properly, will grow over time and lead to serious financial challenges. It is also slowing you down on your road to financial independence. Ask yourself a question: how bad is your bad debt? Each situation is different but the following scenarios are early warning signs. You are using more than one bad debt products – credit card, overdraft facility, cash loan, car loan etc. You owe more than 50% on your credit cards. All your monthly bad debt payments sum up to more than 25% of your income.
You need to make all possible efforts to build a contingency reserve. Your contingency reserve is your monthly costs multiplied by 6. This is a highly recommended item on your list and a great milestone in personal finance as well. As soon as you reach your contingency reserve you will no longer be afraid of losing a job, you will no longer be afraid of falling into the bad debt trap. With contingency reserve and six months, you can really figure out the different way in case something unexpected happens to you.
People have a natural tendency to spend more when they earn more. They are also tempted by retailers to buy various items that they do not need and cannot afford. Many of us also get to buy things to impress others or fit in a specific social cycle. All those behaviors conflict with getting financially independent. We have all seen great fortunes that have evaporated so many times. I want you to understand if you are prone to losing your money and help you prevent it.
One of the greatest mistakes in personal finance is buying depreciating assets. A new car is the best example. The moment you buy a new car and make one mile it loses 20 - 30% in value. This mistake is costly and yet it is being made by many people around the world. They also multiply the negative effect by leasing a new car. Not only they lose money over time, they also build up their fixed cost that I mentioned in the previous section. Not to mention, they pay interest on that bad debt.
Instead of buying depreciating assets you should look for opportunities to invest in assets that give you cash in return. A rental real estate is a great example of such investment. This type of asset not only gives you cash flow but it gives you two more great things. First of all, it helps you fight inflation. Second of all, you are in control of the cash flow. The rule of thumb is that good management equals good profits. It is all up to you.
Some people do not want to be in control or they do not have the time to do it. They entrust their hard earned money to be managed by someone else. Let's be clear here. They want your money so that they can earn hard cash commission. You do not have any guarantee of returns in most cases. You have limited opportunities to fight inflation and most of all, in most cases, those so-called investments do not produce cash over time. In consequence, they do not allow you to buy more assets. You might look richer, but only on paper...
You need to understand the difference between investment and speculation. Investment is committing cash or capital in exchange for cash flow. Speculation, on the other hand, is committing cash or capital in hope your the item you have bought grows in value over time. Typical examples of speculation now are cryptocurrencies, currencies or even buying a piece of real estate hoping that it will grow in value. You must avoid speculation at all cost. It may hurt your finances.
Leverage is an efficient way of using borrowed money. It allows to buy assets faster, it also enhances returns on your cash, and finally, it helps in beating inflation. Let me elaborate on each these arguments. You need to be careful with leverage as it works both ways. When you invest in assets that produce poor returns and finance it with a loan you will find yourself in trouble. You might enter a negative cash-flow situation.
Finally, everything about personal finance comes down to understanding your key metrics. Let just cast light on the three most critical ones. You need to understand your cost to income ratio, fixed expenses to income ratio, debt to income ratio. Have a look at the graph below that shows some more key metrics and ranges you should be looking when you want to progress with your personal finance (green zones).
