Having healthy personal finances is a pivotal component for every family and society. The small, taken together, ultimately becomes the large. Our collective body ultimately becomes what we call our society. Whether it be for yourself or society, understanding what constitutes healthy personal finances is critical to creating and maintaining an environment in which we can economically thrive.
Three parts are needed to be in good order for a person/family’s personal finances to be considered in good health. The first component, and most important, is ones ‘emergency’ savings. The second is the ratio of spending to take home pay per month. The third concerns ongoing savings.
The importance of having some form of emergency savings on hand cannot be stressed enough. The term emergency is a loose term that applies to any savings held that are not designated for some other purpose. To exhibit health in this first area of your personal finances, it is necessary to have a minimum of six months of savings on hand.
Establishing a reserve of six months or more provides protection against a number of potential maladies that can occur. The most frequently cited is job loss. The loss of a job means for most people the loss of their regular occurring income. Since the ability to reduce expenses is not directly tied to whether you receive all, some or no income per month, savings must exist to service the expenses when your regular income is no longer present.
What we have experienced since the Great Recession is the fact that regaining employment is not often a fast transition. It may take months and involve relocation before one gets back to establishing a regular form of employment. Six months should be your minimum emergency savings set-aside.
If you’re earning above $60,000 annually, then a threshold above six months would strongly be suggested. Generally speaking, higher level jobs in organizations are fewer in number than lower level jobs. Therefore, establishing employment again as a higher earner would be more difficult, especially in a time when the economy is experiencing a contraction.
The second pillar is built upon establishing a sustainable ratio of monthly spending to monthly take home pay. The first step is to establish what your monthly expenses are. An average must be identified. With the average, certain non-frequent payments should be incorporated. Examples of ‘non-frequent’ expenses are DMV registration and insurance. These events do not occur monthly, but are regular and need to be identified.
Once you have arrived at a reasonable figure of what your monthly expenses are, then the expense can be compared to monthly take home pay. In doing the comparison, the initial goal is to establish a portion of ‘slack’. The slack that is needed between expenses and pay serves as a buffer. The buffer serves as protection against monthly spending that swings above the determined average. The minimum amount of slack needed in the establishment and maintenance of a health spending to pay ratio is 10%. If you lack control of your spending habits, then the amount of slack would need to be higher; say 20% or 30%.
The way the spending to pay ratio works is simple. In the case that you determine the average amount spent per month is $3,000 and take home pay is $3,500, then your spending to pay ratio would be .86 (divided the two dollar amounts). For every dollar you bring home per month, .86 cents is spent. The amount of slack you have per dollar is .14 cents or 14%. In a situation where ones control on spending is relatively strong, the 14% amount of slack would be a suitable buffer.
The third component is ongoing savings. Ongoing savings can be established in multiple ways. Depending on the avenue chosen, the re-evaluation of the spending to pay ratio might be necessary.
Ongoing savings will constitute something different for everyone. Retirement is often a binding theme, but people save for many other items. Someone might save for a TV, while another might save for a boat and another might save to start their own business. Even amongst the multitude of possibilities, general guidance can be established.
When a pre-defined contribution is being made out of ones paycheck for retirement purposes (401k, 403b or another tax sheltered account), then that money is not part of ones take home pay. In most cases, when payroll is run, the contribution to the tax sheltered account is diverted directly to the account and not included as part of the final paycheck. In such cases, the take home pay amount is not inflated by the inclusion of retirement funds. If this is not the case, then the amount dedicated to retirement pay needs to be deducted from the take home pay amount being used to establish the spending to pay ratio.
Other items that are being saved for (car, boat, house, business, etc.) need to be deducted from the amount of take home pay per month. The savings in such an instance is a savings to serve a future expense. The savings is not to serve as protection against an unknown event, retirement, or what would be considered ‘slack’ in the amount you spent this month versus what you brought home.
An example of the principal above would be a situation where you were saving $300 per month for a new television. If we go back to our example of having $3,000 in expenses per month and $3,500 of take home pay, we would need to deduct the $300 from our $3,500 take home pay. In this instance the $3,500 would fall to $3,200 and our spend to pay ratio would become .94. A ratio of .94 means our ‘slack’ would be .06 or 6%, which puts us below the 10% threshold.
Savings is paramount to establishing and maintaining a healthy personal finance system. Each of the three components outline above is structured via the establishment of savings. This is done to preserve the quality of life we’ve come to know and ensure the financial goals we’ve set forth are realized. Without being aware of our personal finances and establishing controls we are feathers in the wind hoping that fate blows us in the right direction.
For the good of yourself, your family and society, don’t reduce yourself to a feather in the wind.