Up to this point, we’ve discussed lifestyle design as a centerpiece to comprehensive financial planning. The areas we have reviewed have largely been big-picture, contemplative pieces. These last three components affect you more on a day-to-day basis. They are the most fundamental pieces of your financial fitness. The first of these is net worth tracking.
Lifestyle Design Component #5: What Is Net Worth Tracking?
If someone were to ask you what your net worth is, would you be able to answer? Many wouldn’t. As with any good cause, awareness is key. How can you begin working on your financial fitness and improving it if you don’t even know where you’re starting from?
For most, it’s a simple calculation. Take the value of all of your major assets (house, cars, bank accounts, investments, etc.) and subtract all of your debts (student loans, mortgage, credit cards, etc.).
Whatever your number is, you should not let that define the value of your life. It provides insight to your financial picture, and digging deeper into net worth ratios can help identify issues that need addressing. However, money and wealth are means to an end, not ends in and of themselves. The ends are your goals and the vision you have for your best life.
Once you have your net worth calculated you need a way of tracking its progress over time. Whether it’s a spreadsheet you update manually or a site like Mint, it’s important to constantly keep up with the changes so you know where you are headed. Many financial advisors, including ourselves, utilize financial planning software that has the capability to do this for you and share that information with your advisor.
So, you know where you are and the direction you are heading. You should also pay attention to the balance between certain areas of your net worth. Below are some key metrics to keep an eye on:
- Emergency fund ratio (total cash account assets/estimated monthly expenses) – This ties into our discussion on cash flow below. As a rule of thumb, this ratio should range from 3 to 6. The ultimate goal for you will depend on your comfort level and specific situation.
- Debt ratio (total debt/total assets) – This represents the percent of your assets that are essentially supported through debts. If you have assets of $150,000 and debts of $150,000, then essentially all of your assets are directly or indirectly supported by debt. It is not uncommon for those with student loans to have a negative net worth. In these cases, there is an unaccounted for asset that is being supported by those loans: your human capital. Younger people tend to have larger debt ratios but should see a steady decrease in this figure as they age.
- Personal asset ratio (total personal assets/total assets) – This reveals how much of your net worth is tied up in actual “things.” Just as with the debt ratio, this tends to be higher for younger individuals, but should trend downward as you get older. You do not want to have too much of your wealth tied to physical possessions.
These are just a couple things to keep in mind as you calculate and track the progress of your net worth.
Lifestyle Design Component #6: What Is Cash Flow Management?
If your net worth is a snap shot of where you are now, then cash flow is how you get to where you want to be. Effectively managing your cash flow is the easiest way to live a financially fit lifestyle. Figuring out how to do so while aligning your spending with your goals and values is the key to living your best life.
Cash flow management is the process of managing your income and expenses in a manner that helps you achieve your goals and ensures financial security. Of course, this mostly comes down to budgeting. Very few people enjoy budgeting. However, I view it as an empowering exercise that helps you identify what’s truly important to you.
We’ve previously discussed whether or not you need a budget. My argument in the affirmative equated budgeting to counting calories when it comes to losing weight. Both increase your awareness of the constant small steps you take each day to accomplish a larger goal. Revisit that post for a quick run down on how to calculate your monthly cash flow.
If your net monthly cash flow is negative, you should find ways to cut back. If or when your cash flow is positive, you can start to see just how empowering budgeting can be. It allows you to know where all your money is going and where it’s coming from. Lastly, you should make every effort to align your spending with your goals and priorities. That would likely have a very positive impact on your life.
Lifestyle Design Component #7: What Is Debt & Credit Management?
The cash flow management discussion easily flows into debt and credit management. We tie both of these things together because they are so often intertwined. How you manage debt has a large impact on your credit. Additionally, great credit can help you attain debt and better terms for managing that debt.
First lets touch on credit management and some tips that can help you in the long run. Much like your net worth, you should constantly be monitoring your credit. There are a couple ways to do this. First, find a high quality, free app to help track your credit score and alerts. I personally use Credit Karma, but you can decide which one is best for you. Second, you should regularly review your free credit reports. Annualcreditreport.com allows you to view your report from each of the big three credit reporting companies once a year for free. A good approach is to request your report from one of the big three every four months. This way you are regularly checking your report without paying for extra reports.
From a credit management standpoint, here are some of the most important factors to consider:
- Payment history – Make payments on time.
- Credit usage – Maintain a low utilization rate (ratio between credit balance and credit limit).
- Length of credit history – Avoid closing accounts and opening new accounts, unless necessary. The longer your credit history, the better.
The main purpose of credit is to help attain debt and better terms on borrowing. Managing that debt after it has been acquired is equally important. I’m beginning to sound like a broken record, but the key to debt management begins with awareness. Simply knowing the terms of your debts (balance, interest rate, payment, timeline, etc.) is the first step to properly managing them. Work on your cash flow to ensure you are at least paying the minimum payments for each debt. Then you can look into different strategies for paying off debt, as we did when we discussed melting the debt snowball.
Additionally, an advisor can review your debts and their terms with you to craft a more detailed strategy. This could mean making extra payments on high-interest debts, consolidating student loans, or simply staying the course on low-interest debts. Having a plan at all will put you ahead of the curve and help you control your debt instead of it controlling you.
How does it all fit together?
As we mentioned before, these components of lifestyle design affect our day-to-day activities more than the previous components we discussed. Your net worth represents your current financial picture and cash flow is the most effective way to make significant improvements to that picture. For many, properly managing their debt and credit with that cash flow is a major priority. Financial circles frequently discuss the power of compounding. With debt, that power is working against you. It pays to have a great plan in place to manage that debt.
All these pieces come together, along with your goals, work-life balance, lifestyle projections, and legacy planning, to complete the area of lifestyle design. In our next piece, we will begin digging into investment management and the important components involved. As always, if you have any questions or want to reach out, please contact us.