Understanding where your money goes

Do you know how much money you’ll have saved by the time your retire? Or how long before you’ve saved enough for a downpayment on a house?

If you are like most people, you probably don’t think much about what happens to the money you bring home. You no doubt pay a bunch of bills and expenses, maybe pay off a bit of debt or a mortgage, and if there is anything left, invest it for retirement or in savings. But if you don’t have a plan for where your money is going, you won’t be able to plan for financial future. With a bit of planning you’ll be able to answer questions like “when can I get a 10% downpayment on new house” or “can I retire at age 60”.

Before you can start planning your finances, you need to understand what happens to your money. Thing of your household like a factory: a bunch of raw materials go in at one end, and some finished products come out at the other. Except in your household, a bunch of money goes in at one end (your wages) and a bunch of money goes out at the other end (things you spend your money on, like bills). Hopefully your spending is less than your income, so you keep some money inside your household. This money is your savings.

Let’s break this down into a bit more depth. A typical household has one major sort of income: your wages.

If you are lucky, you’ll also have some income from interest on savings or dividends on shares, but that it normally a small fraction of your wages.

What happens to the income? It is split between three things:

• You spend on bills (such as cable TV) or other expenses (such as groceries)
• You use some of it to pay off debt (such as a mortgage or student loan)
• You put some of it into savings or investment – either for retirement (such as a Roth IRA) or other savings or investments

It is important to get the balance right between these three areas. If you spend all your money on unnecessary expenses, then you can’t save for the future or pay off debt. The amount you spend on each area depends on a lot of factors, such as how much you earn, how much debt you have, and so on. But in general, you should aim to:

Minimize your expenses

Minimize your expenses as far as practical. For example, if you buy a coffee everyday, maybe you can skip a day a week. Even small savings, when calculated over years or decades, add up to significant amounts of money. Of course, big savings are also good. Do you really need a new flat screen TV if your current tube TV works?

Pay off high-interest debt

If you run a credit card balance, then try to pay it off. Unless you have a teaser rate, you’ll be paying a high interest rate on this debt. You should try to reduce your credit card debt over time, with the aim of eliminating it. Look to see if you can move it to lower cost debt, such as a home equity line of credit (HELOC).

Save for retirement

You need to save for your retirement. Have you thought about where your income will come from when you are retired? Unless you have a company pension (increasingly rare these days), you shouldn’t rely on social security to pay you enough to live comfortably on. That means you must save your own money. If your company offers a 401(k) plan, use it. If not, put money into an traditional or Roth IRA.

You need to get these three areas in balance. If you aren’t saving for retirement today, start saving. If you don’t have enough money to start saving, then reduce your expenses. Similarly for high-interest debt – if you don’t have any spare money, reduce your expenses to start paying down your debt.

If you have got the above in step, then you can start to save and invest additional money. Why would you do that rather than spend it? Because savings earn your more income!