Financial Planning is a step-by-step process to meet your financial goals. It requires a lot of thought and understanding. A meticulously made financial plan is the key to a secure future. But for beginners, who have little to no knowledge about managing money, the information out there can be overwhelming and downright confusing.
A financial plan involves understanding your income, making a budget, saving for the future, and investing to make your money grow. It can be a little complicated at first, but with the proper understanding, you can easily make one!
A good financial plan can enable you to spend wisely while also saving for a rainy day. Many professionals can offer you good advice, but it is also important that you know the basics so you can decide which advice to work on. If you have always been questioning “Where do I start?” then you are at the right place. This comprehensive guide on Financial Planning For Beginners is all your answers in one place!
Importance of Financial Planning for Beginners
Financial planning will only make sense if you understand its importance. Consider this, if you want to save for your retirement, you will have to plan for it while you are still working. Similarly, if you aim to buy a house in the coming ten years, you will have to plan for it starting now. This is the gist of financial planning. In reality, there are many benefits of planning your expenses and savings, such as:
By making proper financial plans, you can understand and manage your income. Based on your monthly income, you can decide how much to save and how much to spend. It can also help you stay out of debt by keeping your expenses less than your income.
While savings might be possible without a financial plan, you can save better with one. As financial planning involves making a budget, you can set a definite amount of money aside for savings every month.
Setting Financial Goals
Financial goals like buying a house, or saving for your child’s college become more feasible if you have planned them well. Financial plans not only help you save but also raise enough money in a set period of time. You can consult a professional for setting realistic goals or also ask opinions from your family and friends.
Certain circumstances can be unpredictable and cause a financial drain. Preparing for such situations well ahead of time can save you a lot of time and money. It is important to secure the future of your family. Emergency funds can also help you continue working towards your financial goals without the financial burden becoming a hurdle.
Retirement is a time when you lack income but still have expenses. To save for such times, you need to have a retirement fund. If you are planning to retire in 10 years, a financial plan can help you decide the right investment and savings plan. Investment bears a better fruit if done for a long time.
What are the Steps in the Financial Planning Process?
Now that you have understood the Importance of financial planning, let us look at the steps involved to create one:
1.Know Your Finances
As the popular saying goes “Well begun is half done.” The very first step to your financial planning is evaluating your income and assets. Only after thoroughly understanding this, you will be able to proceed with any goals and also focus on removing any weak points.
Your net worth: To determine your net worth, you need to understand two things, assets, and liabilities. Assets are anything that increases the value such as money in your bank account or any land you own. Liabilities are things that reduce the value of your net worth such as any debts or loans.
By subtracting your liabilities from your assets, you can determine your net worth. Your net worth can change over time, depending on how you manage your money. If you pay off debts then your net worth will increase. Similarly, if you take any loan, your net worth will decrease.
For good monetary health, your assets should always be greater than your liabilities. This is called positive net worth. If your liabilities are greater than your assets, it is called negative net worth.
Your expenses: While your net worth is quite stable and only changes over a long period of time, your income and expenses keep fluctuating every day. So, it is necessary to keep track of your everyday expenses. Just like positive net worth, it is good to keep your expenses less than your income to avoid any debt.
After determining your cash flow, you will have a fair understanding of where you need to cut down on expenses, how much you can save every day, so on and so forth.
2.Make a Budget
Once you have calculated your income, you have to now manage your monthly expenses and savings. For that, you will have to make a budget. It is useful for keeping your everyday expenses in check and also for managing your savings. You can ask for insights from your family, friends, and colleagues on how to make a feasible budget, or you can consult a professional.
A good rule for making a budget is the 50-30-20 rule. It is a simple rule which works by setting different percentages of your net income for different purposes.
By the rule,
- 50% of net income goes to essentials.
- 30% of net income goes to wants.
- 20% of net income goes to savings.
You can change the rule according to your convenience and needs. Make sure to consider every expense when making your budget. This includes major expenses like groceries and rent to minor expenses like dining out and new clothing.
You can go the old-school way and use a paper and pen to make a budget or use budget-making apps to simplify the process.
3.Set Financial Goals
What next after making a budget? How to use your savings? How much should you invest? All this can be answered by setting financial goals. It encourages you to save more and watch your expenses. You can set several short-term goals and one or two long-term goals to keep track of them effectively.
A good financial goal should:
- Be specific and detailed.
- Should be measurable over a period of time
- Should be achievable in reality
- Should make sense to you over a long period of time
- Have a specific time limit
If you have one long-term plan, divide it into several short-term goals so you can measure the progress effectively. Doing so can also enable you to tweak your goals as time goes by, without losing the actuality of the long-term goal.
4.Make an Emergency Fund
You have set some financial goals, say you have decided to save 10 lakhs for your daughter’s college fees. But what if you lose your job and are not able to keep up with the expenses? For such situations, it is crucial to make an emergency fund. Living paycheck to paycheck might make sense in the short term and also look possible, but an unexpected expense, big or small, can put you in great trouble.
You should evaluate all kinds of possibilities like a sudden medical emergency or you losing your job. Your emergency fund should have enough money to at least give you time to find a new source of income or plan your existing income differently.
It is also a good idea to make two different funds, one for small deviations in your finances, say an unexpected illness, and the other for sudden emergencies like meeting an accident or losing your house.
5.Pay Off Debts
Prioritize paying your debts. This can help in increasing your net worth and also save money as you will have to pay lesser interest if you pay off your debt sooner. Two popular methods address the debt problem differently. Depending on your current situation, you can choose either of the methods to successfully pay off your debts. Before following any method, you need to determine the amount you can spare every month to pay off your debts.
- Debt Avalanche Method
The debt avalanche method is a method where you make minimum payments to all your outstanding debts. Then, if there is any more money remaining to pay off the debt, you prioritize the debt which has the highest interest rate. Through this method, you can save more money on interest.
- Debt Snowball Method
This method involves prioritizing the smaller debts and closing them off. This is based on the approach of completing the easiest tasks first. You can then follow an ascending order to pay the other debts. This will help in minimizing the number of debts at hand.
For all the above steps, there has to be a constant flow of cash. Apart from your income, you can maintain the cash flow through investment. Investing enables you to grow the money you have been saving. Investing as a beginner can be difficult, but you can invest enough over time to accomplish your financial goals through small steps. There are different ways you can invest your money which range from small to huge risks.
- Stocks: You can either invest in common stocks shared by public traded companies or have an ownership stake in a private business. Both ways, your returns depend on how the company performs financially. You can consult a broker to know exactly which stocks you need to buy. But remember, stock markets are also subject to risks.
- Real Estate: Investing in real estate is good if you have a substantial amount of money ready for investment. Buying properties and then selling them at a higher price is a good way to earn profit. You can also rent or lease your property and keep earning a side income through it.
- Mutual Funds: A mutual fund is somewhat similar to investing in stocks, but comprises much more than just stocks. It also consists of bonds and other kinds of securities and such funds are overseen by a professional manager. In mutual funds, there are several investors who pool in their money to maximize the returns. They have predetermined strategies to minimize loss while trying to get the maximum returns for each person.
As discussed above, constant cash flow is important in any financial plan. But what happens when you retire and stop earning? For that, you will have to make a retirement fund. Most investments work the best over a long period of time, so it is better to start as early as possible. Even if you are in your 20s and retirement just seems far away, it is good to start investing as you can save a little every year and you will end up with a substantial amount when you actually retire. Keep in mind that retirement will also mean more medical expenses and possibly more travel expenses and you should plan your retirement funds accordingly.
It is best to save at least 10% of your net income every year for your retirement fund. The later you start, the more you will have to save every year.
Just like an emergency fund, you should also have additional protection in case something goes terribly wrong. This is what insurance is for. Depending on the type of situation, there are different insurance options available.
- Life Insurance : Life insurance is helpful in providing adequate funds to your family in case you pass away.
- Health Insurance : In case of any medical emergencies which require you to spend money for health care, you can claim your health insurance. Depending on your age, health insurance premiums will vary.
- Vehicle Insurance : It is insurance that provides necessary funds in case your vehicle is involved in an accident, is stolen, or is damaged.
- Homeowners Insurance : It provides you funds in case there is some damage to your house or in case of theft.
Most of your investment returns are heavily taxed. But there are many ways in which you can save a lot of money by keeping your taxes to a minimum. By considering the time of your purchase, the time of your income, and planning other expenditures, you can make the maximum out of your gains without paying heavy taxes.
10.Review your Plan Continuously
After completing all the steps, you might feel that your planning is over. But it is not so. Making financial plans isn’t a one-time process, but a continuous one. Your net worth, assets, and goals keep on changing as you follow each step of this financial plan so, it is important that you keep reviewing your plan and make any changes where you feel necessary. It is a good practice to review it at least once a year. It is also crucial to evaluate your plan once you achieve any important milestone like having a child, getting married, etc.
The 7 Key Components of Financial Planning
Now that you know how to make a financial plan, you must have also understood that for each person, financial plans will vary. So how to know if your financial plan is good enough?
To evaluate that you have to consider these 7 key components that form the backbone of a good financial plan. Let us understand them in detail:
1.Cash Flow Analysis
In financial planning for beginners, this is the first step. This involves calculating and understanding your income as well as your assets and debts. In simple words, it helps to manage your money in such a way that your expenses are always less than your income.
Everyone has different financial goals. Some want to save for their children’s marriage while some others might want to buy a car. Depending on the type of goal you have and also on your monthly income, a feasible long-term goal can be set. Goals have to be realistic and achievable in a given frame of time. Depending on the time period, goals can be divided into short-term and long-term goals.
There are several different ways you can invest your money. Investment helps you make your money grow. Different investments vary based on the duration, returns and risks involved. By studying in detail the different types of investment, you can choose the one that is most suitable for you.
Though life is going well for you right now, certain unforeseen circumstances can prove to be an obstacle to your financial goals. You may lose your job, someone in your family might need expensive medical care, the list is endless. It is important to prepare beforehand for such situations. It can also be useful to calculate the risks involved in your investments so that you do not end up losing too much money.
The cost of education has been seeing a lot of growth in the past few years. Everyone dreams of providing their children with quality education. These are some costs that you can estimate beforehand and plan accordingly. Take into consideration options such as student loans and fixed deposits for your children’s education.
There are many ways in which you can reduce the taxes owed to the government. By smart planning, you can make the most out of your investment returns, while keeping the taxes to a minimum.
The ultimate aim of a financial plan is to save for your retirement. A good financial plan will make sure that your funds secure your retirement, keeping in mind all the expenditures such as medical costs and travel expenses.
Common mistakes in Financial Planning
Financial planning for beginners involves a little bit of trial and error. A good financial plan makes your money grow but has little room for mistakes. Here are the few most common mistakes people make and how to avoid them:
1. Not thinking of Inflation
Money loses value over time. Most people tend to ignore this when making financial plans. While you consider an increase in your monthly income over a period of time, you should also consider the fact that the prices for commodities will also steadily rise, leading to more expenses.
To avoid losing money due to inflation, have only limited savings in safe investments like government bonds and bank accounts, otherwise, your returns might be much lower than the inflation rate.
2. Not Considering Retirement Expenses
When you save or invest for retirement, it should be obvious that there will be additional medical and travel expenses, considering your old age. But surprisingly, most people tend to ignore this fact and only consider everyday expenses when planning retirement savings.
You should understand that expenses only increase with age and save suitably. Otherwise, you might end up emptying your savings quite earlier than planned.
3. Saving Too Little
This cannot be stressed enough. You should start saving early on in life. During your younger years, you should invest more in long-term savings than short-term, as long-term investments give higher returns with time. Compounding can even double or triple your money if saved for a sufficiently long time.
Such savings can not only be made by managing your day-to-day expenses, but also by saving on taxes. Effective tax savings can help you save a lot of money if you plan wisely.
4. Investing Too Much or Too little
While investing, it is crucial to take into account all the risks involved and check if your financial plan has room for so much risk. Many advise that young people should spend most of their money on investments. But, such investments should not be made blindly and should involve calculated risk. Also, you should only invest the money that is in excess of your savings. Do make it a point to save a bare minimum every month and not spend all your money on investments, as they have the potential to lose all your money.
5. Buying Insurance To Save Tax
A common misconception among people, especially beginners in financial planning is that: one should buy insurance to save tax. While it does help save tax, it should not be considered an investment, rather it is only an expense. Most of the premium that you pay for insurance goes to waste.
Only buy insurance that is absolutely necessary like health and life insurances.
It is important to note that financial success has a different meaning to every person. Some might define it as buying a house, while some might just want to provide quality education to their children. There is no rule set in stone. Through this guide, we hope you have learned how to make a financial plan being a beginner. Happy planning!