Many a person has found himself asking one particular question over and over again. “Where does all my money go?” A financially literate person will know the answer to that question.
According to the United States Government Accountability Office, financial literacy “is the ability to make informed judgments and to take effective actions regarding the current and future use and management of money. It includes the ability to understand financial choices, plan for the future, spend wisely, and manage the challenges associated with life events such as a job loss, saving for retirement, or paying for a child’s education.”
Characteristics of financially literate individuals:
• They competently manage their personal finances.
• They utilize credit wisely.
There are three basic components to successful money management: a personalized budget, personal financial goals, and personal net worth. By understanding the following, you’ll know the answer to that dreaded question “Where does all my money go?”
Personalized Budget
The first component of successful money management is a budget. A budget is comprised of income and expenses. Income is the inflow of money. It includes money that is earned from working, money received from a scholarship, or a monetary gift from family or friends.
An expense is the outflow of money. Many people are not honest with themselves regarding their expenses, and as a result, they have trouble sticking to a budget. A foolproof method for accurately determining individual expenses is to keep a financial diary for at least two weeks, in which every expense is recorded. As a general rule, if money is spent on an item, whether it is a morning mocha latte, a sandwich for lunch, or a monthly credit card payment, it is an expense.
A personalized budget indicates what a person can actually afford, and it serves as a reminder of when bills are due, which helps make sure bills are paid on time. As a result, a budget reduces the amount of time spent worrying about finances, which has a positive impact on mental health
Personalized Financial Goals
The second component of successful money management is financial goals. Financial goals are an individual’s personal monetary objectives, and they are most often determined by a future requirement for funds. Financial goals are either short-term or long-term. Short-term financial goals can usually be achieved in one to two years, or less. Long-term financial goals take much longer to achieve, usually five years or more, and often involve large purchases or substantial sums of money.
Examples of short-term financial goals:
• saving to purchase a new laptop computer
• paying off a credit card balance
• increasing savings account balance by $1000 in a year
Examples of long-term financial goals:
• paying off student loan debt
• purchasing a home
• saving for future retirement needs
To achieve personal financial goals, it is crucial that a person prioritizes his spending, and determines whether money is being used to purchase items that are needed versus items that are merely wanted. For example, as big screen television is not a necessity as far as most people are concerned, despite it being a highly desired item. Eliminating expenses for items that are not genuine needs will help a person meet his financial goals faster.
Financial goals are not static. They will change multiple times over the course of a person’s life. As life situations change, so will financial goals. For example, a college student may have a short-term goal of saving to buy a new leather jacket. Once he graduates and is gainfully employed, he may revise his short-term goal to paying off his credit cards instead.
Personal Net Worth
The third component of successful money management is personal net worth. Personal net worth is the difference between an individual's total liabilities and assets. An asset is any item of monetary value owned by an individual, including cash, vehicle, homes and land. A liability is a legal debt or financial obligation incurred by an individual, including auto loans, home loans, and student loans.
Distinguishing assets from liabilities can be tricky. Some items can be classified as both, or will change over time. For instance, a vehicle that a person is still paying for is a liability, but a vehicle that a person owns is an asset.
A statement of personal net wealth is a useful tool for measuring personal financial health and monitoring individual progress towards achieving personal financial goals. Personal net worth is a measure of individual wealth, and it can be either positive or negative. Ideally, personal net worth should be a positive number. A positive number means that a person had more assets than liabilities. A negative number means the person has more liabilities than assets.
A person’s net worth is dynamic, meaning it changes over the course of time.
Credit
Credit allows a person to borrow money and pay it back with interest. Interest is money a financial institute charges to let a person borrow their money. Credit and the associated interest payments are liabilities.
There are many reasons to use credit:
• pay for large items over time
• build credit history
• safer than carrying cash
• emergency situations
The most obvious reason not to use credit is the freedom and peace of mind that come from living debt-free. A person who chooses to utilize credit should make sure he is being responsible. Responsible credit users do not borrow more than they can afford to repay, they pay their monthly bills on time or early, and they pay more than the minimum payment.
One of easiest ways to get credit is with a credit card. A credit card is a revolving line of credit, meaning that as money that is borrowed is repaid, it can be re-borrowed. Revolving lines of credit require a person to pay all or part of the total bill each month. However, if a person pays the minimum payment only, it will take much longer to pay off the entire balance.
There are many other types of credit. Consumer installment loans are fixed sums of money that are borrowed and repaid in equal payments over time. Most auto loans are installment loans. Home loans are used to purchase a home, make home improvements, or to refinance a previous home loan, usually for a better interest rate.
Lastly, rent-to-own services allow a person use an item for a period of time by making monthly or weekly payments. If the item is purchased, the rental payments will be partially credited toward the purchase price. If the item is not purchased, it is simply returned at the end of the rental period. The store is the legal owner of the item until the final payment is made and can take the item back if a payment is missed.
