Savvy with your money: Financial planning should be realistic and match your income

Preparing a financial plan to match your income will help you get a grip on your day-to-day expenditure, writes John Lowe

Remember that just because you are never in arrears and have an excellent credit rating, it doesn’t mean you are debt-free.

MANY people are under the impression that financial planning is a complex process requiring great expertise.

In fact, creating a financial plan is a remarkably straightforward activity involving three easy steps:

    • Decide what your financial or money
      objectives are, and prioritise them

    • Assess what resources you have
      available to you now, and consider what resources you may have in the future

    • Work out what actions you need to take to make your financial objectives come true.

 

Why you need a financial plan

 

Your financial plan should have the same qualities as the road map analogy. That is to say, it should help you to reach your destination; to make your journey as fast as possible; and to prevent you wasting time or energy.

A little planning brings big rewards. Having a financial plan will bring both material and emotional rewards.

From a material perspective a financial plan will make it possible for you to meet your
financial objectives. These might include some or all of the following:

    • Wiping out all your personal debts.

    • Paying off your mortgage years earlier.

    • Never having to borrow again, having enough money to afford the things that are important to you, such as an education for your children or a second home.

    • Having enough money to retire early.

    • Knowing that you and your dependants are protected against financial hardships.

    • Being wealthy enough never to have to worry about the future — whatever it may bring.

 

And the emotional benefits? You’ll feel a tangible peace of mind once you have your financial affairs in order. In addition, a well-considered financial plan guarantees that you will never need to waste energy worrying about money again.

Some people’s circumstances, of course, may be such that they will not manage to achieve any or all of these objectives. For these people, financial planning is crucial to getting the maximum advantage from limited resources even with insolvency.

Suppose you don’t bother with a financial plan at all? Leaving something as important as your financial future to chance is risky.

True, we live in a country with a relatively generous state benefit system. But would you really want to rely on it? You probably wouldn’t starve, but you wouldn’t have an easy time of it.

Incidentally, many people assume that the worst thing anyone can do is ignore financial planning completely. In fact, in my experience the people who are worst off are those who compartmentalise their money decisions. Let me give you just three examples:

1. When you want to buy a home, you look for a mortgage.

2. When you begin to think about retirement, you start a pension.

3. When you have a young family, you take out life insurance.

The trouble with a compartmentalised approach to money is that it is both wasteful and risky because you may:

    • End up spending more than you have to on borrowing money.

    • By default, pay more tax than you need to.

    • End up with inferior and expensive financial products.

    • Risk your capital, your income, and the standard of living of you and your dependants.

    • Miss opportunities.

    • Make yourself unhappy worrying about your financial security.

 

A symptom of this approach is responding to ad hoc situations in a knee-jerk manner, for example, subscribing for newly issued shares on a whim, or paying for education fees when you hadn’t expected to do so.

Incidentally, one of the key benefits of creating a financial plan is that it will involve a review of your existing financial products. Such a review is bound to result in all sorts of savings as you identify products that are either overpriced or unnecessary. Let me give you just one real-life example:

One of the Money Doctor’s ‘patients’, Tony, an ex-banker, told me that he’d spent more time choosing his last car than choosing his mortgage. As a result he was, without realising it, paying 1% above the home loan market rate.

He’d also allowed himself to be sold a very expensive life insurance plan. I calculated that, over the 25-year term of Tony’s €210,000 mortgage, these two products alone would cost him a staggering additional €38,000 in unnecessary loan and insurance payments.

Frankly, because people pay less attention to their finances than to other areas of their lives, they tend to get ‘ripped off’. With a financial plan in place, you’ll know that you aren’t:

    • Accepting lower rates of return on your savings.

    • Paying more to borrow than you have to.

    • Taking out insurance policies that you don’t need, or that don’t provide you with the protection that you want, and that may well be over-priced.

    • Making poor investment decisions.

    • Failing to plan properly for your
      retirement.

    • Putting your money at risk.

 

What does a financial plan look like?

 

Obviously, there is no set period for a
financial plan. My general advice is to write it so that it covers the current and next phase of your life.

For instance, if you’ve just left university and you’re starting your first job, then you might write a financial plan designed to take you through to when you own your home.

Bear in mind that financial plans need to be flexible. You may change your own ideas about what you want or circumstances may intervene and require a change of direction.

A financial plan that only covers a specific, short-term requirement (for instance, saving for your retirement) isn’t going to bring you lasting financial success.

However, you may decide you’d like some professional help. There are any number of people who would like to help you with your personal finances, from bank managers to life insurance salespeople, from credit brokers to pension specialists.

The golden rule is: the fewer options the ‘experts’ can offer you, the less you should trust them.

Let me give you one pertinent example. If you go to your bank and express an interest in taking out a pension, whoever you speak to is duty-bound to offer you something from the bank’s own range of products, if they have their own tied agency, even if he or she knows that you would get a better deal elsewhere.

If, on the other hand, you go to an independent financial adviser he or she should recommend the best and most competitively priced product for your needs.

Many people begin the whole financial planning process because they want to resolve a particular financial question. But you shouldn’t look at financial needs in isolation.

Every financial decision you make should be part of an overall plan. Thus, a particular product — such as a mortgage, loan, insurance policy or investment — should not just be judged on its own particular merits but also in terms of how it moves you closer to your financial objectives.

For this reason, no financial plan can be created until you have set and prioritised your financial objectives.

How do you decide what your financial objectives should be?

 

My advice is to start by dreaming. Consider what you’d like to be doing in, say, five years time, 10 years’ time, and 20 years’ time.

Consider what work (if any) you’ll be doing, where you’ll be living, and how you’ll be spending your leisure time. What will your family situation be? Once you have a clear picture of the future life you’d like to have, start expressing it in financial terms.

Your possible financial objectives might include:

    • Owning your own home, outright, without a mortgage, making sure you have sufficient income to retire (possibly early) and live in comfort.

    • Ensuring that you and your dependants will not suffer financial hardship regardless of any misfortunes that may befall you.

    • Having sufficient wealth to pay for things that you consider important, whether it’s charitable donations, an education for your children, or some other item such as a second home or a caravan.

    • Having sufficient wealth to allow you to spend your time as you wish, for instance, having the money to start your own business.

 

Having produced a list of financial objectives, your next task should be to put them in order of priority.

What you consider important will be determined to a great extent by your personal circumstances. For instance, if you’re in third-level education, you’ll have a very different view of money to someone five years away from retirement.

Someone with a lot of debts will have different concerns to someone with a lump sum to invest.

Nevertheless, regardless of your age, existing wealth, health, number of dependants, or — for that matter — any other factor, I would recommend that you keep the following
principles in mind when deciding what your financial priorities should be:

1. For most people, their greatest asset is their income. Unless you are fortunate enough to receive a windfall, it is almost certainly your income which you will use to achieve your financial objectives. Under the circumstances you don’t want to risk it and you don’t want to waste it.

There are all sorts of relatively inexpensive insurance policies designed to protect your income. And by making sure that you don’t waste a single cent (especially when buying financial services) you can ensure that it’s used to optimum purpose.

2. Personal debt — by which I mean everything from store cards to mortgages — will be the biggest drain on your income. If you’ve borrowed money (and, obviously, there are many circumstances under which this makes excellent sense) then you should make it a priority to repay your loans as quickly as possible. This is easily achievable as I explain in Part 3.

3. It’s vital to have a safety net or emergency fund to deal with those little trials, tribulations and extra expenses that life often throws our way. In Part 6, I suggest how much this fund should be, and the best way to build it up.

4. If you’ve got a good, secure income, it doesn’t actually matter what other assets you own. Emotionally, it’s nice to have the security of owning your own home. Financially, it certainly makes sense.

But, actually, the best investment that most people could ever make is in a really decent pension plan. With a good pension plan you can leave work early and — if you live to 100 or more — never have to worry about money again. One of the best things about modern pension plans is that they are both flexible and diverse.

5. It is not inconceivable that we will live to a very old age and in some cases suffer a reduction in our mental ability to handle money matters. Before this may arise it is worth considering setting up an enduring power of attorney.

This is a document providing for the management of a person’s affairs in the event of their becoming mentally incapacitated. The appointed person (the ‘attorney’) may be allowed to take a wide range of actions on your behalf in relation to property, business and social affairs. He or she may make payments from the specified accounts, make appropriate provision for any specified person’s needs and make appropriate gifts to the donor’s relations or friends.

You can appoint anyone you wish to be your attorney, including a spouse, family member, friend, colleague, etc.

6. Know thyself! There’s no point in setting financial objectives that you’re going to find impossible to attain. Your financial objectives may involve modest changes in your behaviour, but they shouldn’t require a complete change in your personality.

To this, I suppose I might add long-term care planning if you’re worried that your pension and/or the state may not provide for you sufficiently in retirement.

Once you settle on your overall objectives, you’ll have to decide which is the most
important to you. For instance, would you rather pay off your mortgage 10 years’ early, or take an annual holiday overseas? Is being able to retire early more important than putting your children through private school?

You must also weigh up other priorities. I always recommend that those with dependants take out income protection insurance before they take out life cover. Why?

Anyone under retirement age is 20 times more likely to be unable to work for a prolonged period due to sickness than they are to die. Another recommendation I make is that people with high personal debt pay it off before they start saving. This is because it costs more to borrow than you can hope to earn from most forms of low-risk investment.

Anyway, the two key points I want to make are:

1. Keep your financial expectations
realistic.

2. Test them to make sure.

Keeping borrowing costs down

There are times when it makes sense to borrow money. And times when borrowing is unavoidable.

Either way, you want to make sure that you don’t pay a cent more than you have to.

If there is one area of personal finance where consumers get ripped off regularly, then it is when they borrow.

Look at the difference.

Nothing better illustrates the way in which consumers can overpay for a loan than a quick comparison of rates:

    • Secured loan from one of the specialist lenders 6%+

    • Personal loan (unsecured) from any high street bank 10%+

    • Credit card from any of the main providers 17%+

    • Store card from any of the major retail outlets 19%+

    • As a consumer it is not impossible that you might simultaneously be paying anything from 6% to 20% to borrow money — which is ridiculous.

    • There are times when it makes excellent sense to borrow.

    • For instance, if you want to:

    • buy, build or improve your home

    • finance a property investment

    • pay for education

    • pay for a car or other necessary item

    • start a business.

There are also times when it is impossible not to borrow money — if you are temporarily unable to earn an income, for instance, for some reason beyond your control.

There is no intrinsic harm, either, in genuine short-term borrowing for some luxury item.

What is really dangerous, however, is short-term borrowing that becomes long-term borrowing without you meaning it to do so.

This is not only extremely expensive but makes you more vulnerable to financial problems.

I can’t emphasise enough how bad it is for your financial wellbeing to borrow money to pay for living expenses.In particular, you should definitely avoid long-term credit card and store card debt.

Making sure that you pay the lowest rate of interest is one way to keep the cost of borrowing down.

Paying your debts back quickly is another. Compound interest really works against you when borrowing money.

The difference between paying back €1,000 at 15% APR over one year and — say — three years is a staggering €300 in interest.

It is vital at all times to be aware that defaulting on loans or credit cards is registered with the Irish Credit Bureau (ICB) and will greatly affect your ability to borrow or borrow at attractive interest rates.

Never let unauthorised arrears build up on any loan.

If your circumstances change during the term of a loan, inform the lender and come to an agreed and realistic repayment schedule.

Even negotiating an extension to an interest-only repayment will be recorded in the ICB.

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