23 Jun The Pyramid of Personal Finance
Posted at 04:00h in Being Smart with Money, Budgeting, Getting out of debt, investing, Life Insurance, Saving for College, Saving Money, Wills 2 Comments
There are other pyramids out there, but this one I developed myself when I was a financial advisor. My company had given me one to use and I didn’t agree with everything on it and felt like it was missing some key components, so I adjusted it accordingly. Here is a copy of the pyramid, and I will go over each section in depth.
Section 1: Just starting out
If you have neglected your personal finances, or if you are just starting out on your own, you probably fall into this category. I will try to break it down into parts.
A. Insurance (Everyones favorite type of salesperson!)
P&C Ins. (or renters ins.)-If you own a home and have a mortgage, you must have insurance, same for cars in most states. However, you want to make sure you have enough coverage. Do not skimp on coverage and limits. For auto insurance go for the highest limits you can afford. As long as you have a good driving record the higher limits ($1 million or $500,000) don’t always make a huge difference. If you rent, you MUST have renters insurance. I personally know 2 people who have been robbed and you are not covered unless you have renters insurance. It is usually very cheap ($10-$20/month), so there is no excuse for not having it.
Health Insurance- You may think you can’t afford health insurance, but the truth is you can’t afford not to have it. Full coverage insurance can be very expensive, however there all alternatives. You can always go with a high deductible plan and use an HSA to pay for healthcare costs.
Long Term Disability- Probably the least known insurance. People assume if they become disabled that the government will take care of them. First of all, do you really want the government to take care of you? Second, if you know anyone who has gone through it, trying to get on social security disability income can be extremely difficult. Also, depending on your “credits”, you may not receive near as much as you need. Long Term disability is based on your current income and depending on the policy will provide you income until age 65. The cost is based on your risk, so the more dangerous the job the more expensive. However, for most people it is very affordable ($18-$25/month).
Life Insurance- Life insurance gets a bad name because of pushy salesman, but it is so important. If you have anyone who depends on you (children or spouse), then you need life insurance. Be sure to go for term, not whole. Term insurance is much cheaper and because there are so many companies the rates are very competitive. For example, I have $1 million, and only pay $38/month. My wife has $500,000 on her for $23/month. How did I come up with these figures? First, you must determine what your value is economically speaking. It may be morbid, but necessary. For me, we considered how much we would need to pay off the mortgage, put enough in savings for a large emergency fund, have enough to fully fund our kids college, and have enough for my wife to live on and go back to school. Term policies are typically for 10, 20, or 30 years. So if you get a 20 year policy in your 20’s, and then (as long as your are healthy again) in your 40’s, by the time you are in your 60’s you shouldn’t need it anymore as you should be financially independent.
Long term care (if you are over 60)- If you would prefer to have your choice of care when/if you become unable to care for yourself, then I suggest purchasing long term care insurance. Statisitcs show a very small amount of people needing care before age 60, so you can probably wait until you are closer to that age to purchase it. Be prepared, it is expensive, but how much is it worth to not be put in a welfare nursing home?
Make and follow a budget, its the single most important thing you can do to become financially responsible, save money, and accomplish your goals. Going along with this, once you have a budget you need to save up $1000 as a starter emergency fund. By emergency I mean you do not spend this money unless it is an emergency, and if you do spend it, you stop everything and build it back to $1000 asap. Always having $1000 in the bank gives you peace of mind because most true emergencies do not cost over $1000. If it does I suggest shopping around, because even major car repairs, a/c repairs, etc, can usually be done for a fraction of the price by finding individuals rather than going to a shop or big company.
C. Stop borrowing money!
You can’t get out of a hole if you keep digging out the bottom. Is that how the saying goes? Anyway, no matter how well you budget and save, if you keep piling up credit card and/or student loan debt and taking out loans for cars then you are not really accomplishing anything. Borrowing to buy a house is a little different, but you should still be smart about it. Just because the bank will loan you a certain amount, doesn’t mean you need to borrow that much. A good rule of thumb is for your house payment to be around 25-35% of your monthly income.
D. Will/Legal Stuff
Every adult (18 or over in case you are wondering) should have a will. Shocking! Something like 80% of people do not have a will. It takes a few minutes for most people to fill it out and then you can take it to a notary and make it official. Why do you need a will if you are 18? The main reason everyone needs a will is to avoid any potential problems in probate court and make your real intentions known. You should also have a living will so you can state what you would want to happen in the event you can not make a decision for yourself. For those who have more assets and children, you may want to consider a living trust as well. Bottom line, find a good attorney that can become your family attorney and get this stuff taken care of. Once it’s done you just have to review after major life events or when you want to change it.
Section 2: Debt Free!
By debt free I mean debt free except the house. That will take a little longer. Once you have paid off all of your other debts, your next goal is to increase your starter emergency fund to a fully funded emergency fund. Depending on your situation you want to save 3-6 months of your household expenses into a savings account. This account should have 1 day liquidity, meaning you should be able to get to it right away (no cd’s).
Section 3: Fully funding retirement and educational savings
At this point you want to start fully funding your retirement at about 15% of your income. The next step is to be saving kids college, I recommend ESA’s or a 529 plan depending on your situation. Once you have these things started its time to start paying off that mortgage! By the way if someone tells you not to pay off your mortgage because of the “tax writeoff” just walk away from them mid sentence. Well, you don’t have to be that rude but do not listen to them. That is one of those old wive’s tales just like a dog’s mouth being cleaner than ours. Just use common sense, they’re not. And not paying off your mortgage to save on taxes is just foolish, and here is why. First, you only save on taxes if you itemize which most people do not. Second, even if you do itemize you only save on the amount of taxes you would have paid on that amount (because it decreased your income by the amount of taxes paid). So if you paid $10,000 in interest and you are in a 15% tax bracket, then you would save $1500 in income taxes. So what people are saying is you should keep sending the mortgage company $10,000 a year to avoid paying the government $1500 more in income taxes a year.
Section 4: Financial Independence!
At this point you have zero debt, including no mortgage! You are fully funding retirement and education funds, and you have a large emergency fund. Now you have so much extra money you don’t know what to do with it. This is where you start investing outside of retirement, this could be done in mutual funds, real estate, or whatever else you wanted. This would also be a great time to ramp up charitable contributions, or maybe even start a foundation.
The original post was from April 2012, so this message is a bit outdated.
Message to Claire:
Wow, so much has changed in the last few months. The word explosion we read about around 18 months certainly happened. Your mom cannot get over how cute it is when you say “bubble”. You are getting better at saying phrases like “I sit”, “I want nana”, and “I dont know momma” which we think means you don’t know where momma is. We are getting so much closer to our best friends first child being here, and I think you and him will be best friends. It will be fun to see how you handle being around a newborn baby. Hopefully wel,l since you may have one in your own house soon. Sometimes I wish you could just stay this young forever so I wouldn’t have to go through the teenage years, but then I know you will be a good kid. I still haven’t decided what age I will have you read all of these, I guess im just going to wing it. Just remember no matter what you do or how much you think you hate us sometimes, we will always love you. That being said, try not to be too crazy.