Ten Key Components of Financial Planning
A study conducted in 2018 revealed that 82% of millennials felt their financial plans needed a significant overhaul and improvement. Then, in light of the COVID pandemic, 20% of these young adults made significant adjustments to their finances.
A variety of reasons play a role in wanting to implement positive changes to your financial plans. However, the number one reason is undoubtedly to secure a better future for yourself.
Here are 10 key components of financial planning that can lay the foundation for your economic game plan. Whatever your goals may be, implementing these elements can help guide you toward financial security.
1. Identify Your Goals
The first component of a financial plan is to understand its purpose and define the objectives you wish to achieve by creating one. You may begin by asking, “What is a financial plan?” Simply put, it is your compass or guide helping you navigate and control your income, expenses, savings, and investments.
However, to create an effective financial plan, you must identify and set economic goals for yourself. In other words, your compass must point north toward your ultimate endpoint. For many, financial goals are long-term: buying a home, saving for retirement, or eliminating all debt. Ultimately, identifying the end goal helps you stay focused and adhere to the plan you create.
2. Understand Cash Flow
Once you have your goal in mind, you need to thoroughly assess your monthly income and expenditures. Of the financial plan elements, understanding your cash flow is by far the most important. This is because you can’t create a plan toward your goals if you don’t know how much money you make, how much you spend, and how much you can save.
To measure your cash flow, you’ll start by deducting your monthly expenditures from your total monthly income. Your income includes all revenue-generating sources, such as a full-time job, freelance work, or real estate property. Your expenses include necessities, such as rent, food, and bills, as well as credit card debt, student loans, and car payments.
When deducting your spending from your income, you want to be left with a positive number. Conversely, a negative number is a red flag that you spend more than you make. Once you have this metric, you can begin formulating a plan that can help you maximize your income to pay for your needs and reach your goals.
3. Create a Budget
Developing a budget is where you begin to make actionable plans to reach your goals. Once you have a good idea of what your cash flow metrics are, you can start outlining your expenses and looking for areas to cut back on. The money you begin to save can then be redirected toward your goals.
To create a budget, first list your monthly income and all expenses. Then, allocate a portion of your income to each categorical expense. There are countless methods for budgeting, and no one way is right. Here are some budgeting options you may consider adopting:
- 50/30/20 method: allot 50% of your income to necessities, 30% to wants, and 20% to savings
- Line item: list every monthly expense on a sheet or Excel document. Then, specify the maximum amount you can spend on that monthly expense.
- Envelope system: withdraw your monthly income as cash. Then, divide the funds between several envelopes that are each dedicated to a specific expense. The amount you dedicate to each envelope is up to you, but once you have spent all the cash in a particular envelope, you can no longer spend in that category.
- Zero-based: the goal of this budgeting method is to subtract your monthly expenses from your income to reach zero. As a result, you can ensure you are not overspending, maintaining your cash flow, and that every dollar has a purpose.
Ultimately, finding a budget that you can stick to and that fits your lifestyle will take trial and error. A successful budget is a crucial component of a financial plan as it helps keep you accountable and encourages you to take direct steps to achieving your goals.
4. Manage Debt
A financial plan is not only made up of your goals, cash flow, and budgeting method. Another component of a successful financial plan is creating a debt management solution. Without it, your budgeting efforts will fall short as you continue to hemorrhage money toward high-interest debt that could be better spent toward achieving your goals.
As a result, focus on paying off high-interest or emergency loans immediately. A popular way to pay off debt is the snowball method. With this strategy, you focus on paying down small-sum or high-interest loans first. When those debts have been cleared, you can roll the extra cash into paying off larger-sum loans.
Once all your debts have been repaid, you can refocus your attention on your savings goals. At this time, you may redo your budget to include the extra money you now have. Ideally, you’ll want to dedicate these funds toward your goals.
5. Build Savings
After you’ve cleared yourself of debt and formed a budget, you can begin to focus on building a safety net or savings account for your financial goals. Just like a budget that can help keep you on track, a savings account ensures that you are steadily contributing a portion of your income to your goals. Also, an emergency fund can help mitigate the risks of unexpected financial emergencies. Rather than take on more debt to cover a last-minute expense, you’ll have cash stowed away for that purpose. As a result, you won’t have to worry about emergencies affecting your budget or financial plan.
Many individuals opt to save around 20% of their monthly income. However, building an emergency fund is flexible and can be tailored to your financial situation and budget. As a result, after you assess your cash flow and your budget for necessities, determine how much money you have left over. Finally, calculate how much of that extra cash you can comfortably allocate toward savings.
Some savings account options include:
- Basic savings account: these accounts are the most common and accessible because they can be tied to your checking account. There are low minimums, and individuals have the freedom to transfer money between accounts. Nevertheless, interest rates are very low.
- Certificates of Deposit (CDs): although interest fluctuates with these accounts, you’re still guaranteed to receive your principal amount. CDs are often used for long-term and large-sum goals because they offer higher interest rates. Keep in mind that your money will not be accessible for a set period when using a CD.
- Money Market Savings Account: these accounts are offered by most banks and FDIC guaranteed. Interest rates are higher with a money market savings account, typically around 2% to 3%. Additionally, the funds remain accessible. However, these accounts usually have higher minimum amounts and limits
6. Get Insurance
Contrary to popular belief, creating an effective financial plan also necessitates spending money efficiently. Therefore, another critical part of a financial plan is obtaining insurance, including medical, home, life, disability, and auto.
Insurance is a preventative measure during financial planning as it helps you avoid spending your hard-earned savings on unexpected emergencies. While some emergencies cannot be completely covered by insurance, many others can be lessened.
If your employer offers health coverage, you likely won’t have to pay a monthly premium for it. However, if this option is not available to you, consider bundling your insurance coverage. Most insurance providers offer discounts when you sign up for multiple plans, such as health and life or home and auto coverage.
7. Save for Retirement
As mentioned, many people create a financial plan with the long-term goal of securing a comfortable retirement. As such, your financial plan should include retirement savings as a key component.
Like health insurance, some employers also offer a 401(k)-matching program. Even if you contribute a small portion of your income, your retirement savings can quickly add up if your employer also contributes to the account. Just like an individual savings account, calculate your cash flow and budget, then allocate a comfortable amount to your retirement.
If your employer doesn’t offer a matching program, you can always open an individual retirement account (IRA). Although it will take longer to save for retirement without the benefit of matching, an IRA often offers better interest rates than regular savings accounts.
Also, a retirement savings calculator is a handy tool that can help you determine how much you will need based on your projected expenses. In addition to living expenses, you’ll also need to account for medical costs, taxes, and mortgage fees when planning for retirement.
8. Invest
Besides a traditional savings account, there are other methods to grow your money that may offer higher interest rates. As a result, aside from budgeting and opening a savings account, another key component of a financial plan is strategically investing your money.
Risk-averse individuals may opt for the following investment options as they offer relatively stable growth:
Treasury Bond (T-bond)
T-bonds are long-term investments that are fully backed by the U.S. government. Terms range between 10 and 30 years, offering semiannual dividends. The interest rate is fixed for T-bonds. This rate is usually a portion of the principal amount.
Treasury Inflation-protected Securities (TIPS)
TIPS are also fully backed by the U.S. government and have 10-to-30-year terms. Additionally, the interest rate is fixed, and investors are paid semiannual dividends. However, unlike T-bonds, the principal amount in a TIPS fluctuates with an increase in inflation. As a result, the investor’s purchasing power is never compromised, and their principal amount is protected. With a TIPS, the investor will never receive less than their original principal.
Mutual Funds
With a mutual fund, a professional will invest your money on your behalf. Mutual funds are riskier investment options because your money goes directly into the stock market. However, with the help of an investment manager, you can diversify your portfolio with several stocks to help mitigate some of the risks. Although mutual funds come with more risk, these accounts also offer faster and larger growth opportunities.
9. Mitigate Risks
As previously mentioned, savings accounts and insurance are both preventative components in a financial plan. They are there to offer a cushion in case of an emergency. However, it is not enough to have a safety net in place. You must also anticipate possible risks to develop a plan in case it occurs.
As a result, another component of a financial plan is to forecast possible risks and prepare financially for them. For instance, you may become ill or suffer an injury that makes you unable to work. As such, you’ll need to determine how much money to save to get you through the hardship. Keep in mind that you can always apply for disability. However, until your application is finalized, it is best to have funds stored away to keep you afloat.
By recognizing possible risks, you can have a better idea of how much to dedicate to your savings accounts or which types of insurance plans are necessary. When it comes to finances and your livelihood, you can never be overprepared.
10. Consolidate Your Estate
The last component of a financial plan includes estate planning. Although this is a fact of life many of us would like to avoid, it is important to determine what will happen to your assets, especially if you have dependents. Most importantly, if you have life insurance and retirement savings, make sure to keep your beneficiaries up to date.
Therefore, when completing your financial plan, also include a written will. In this document, outline all your assets and your last wishes regarding what will be done after your passing. For instance, many individuals with dependents transfer their assets to their loved ones. In the event of an unexpected passing, having a thoroughly written will can ease the asset dispersal process for your family.
Sum Up
If you’re creating a financial plan or revamping an existing one, these 10 key components can help guide you. Although each element of a financial plan is equally important to overall success, keep in mind that you have the flexibility to adjust your plan according to your circumstances and goals.
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