WASHINGTON, April 20, 2016 — April is Financial Literacy Month. The importance of financial literacy has grown since the financial crisis in 2008, which worsened Americans’ financial woes. Americans carry more than $2 trillion in consumer debt. One study estimated that more than 30 percent of Americans have no extra cash for emergencies. Understanding how personal finance works is the first step to financial stability.
The web site will take you through what they call “Thirty steps to financial wellness.” It provides an excellent path out of financial distress. Here are the basics:
Match your spending to your income. Your first expenditure should be to pay yourself. Good financial management would say that everyone should attempt to save at least 5 percent of income. So take out the savings first and put it into a separate account.
Rank your expenditures in terms of priority. Housing expense is usually first, then other necessities. Continue until all expenditures have been accounted for, or at least well-thought-out estimates. Include credit card payments and everything that you are likely to buy as well as expenditures for any activities. Add up the total expenses.
Compare total expenses to net (after tax) income. Good planning will leave net income 5-10 percent higher than total spending. This leaves a cushion for unexpected expenses.
For many people, saving seems impossible. This is mostly because they do not pay themselves first. Maintaining a contingency reserve is also impossible when expenses are higher than net income. And that’s where the problem comes in.
There are only two solutions: Either increase income or reduce expenses. Increasing income, whether by working more or finding a better job, is usually more difficult than cutting expenses. Failing both, most people go into debt. They reason that as long as they can make the payments, they can carry the debt. This will eventually lead to problems.
Carrying debt can make sense if the debt is used to purchase long-term assets, like a house, a car or new appliances. It makes no sense if it is used to pay for luxuries (including entertainment) or to cover normal living expenses. Credit card balances should be paid down to zero every month. Then you can start living within your means.
When purchasing a house or a car, understand how much you can afford. For the purchase of a house, you need enough cash to pay the down payment and the closing costs. The down payment is usually at least 10 percent of the purchase price, while closing costs run about 5 percent of the mortgage amount. That can vary based on the fees charged by the bank.
The monthly mortgage payment should be between 25 and 30 percent of your gross (before taxes) monthly income, though it will vary based on a number of factors.
Suppose you purchase a home for $200,000. The mortgage gives you a mortgage for $180,000 and the closing costs are $10,000. Your monthly payment will be $1,400. This includes the payment to the bank and a monthly escrow to pay for the real estate taxes and property insurance.
That means you will need $30,000 in cash up front, and you will need an annual income of about $60,000 to support the mortgage payment.
Financial experts used to advise new households to purchase a home as the foundation for financial (and emotional) security. That may be a good option today, but given recent problems in the housing market and the increased mobility of the younger generation, owning a home may not be the right financial decision.
In order to achieve financial stability, you must become literate in the language of finance and understand how financial transactions work. Make sure your monthly budget leaves a surplus after you have saved at least 5 percent of your monthly income. Then you might find that owning a home is the next step.