Different Paths toward Financial Freedom and Debt Reduction
1. Personal financial process – This is the process or the path of managing your income to realize personal economic satisfaction.
2. Financial plan – This is a formal report that outlines your current situation, reviews your needs, and recommends your future activities.
3. Opportunity cost – This is the cost of the next best alternative foregone by making a choice to buy one thing.
4. Time value of money – This is the increase in an amount of cash due to interest earned.
Being financially free means different things to different individuals. For example, one person may define financial freedom to mean having a high income or owning expensive possessions, another to mean being rich to an extent he or she doesn't have to worry about clearing his or her bill, and another to mean being able to donate to organizations that matter to him or her.
Interestingly, how people get rich or attain financial freedom also varies. To some, starting a successful venture or pursuing a high rewarding career are common paths to personal financial freedom. However, wise investing and frugal living can also reward one with long-term financial security. It's good to note that in recent times, an increasing number of individuals are holding the opinion that the quality of their lives should be evaluated based on something other than their material possessions. A renewed focus on friends, family, and serving other people has surfaced.
Most people would like to manage their wealth so that they derive optimal value from each dollar. To attain financial goals, you need to identify and set financial goal and prioritize them. Financial freedom is often a result of personal satisfaction and an organized system that is more often called financial planning or money management. An overview of the basic financial management process is given below;
Your Personal Financial Plan
We will discuss personal finance management later in this article, but first things first, what's your money personality?
Understanding Your Money Personality
Have you ever asked yourself why you spend money in a particular way? A lot of factors determine your money personality. You spend your income to make yourself feel good and to feel a particular way. Other factors that may influence your spending habits include:
And access to credit
In addition, shopping has become a hobby for some people, and there are a lot of good places and a vast variety of goods that are affordable. The best way to change how you spend your money is to understand your money personality. Look at the following and find out where you fit.
Hoarder – Hoarders like to save, plan and prioritize their expenses.
Spender – They enjoy spending their income.
Planner – Planers are nitty-gritty, they prefer to take one step at a time with their money.
Dreamer – They hatch passionate plans, but they don't know exactly how to put them into reality.
Merger – Individuals in this category prefer to put their entire family income together and plan.
Separatist – They want some of their own money.
Risk takers – They love adventurous investing
Risk avoiders – They prefer to spend their money on the sure thing.
The Benefits of Personal Financial Planning
Personal financial planning process lets you control your current financial situation. Every individual, household, or family has a unique financial situation. Therefore, financial decisions cannot be done for you. There are a lot of benefits of developing an effective personal financial plan. They include:
You increase your effectiveness in getting, using, as well as saving your finances throughout your life.
You are able to control your affairs better by avoiding debt, bankruptcy, or depending on others.
You enhance your personal relationship due to effective, well-planned, and predictable financial decisions with others.
You get a sense of a good future due to anticipating expenses, looking to the future, and realizing your personal objectives.
Different factors influence individuals' financial decisions. For instance, people in their 30s spend their cash differently from people in their 40s. Personal factors such as income, age, personal beliefs, and household size also affect people's saving and spending patterns. Your lifestyle or life situation is affected by a combination of different factors.
Here is a six-step financial control process that can help you attain financial freedom:
1. Determine Your Present Financial Situation
In this step, you should determining your income, living expenses, debts, and savings. You should make a list of your debt balances, your current asset as well as the amount you spend on different things. This forms the foundation of your financial planning process.
2. Develop Your Financial Objectives
Why do so many people have money issues? There are two main answers to this question:
1. Poor planning as well as weak financial management techniques in areas such as use of credit and spending.
2. Extensive selling efforts, advertising, and product and service availability that encourage people to overbuy.
Achieving your personal financial satisfaction begins with setting sound financial objectives. You need to know what you would like to do in the future. Financial goal setting can be categorized into three horizons:
1. Short-term objectives- Goals to be realized within a year such as saving to pay off debt or vacation.
2. Intermediate objectives – Goals to be realized within two to five years.
3. Long-term objectives – Goals to be realized after five years such as the purchase of a vacation home, fees for kids' college education, or retirement.
Long-term objectives should be planned and coordinated with both the short-term and intermediate objectives in mind. Planning and realizing short-term objectives is often the foundation for moving toward future financial security (long-term objectives). For instance, saving for an initial payment to purchase a home is a short-term objective that can be the foundation of future objective – owning a home.
Based on your present situation and future expectation, you can develop your financial objectives using the following four steps:
Goal-setting is significant when making your financial decisions. These decisions are the foundations of planning, adopting, and evaluating the progress of your investing, saving, and spending activities. Your financial objectives should be SMART.
You should regularly analyze your financial objectives and values. The aim of analyzing your objectives is to differentiate your wants from your needs. Also, try and determine how you feel about money and figure out why you feel that way. Ask yourself:
Are your objectives based on household needs, luxury times, or social pressures?
How will possible changes in economic conditions, such as unemployment, impact your lifestyle and financial goals?
The primary goal of this step is to help you differentiate needs from wants. Smart financial goals are a vital part of effective financial planning. Yes, someone can help you set financial goals, but it's up to you to select the ones you want to pursue. You goals can range from spending all you money to saving and investing in programs that boost your financial security.
3. Identify Alternative Course of Actions
Examining alternative courses of action is always important when making financial decisions. In financial planning, alternative courses of action normally fall under 4 categories:
Continuing with the same plan – For instance, you might realize that the amount you have been saving, every month, is enough and continue saving the same amount.
Expand your current situation – You might decide to increase your savings.
Change your current situation – You might decide to use an alternative saving account – picture a change from the money market account to a savings account
Take another course of action – You might decide to use your savings to pay debts.
Different decisions require different course of actions – these are just some of the main alternatives. Carefully considering all the available options will help you set sound financial goals.
4. Evaluate Your Alternatives
You should review the possible alternative plans taking into consideration your personal values, current economic situations, and your life situation. For instance, how will the age and number of your dependents influence your savings? How do you like spending your free time? When evaluating alternatives, consider the following;
Opportunity Cost of Each Decision: It's important to realize that making a decision means that you will have to forgo an alternative course of action. For example, a decision to invest in shares may mean you won't have money to finance your vacation. A decision to further your education may mean you won't have enough time to take on a full time job. Note that the actual cost of the forgone alternative (opportunity cost) cannot always be quantified in monetary terms. The resources spent on a given alternative have alternative use (value) which is lost. Thus, when making your financial decision, carefully consider the lost value – opportunity costs as measured in form of dollars, personal resources, and financial resources.
Personal Opportunity Costs - This cost relates to the time used to complete a certain project. This time cannot be used to complete another project. For instance, time used for working is not available for studying. Another form of personal opportunity cost relates to your health. Lack of sleep, poor eating habits, or even avoiding workouts can lead to illness, increased health costs, reduced financial security, or time away from work or school. Just like financial resources, personal resources (knowledge, health, energy, abilities, time, etc) require wise management and planning.
Financial Opportunity Costs - A shilling today is worth more than a shilling tomorrow, right? For instance, would you rather have $500 today or $550 two years from today? How about $600 two years from today instead of $500? Your answer will depend on different factors such as uncertainty of the future, current interest rate, and your current needs. For you to accept a future payment, you will want to be compensated for the risk – time value of money.
Spending cash from your savings means foregoing interest earnings; but your purchase might be of higher value than the interest you would have earned.
Evaluate the Risk:
Uncertainty (risk) is an essential part of every financial decision. For example, choosing an accounting major has a risk. What if you later find out that you do not enjoy accounting? The risk also varies from one alternative to another. For example, depositing money in a saving account has a very low risk compared to trading in stock. The various type of risk you will need to consider when evaluating alternatives include:
Inflation risk: Falling or rising prices can cause decline or increase in purchasing power. Faced with this risk, you should decide whether to buy an item today or in future. If you opt to buy later, you may end up paying more.
Interest rate risk - Rising interest rate will affect you negatively if you have a debt, and positively if you are an investor. Taking out loans when interest rates are low is advantageous but note that variable rates can later increase, requiring you to pay higher instalments.
Income Risk – This is the risk that one will lose his or her job – source of income. Individuals at risk of loss of income should save while still employed or acquire skills that will help them acquire jobs later.
Personal Risk – Personal risk may arise in form of extra costs associated with financial decisions and purchases, safety risk, and/or health risks.
Liquidity Risk – Some investments and savings have varying potential for earnings. However, investments are also difficult to sell without significant loss or to convert into cash without loss in value.
5. Form and Implement Your Financial Action Plan
At this stage, your goal is to determine the action plan you will follow to attain your goals. For instance, you can save more by cutting on your expenditure or increasing your income by working extra hours.
6. Review and Revise Your Financial Plan
Financial planning is a dynamic process that does not end. You should regularly review your decisions to see if you are heading in the right direction. For instance, assess your plan once or twice a year.
Financial Planning Activities
To realize financial freedom, you need to coordinate different elements of your financial plan through wise decision making and organized planning. The figure below shows an outline of the eight critical personal financial planning areas you should pay key attention to.
1. Obtaining – You obtain your finances from your employment, ownership of a business, or investment. Obtaining your finances is the pillar of your financial planning because you can only optimize what you have.
2. Planning – Budgeted spending is the key to realizing financial security. Budget such that you spend less than your income at any given time.
3. Saving – Your future financial security begins by establishing and implementing a saving plan for unexpected bills, emergencies, purchase of special items and services such as a vacation home and more. Without savings, you will constantly run out of options and borrow.
4. Borrowing – Learn to live within your means – be in control of your credit card and only borrow for good reasons.
5. Spending – The ultimate goal of personal financial planning is to help you obtain the stuff that you want rather than prevent you from enjoying your life. You should outline your living expenditure as well as other financial needs in your spending plan. You should always strive to spend less than you earn.
6. Managing Risk – A suitable insurance plan is another element of effective personal financial planning. Note the usage of the word "suitable." This is because all insurance policies are not made equal. For example, the number of individuals who suffer diseases or disabling injuries at age 55 is higher than the individuals who die at this age, so individuals of this age may require disability or disease insurance more than life insurance.
7. Investing – Most individuals invest for two reasons: to derive short-time income or to enjoy future income. If your goal is to enjoy current income, opt for investments that pay regular interest and dividends. Some of the available long-term investments include; real estate, mutual funds, and bonds.
8. Retirement and Estate Planning – Everyone desires future financial security after employment. However, retirement planning involves more than financial health; it covers things to do with your recreation activities, your housing situation, and possible volunteer or part-time work upon retirement.
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