What Is Financial Planning, and Why Is It Necessary?
Financial planning is a detailed statement of an individual or a family’s long-term goals and the investment and saving strategies that need to be followed in order to manage their incomes efficiently to fulfill these goals. It not only helps you figure out how to make your money work for you, but also provides a road map to carefully navigate each milestone that you will come across in your life.
Financial planning is not something that only the wealthy need to consider. It is just as important for anyone who wants to live a financially stable life and, more importantly, be prepared to handle major life events that often demand excess and unanticipated expenses.
Problems, emergencies, and most expenditures do not give advance notice before coming into our lives. Yet it is possible to be prepared for such eventualities by being proactive. All it takes is some understanding of some of the important aspects of managing your finances and executing them in the best way possible.
Also, there are situations that we plan for, like taking a vacation, pursuing higher studies, or even starting a business. These events can be carried out in a hassle free and less stressful manner – provided we have planned our finances in advance.
Steps to Help You with Advance Financial Planning
The goal of financial planning is to spell out specific ongoing processes, which shall work towards:
- Supporting your existing financial needs
- Reducing any monetary stress for the short term
- Building a nest egg for a healthy and stress-free living post-retirement
This central theme shall remain constant regardless of whether you make your own financial plan or hire a professional to do it for you. When considering an advance financial plan, prepare for the following steps:
- Pinpoint your life goals: Do you want to buy a house? How about kids? When do you think you would like to retire? How much income would you need then? If you can identify your life goals and put a realistic monetary figure against each goal, that is the first part of the jigsaw puzzle that is your financial plan.
- Carefully assess your financial data: Quantify components of your income, your salary, investments, and other assets. A similar analysis of your liabilities, payments, and debts shall yield the components of your expenses. Divide your total income by that of your expenses, and there is your net worth. This financial data serves as the other set of reference points for your financial plan.
- Contrast goals with financial data: A head-to-head comparison between your life goals and your financial data (income, expenses, and net worth) should give you a clearer picture of where you stand right now, versus where you need to be monetarily in keeping with your important life goals. If the gap looks too big, don’t worry, because the whole purpose behind advance financial planning is to get going in the right direction and reach there eventually.
- Plan for the short, medium, and long term: Creating a budget and following it through – a common step in virtually all financial plans – meets your immediate financial goals (for the next week or month). Ways to reduce credit card debt could be a medium-term step, but it also opens avenues for long-term saving. Having steps in your financial plan that play out over different intervals is both practical and prudent.
- Set realistic goals that support one another: If you closely examine the examples in the previous step, you will notice that budgeting automatically helps in making available funds that can go towards reducing high-interest credit card debts. As a result, your credit rating improves over time, which could then come handy when buying a house.
- Adapt your plan to life events: No matter how well you have planned your finances, it will need constant revisits and adjustments based on your life events. Since the only constant in life is change, you and your plan should be flexible and pragmatic enough to change and deal with life’s intervention moments, like a marriage, birth, or death of a loved one.
Important Life Events Where Advance Financial Planning Is Essential
While higher education is a standard many strive for, it nevertheless brings the added significant financial burden. You need not depend on student loans alone to think of advance financial planning for your higher education. The greater sum of your college fee that you are able to cover on your own, the less you have to pay back in terms of loan amount once you graduate and begin working full time.
If you sit down with a financial advisor, they will take you through different student aid options. It begins with something as basic as filling out the Free Application for Federal Student Aid (FAFSA), where the decision of how much aid to award to whom depends on your asset base. But it is still worth a shot, as any amount of aid would go towards removing that much financial burden off your shoulders.
You could also plan in advance and save up as much as you can before you finally decide to attend a college or university. It could be a small amount from your salary, cash gifts from family, or even the occasional yard sale. Keep in mind that even small amounts of money eventually add up.
Then there is always the option of taking it slow by attending community college or engaging in part-time jobs to pay off some part of the tuition fee. Finally, you could apply for scholarships and grants for specific fields of study, special skills, and hobbies, and as long as you are well prepared, there is virtually something for everyone out there.
Whether you are newly engaged, thinking about the prospect of marriage, or in the middle of planning your nuptials, it is never a bad idea to discuss advance financial planning with your partner. A lot of times, marital discords come up as a direct result of not knowing or worse – having the wrong idea about your partner’s financial well-being prior to taking your vows.
Get a firm idea of each other’s credit score and outstanding loans beforehand. This will give either party the time to contemplate strategies of improving the other’s credit score or aid in paying off remaining student loan debts.
While consolidating your debts into a single payable entity can be helpful, it should be done with caution. More importantly, a decision needs to be made if you should consolidate your respective debts separately or combine the two of your debts with a personal loan.
The same rule applies to sharing a joint bank account. It requires forward planning so that there is always money in the joint account to pay for bills on time. Also, if one of your credit scores is low, then consolidating debts into a joint account can instantly bring down the higher credit score.
Then there is the little matter of a possible prenup. While the topic of prenuptials can be a tricky conversation to be had with your future spouse, getting one certainly does have its advantages. From safeguarding premarital assets to protecting you from your partner’s undeclared debts, a prenuptial agreement, despite its morose theme, keeps you from financial ruin in the unfortunate event of marital separation.
Buying a Car
Like your home, purchasing a car also involves taking out a substantial loan and repaying it through monthly payments for years. Whether it be banks or credit unions, they take into consideration your credit score and history before establishing the interest rate and other applicable terms for your auto loan.
Therefore, part of a prudent financial plan begins with managing your credits responsibly through timely payments well before you approach a lender for an auto loan. While car dealerships are more than happy to arrange financing, they will as readily charge you a dealer reserve, which is basically a mark-up (usually between 1-2% over the base interest rate) for connecting you with one of their finance company partners.
Other steps would include performing all necessary legwork related to brands, models, and pricing to help you settle on a budget. This should ideally be complemented by any savings you may have built up to cover for the down payment, along with the trade-in value of your old vehicle (if you own one already).
Finally, when you begin your vehicle shopping in earnest, be mindful of picking a model and negotiating a price that is a couple of thousand dollars less than your actual budget, as that is roughly the amount that will go towards paying fees and taxes.
Buying a House
Buying your new home can be one of the most exhilarating and stressful events in your life, as it is the largest purchase a consumer makes in their life. However, doing a basic amount of advance financial planning can help you successfully shop for your dream home, apply for the right mortgage, and close the deal in time.
It all begins with determining the cost of a house that you can actually afford and working from there. Saving beforehand for a down payment is another step in the financial planning staircase, as it amounts for anywhere between 3.5-20% of the actual purchase price. If you do not start early with your savings, then you may lose out on an excellent residential ownership deal when the time comes.
Finally, there is the mortgage to consider. Getting pre-approved for a mortgage, while a non-binding process, portrays you as a serious buyer in the market. Deciding between the various types of fixed or variable mortgage rates shall depend on your repayment potential, which again requires a great deal of financial foresight.
Moreover, you are going to be charged an additional monthly premium for private mortgage insurance by the lender if you choose to put a down payment of less than 20%, so there is that extra component to consider.
Taking a Vacation
Come summertime, that long-awaited family holiday to a vacation destination lets your mind and body recuperate much of what was lost from months of work. On the flipside, if you have not planned for your vacation, then don’t be shocked when you see your credit card bills reach $10,000 or more.
To begin with, consider asking your financial institution to set up a vacation fund – one which gets small, monthly contributions from your pay check. Basically, your aim should be to cover for at least 15 days of travel, including everything from airfare, hotel bookings, transport, food, beverage, insurance, and incidental costs like excursions. So the faster you are able to come up with an estimate of the biggest expenses, the more realistic your budget shall be.
Transportation happens to be an area where cost overruns can easily get out of hand. For something like flight tickets, don’t just look for the cheapest airfare, but consider other factors like baggage check-in costs. Planning strategies here could include getting your family a frequent flyer number or co-branded credit cards for your preferred airline. Similarly, for road trips, consider extra costs of gas, car insurance, and overall rental.
Factor in any extra costs for guides, attractions, and food outside your vacation spot if you are staying at an affordable hotel. In case you have booked a resort, think about on-site food, tips to service staff, and additional resort fees. All of this should ideally be coming out of your vacation fund, so plan and begin saving months before your vacation.
Starting a Family
Starting a family is a major life event that can bring about a diverse change in the household, especially for a young family where the spouses have just settled in their careers or businesses. Usually, the mother has to take a long break for pre and postnatal care, and many women prefer to extend their maternity leave to be able to spend some quality time with their newborn. However, this means the family has to depend on a single income source of the other parent, and this proves to be extremely difficult without a proper advance financial planning in place.
Along with the pressure of managing the existing household expenses, the single income source will also have to cover all the additional expenditures which comes with the arrival of a child. Costs will include restructuring the living space to accommodate the infant, taking care of family and friends who would come over to visit the newborn, and hiring help or making temporary arrangements to support the mother. Frequent pediatrician visits pile up a lot of bills that might not be covered by the insurance company, and unfortunately, in some cases, this expenditure is multiplied many folds due to any special medical condition related to the child.
Since most couples these days plan before starting a family, it is advisable that they take steps to ensure they have saved, invested, and are prepared for large expenses that come after a child is born.
When you are going through an emergency, like an accident or a health scare for yourself or your family, the least you want to worry about additionally is expenditures. It is obvious you would want to arrange for the best treatment possible during this time, and having a nest egg you can access is a blessing.
Unstable job markets, business losses, and natural disasters are some other emergencies that you may encounter. The only guaranteed way to see such problems through is to plan and set aside a part of your income gradually to build up an emergency fund, look for the best insurance options available, and be confident about starting again after the tough time has passed.
There are so many options to start saving or investing for your retirement that, if planned well, it should not be a big hurdle to cross. Advance financial planning for retirement should include the foresight to estimate increased travel and health care related costs, as you will be growing old. According to experts, in many cases, an individual would need about 80% of their annual income after retirement, and social security should be able to cover about 30-40% of these expenses, but it is an uncertainty that you cannot fully rely on.
So it is best to start investing or saving early in a retirement plan, take full advantage of the opportunity for compounding your money, increase your contribution towards this saving every time you get an increment, and look for options that give you tax savings or tax free income.