“Can I afford that?”
If you’ve ever asked yourself this question and not been sure of the answer, it’s time to establish your financial foundation.
Think of a gleaming, towering skyscraper. It didn’t appear out of thin air. It took months of preparation and carefully designed installation. Most importantly, that skyscraper’s construction started with its foundation. Then, floor-by-floor, it was eventually completed.
The key point here is that the foundation came first. It’s an absolute necessity to the stability and longevity of the building. Without it, the tower would crumble.
Your financial foundation works the exact same way.
Without a proper financial foundation, your finances will never be in perfect harmony and you will never be financially stable. Moreover, you’ll never relieve yourself of financial stress, which is a heavy burden too many people bear.
Financial foundations are an easy concept, but they take a mindful, dedicated approach to put together.
Sticking with the building theme, your foundation will consist of three “pillars”:
- Short-term money
- Emergency money
- Long-term money
Pillar #1: Short-term money “STM”
Your STM reserve will be used to cover your active, day-to-day expenses. Think groceries, rent, utilities, etc. Although there isn’t a universal dollar amount, there is a guideline you should follow to determine how large your STM reserve should be.
Follow the below steps to determine your STM reserve:
- Calculate the amount of money you usually spend in a month. If you use a debit or credit card, you can use your monthly account statements as estimates.
- Take this dollar amount and multiply it be three.
That’s it! That number is the amount of money you should have set aside for your short-term expenses at any given time. For example, if your monthly expenses are $1,000, you should have $3,000 in your STM reserve. This covers the volatility and variance of your expenses.
Let’s face it, we’re all human. Some months you’re going to spend a little more than others, some months you’ll spend a little less. But with a STM reserve, you’re covered.
This will ease your day-to-day financial stress.
Pillar #2: Emergency money “EM”
Think of your EM reserve as a rainy-day fund. You can’t predict your next fender-bender or doctor’s visit. So, you need to have EM at the ready for such an occasion.
Again, there isn’t a universal dollar amount, but the calculation is easy: take that same monthly expenditure amount and multiply by six. Using our example from earlier, $1,000 multiplied by six would give us a $6,000 rainy-day fund.
See how easy this is? This number provides you six months of leeway if you were to ever lose your main source of income (i.e. your job). This gives you plenty of time to reestablish that income stream or find a new job.
Pillar #3: Long-term money “LTM”
We’ve accounted for your active expenses and potential, unexpected expenses. Now, it’s time to turn our attention to the future.
Your LTM is for your future goals, such as a house, graduate school, kids, etc. The sooner you prepare for those occurrences, the sooner you can take advantage of compound interest.
After satisfying your STM and EM reserves, you should contribute at least 20% of your monthly income to your LTM goals. If you’re making $3,000 a month, net of taxes, you’ll set aside $600. Want to reach your goals faster? Up that percentage.
And there’s your financial foundation blueprint!
Tie it all together
Construct these pillars by filling your reserves one-by-one, in the order listed. In other words, start off by focusing on your STM reserve. Once you’ve hit a comfortable point (i.e. about three months of expenses), move on to your EM. Lastly, after you’ve covered your short-term expenses and potential, spontaneous expenditures, you’ll start investing in your future.
A solid, formidable financial foundation is integral to financial success. These three pillars will provide clarity to your financial horizon and ease your financial stress. I know it’s easier said than done, especially if you’re living paycheck-to-paycheck. If that’s the case and you’re barely breaking even, create a budget and cut back on discretionary, non-essential expenses. Or, commit some of your free-time to building a secondary source of income. That way you’ll be on your way to sitting pretty at the top of your skyscraper!