This article delves into the need for financial planning, details the way to assess our financial situation, outlines the steps of goal-setting and discusses the primers on rates (interest, inflation).
"The art is not in making money, but in making money work for us."
Financial planning is an area which even successful people ignore. We undergo annual appraisals in our organisation, but many of us fail to track our finances regularly. This tends to leave a chasm. Thus, assessing financial status is the key to financial freedom.
Importance of Financial Planning
All of us engage in work or business for the purpose of earning money. We know our salaries and perks but few of us know that:
- What is the proportion of our salary we need to save?
- What is the proportion of our salary we need to invest?
- Where to invest?
- What is the return on our investments?
The money that we save after paying rent/EMIs, income tax and other expenses represent real wealth. This needs to be diligently invested to get returns. Time is money. Thus to get better results, we need to start assessing our financial health immediately. This is crucial in current scenario as there is an increase in costs - be it health care or retirement pension. Financial worries are not due to lack of money but often due to lack of planning. Solid financial planning can help us better plan our finances always and more so in uncertain times.
The need for financial planning comes from the basic human nature to have a better control over future. We all have dreams and goals. Financial planning helps us asses the money required to achieve our goals. This in turn helps us plan and realise our dreams. These goals could include:
- A house.
- Education of our children.
- Marriage of our children
- A dream vacation abroad.
- A nest egg for a cozy and quiet retirement.
Financial situation can be easily assessed as:
Net Worth = Value of assets (Gold, RE, deposits, PF, Insurance, MFs, Shares etc) - liabilities such as credit card debt, personal loans (exclude your housing loan EMI and the value of your primary home).
Assessing our financial situation helps in proper budgeting and reducing unwanted expenditure. Thus it helps in making money work for us instead of us working for money. For example, if we can cut expense per month by Rs. 2,000/- and invest it and get 10% return on it for 25 years, we can get more than Rs.26, 00, 000/-. This is easily achievable if we cut down on some expense.
Goal Setting: All of us have dreams such as touring, retiring early or simply a second career or a business idea. These dreams would burst like a water bubble unless they are converted to goals and we are committed to achieve it. To chart an investment plan we need to identify our goals and set a timeline to achieve it.
Steps in Goal Setting
- Need for a goal: Many people wish to retire early. But, neither do they cut expenses nor invest diligently. They are thus unable to retire early as desired. Hence before setting a goal it is important to ascertain if we really wish to realise it.
- Write the goal: Writing down the goal helps commit ourselves towards achieving it.
- Set the time line: Retiring tomorrow doesn't count unless we win a lottery today. There has to be enough time to invest and reap the
benefit. So we need to be sure to give reasonable time levels to achieve our goals.
Interest Rates
Interest rates affect us the most but is least understood. For example, buying a house, getting a hike in salary or the price of commodities is primarily determined by the interest rates.
Interest is the price that one pays for using some one else's money. We invest money in the bank. The bank in turn lends it to a person who needs it and pays an interest to us. A borrower has to repay the principal amount borrowed along with the interest. Interest is the compensation to the lender for lending money for a certain period of time. Without interest rates, borrowers do not get money they need and lenders have no incentive to lend. Hence interest rates remain the cornerstone of the current economic system. Interest rates are usually expressed as percentage per year.
Interest compensates the lenders for the risk that they take whether the borrower will repay at all. They help borrowers make purchases that otherwise would be difficult to make - If banks do not lend money for housing loans many people would find it difficult to buy houses.
The most important point about interest is that it is cost to the borrower and income to the lender. Hence all borrowing decisions have to be taken carefully. Money that we save and lend earns us interest that can be either spent or re-lent so that our wealth increases automatically. Nations and individuals face trouble when they either buy things on credit or purchase things that they do not require.
Inflation
Inflation is the rise in prices of goods and services. For example, rise in the cost of onions from Rs. 5/kg to Rs.10/kg is inflation in its price. Similarly, overall inflation occurs when there is a hike in the price of all goods. Let us assume that about 15 years ago a movie ticket would cost Rs.5, but it now costs Rs.50. This is ten-time rise in the price. The effect of inflation is that if we set aside Rs.5 then, we would now probably be able to buy just a bus ticket with that rather than a movie ticket. This example clearly shows that inflation destroys the value of money. Thus, it is necessary to earn more than inflation. Otherwise we would be losing money. If the rate of return or interest we receive from our investment is 8% and inflation is 6%, then the real rate of return is 2%. Though insignificant, it definitely is better than inflation being 8% and your investment earning 6% in which case you lose 2% every year! Inflation can be defeated to a large extent by investing for returns higher than inflation.
