A Methodology for Personal Financial Planning

Personal financial planning is neither a mystery or an art. It is a methodology and discipline. It is about getting rich slow. There are no shortcuts and no magic tricks. The younger you start, the better. Here are the steps you need to follow.

First, eliminate credit card debt. High interest credit card debt is the biggest threat to most peoples' financial well being. The interest you pay can run over 30% per year. That's money you could put to work in investments. When you pay that money to a credit card company you get nothing in return. Eliminating bad debt like credit card debt should be your number one priority.

Establish an emergency fund. There is no such thing as job security. A job loss could occur any time through no fault of your own. It's necessary to establish a savings fund against disaster. Traditional wisdom says a six to nine month reserve is need. I recommend 9-12 months, especially during times when the economic outlook is negative and jobs at a premium. Keep this money in a liquid form such as a savings account or money market fund.

Review your insurance coverage. If you are single or married without children you probably don't need life insurance. If you do have children estimate how much your spouse will need through their college years. This is the ideal amount of insurance you should have. Purchase term insurance. It is pure protection. Other forms of insurance, like whole life, have an investment component. You can do better elsewhere. Your house insurance should cover the value of your property and replacement cost for your belongings. Things devalue quickly and if you don't have replacement cost coverage you'll have a real problem if a crisis occurs. Liability coverage on your home and automobile should be at least five times your income or double your net asset value, whichever is greater.

Ask what money you will need in the next five years. A house down payment is the number one answer. Set up a savings pan for this goal and contribute regularly. This money should be kept in a safe and liquid asset such as a savings or money market account.

You are now ready for investing. The first thing to do is to review your employer's 401k plan. This money grows tax deferred. If your employer is matching contributions contribute up to it's maximum match first. This is free money and should not be left on the table. The return is actually great enough that it can outstrip the negative of credit card debt. If your employer does not match contributions, invest first in your Roth IRA. The one cardinal rule is to never invest in your company's stock. If your company runs into disaster you lose your job and your investment. Think Enron.

Open a Roth IRA. Use a discount stock broker or mutual fund. company. This money is contributed after taxes and grows tax exempt. When the account has been held five years money may be withdrawn tax free. When young this money is best invested in stock oriented securities. As you get older you can change your investment mix to include safer instruments, such as government bonds. Unless you are willing to follow the market and your companies closely do not invest in individual stocks. Get diversification by buying mutual funds or exchange traded funds. Specify that you want your dividends reinvested. You do not have to make your annual contribution all at once. Make monthly or quarterly contributions . This will make your saving easier and also allow you to dollar cost average into your investments.

Lastly, remember to pay yourself first. Make your investment contributions and then you are free to live off the remainder of your paycheck.

Sources: http://www.investopedia.com/articles/01/061301.asp
http://www.rothira.com/
http://money.howstuffworks.com/personal-finance/financial-planning/401k.htm
http://www.statefarm.com/insurance/identify_insurance.asp