How To Build Your Financial House

ackling your personal finances can be overwhelming when you are unsure where to start. Much as building a home benefits from a blueprint, your financial house might be easier to construct if you use a similar strategy. In fact, a house is a good metaphor for thinking about the structure of a sound financial life.

A Firm Financial Foundation Matters Most

When building a house, the first thing you think about is a solid foundation. Without that, anything constructed above will be unstable and susceptible to collapse. In recent years, we are hearing more about sinkholes and the risks to houses built above them.

In terms of personal finance, unsecured debt like personal loans and credit card balances are the ultimate sinkhole for your financial house.

Don’t be confused about mortgages. They are a secured debt because the house is an asset which could be sold to pay down the existing loan. An auto loan falls somewhere in between because the loan may exceed the actual value of your car or truck – a depreciating asset.

Building the First Financial Floor

Once the unsecured debt is paid off, it’s time to construct your first financial floor.

Some rooms on this level might seem obvious, like health insurance. Everyone has heard stories about how quickly medical bills can result in massive debt and undermine (sink) the best-laid plans. Make sure you have enough health insurance to protect yourself from significant financial hardship.

Another important room on this level is your emergency fund. This should be a savings account set aside for unforeseen circumstances including:

• The loss of a job
• An injury resulting in temporary time away from work (and your paycheck)
• A leak in your water heater necessitating the purchase of a new one

Vacations, tax bills and predictable repairs (to your old roof for example) are examples of expenses you can plan for and schedule according to your cash flow.

An adequate emergency fund can be thought of as ‘debt sinkhole prevention’ because it allows you time to find a new job, pay for expenses while you recover from your injury and buy that water heater. This keeps you from taking on credit card debt and destabilizing your financial house.

An amount equivalent to 3 – 6 months basic living expenses is a good target depending on your financial situation. Find a high-yield savings account or money market account for these funds, and you’ll earn some interest too.

More Rooms on the First Floor

Life and disability insurance are additional rooms to consider on the ground floor of your financial house. Term life insurance makes sense if someone else (or your entire family) is dependent upon your income to maintain a reasonable standard of living.

If no-one is dependent on your income, you do not need life insurance. That doesn’t mean agents won’t try to sell you a policy which they’ll describe as a good investment. It is not. Life insurance exists to protect your family’s source of income.

Disability insurance is similar and often overlooked. It’s actually far more likely you will have a disability than dying prematurely. Consider a policy to provide income to you and your family in the event you are unable to work for an extended period.

It’s possible your employer offers these policies as part of your employee benefits package. Look into it first before deciding if you need additional coverage. If you are self-employed, look for highly rated insurance companies and shop around.

Finally, if your employer provides a 401k savings plan or a 403b plan and offers to match your contribution, add a “closet” to your first floor and participate in this plan up to the amount required to receive the full match. There will be more on retirement planning as construction of your financial house proceeds.