Originally published January 2022
Updated February 2023
The New Year often brings thoughts of getting fit.
Yes, I know that usually means physically…but why not financially?
The thing is, few of us know what it really means to be financially fit.
And even fewer of us know how to get there.
This article will cover the five key elements of financial fitness and how to achieve them.
1: Make a Budget
Budget: Just reading the word may have made your eyes glaze over with boredom, but stay with me.
For the purposes of our discussion, a budget is just a list of priorities that guide how you use the money you take in. Having a clear understanding of where your money comes from and where it goes will help you make better day-to-day decisions and diagnose problems.
You can’t fix what you can’t see.
“Your budget doesn’t need to be formal; write it down on a legal pad if you want.”
Start by listing all your regular fixed expenses like mortgage (or rent), utilities, phone, internet, cable, debt payments, and any other bills that are the same every month.
Next, look back at your spending for the previous three months.
See what you spent on variable expenses like gas, groceries, meals out, clothing purchases, and other purchases to get an idea of your variable expenses each month.
Don’t forget to factor in annual or semi-annual costs like insurance, property taxes, or holiday gifts.
Total all that up and see if you are spending more than you earn.
“If you are overspending, find ways to make cuts.”
You can budget in regular savings if you’ve got money left over each month. If you’re just breaking even and not saving, look for places to cut so you can save.
Read: Want to Be Wealthy? Then Plan On It
2: Establish an Emergency Fund
A 2019 study from the Federal Reserve Board[1] tells us that 24% of adults in the U.S. do not have resources sufficient to cover an unexpected expense of $400 or more.
In other words, they have no emergency fund.
An emergency fund is vital to your financial health.
“Cash is the oxygen of freedom.”
- Morgan Housel
Consider this scenario: You commute to work each day using your car. On the way to work one day, you see smoke coming from under your hood. One expensive tow and diagnostic later, you are handed a $2,000 repair estimate.
If you don’t come up with the money for the repair, you have no way to get to work. With no cash in the bank, you have no option but to put this on your credit card.
Interest rates on credit cards tend to average 16% annually.[2] So now you’ll pay much more for this repair because you had to borrow from a credit card company instead of your own bank account.
You may be wondering, “How much should I keep in my emergency fund?”
As with most personal finance topics, it depends.
If your risk of unemployment is high, if others depend on you for financial support, if your income varies because you are a sales professional or entrepreneur, or if emergencies seem to crop up on a regular basis, consider keeping cash equal to six months of living expenses.
If your risk of unemployment is low, you don’t have dependents, your income is steady each month, and emergencies are rare in your life, you might be able to get by with cash equal to three months of living expenses.
Keeping more than nine months of living expenses in cash may be excessive, unless you have high exposure to risks like medical emergencies, job losses, or natural disasters.
If you don’t have an emergency fund, set aside a fixed amount each month until you’ve reached your funding goal.
And if you have to start over because you used your emergency fund for an emergency, great! The fund did its job.
Read: How much should I be saving? And where should I put it?
3: Establish and Maintain Good Credit
Navigating the modern financial world without a healthy credit history (or any credit history) is difficult.
You may have goals or needs, like buying a home, new furniture, or a newer car.
These will be hard to obtain without credit or costly to obtain if you have poor credit.
If you already have a well-established credit history and healthy credit score, you can skip this next part. If you don’t, read on.
A lender will decide to extend your credit and determine how much to charge you for that credit based on your credit score.
“Your credit score is driven by your credit report.”
There are three major credit reporting agencies that maintain a file on every borrower in the U.S.: Experian, TransUnion, and Equifax.
Federal law mandates that each of these private companies provide you with a copy of your credit report annually, for free, on demand.
If you have no credit or poor credit, start by pulling your report from at least one of these agencies. Check for errors or omissions. Report any that you find to the agency, and have the record corrected.[3]
Next, build your credit.
“The best way to build credit is to use it responsibly. That means paying your bills on time, every time.”
Consider using a credit card for everyday expenses that you pay off every single month. This may feel like a chicken and egg situation (I need to use credit to get credit), and you may have to start with a secured credit card.
Be careful and diligent, and you should see your score rise gradually over time.
Read: Understanding Credit: Your Score vs. Your Report
4: Establish and Maintain Good Debt Ratios
Debt is a fact of modern life.
Not all debt is bad, but too much is not good for your financial health.
Too much debt can lower your credit score and put a strain on your monthly cash flow.
There are two lenses through which to view your debt on your path to financial fitness.
The first is to examine only housing-related debt. Divide your monthly house payment[3] (or rent payment) by your gross monthly income.
If you come out with 0.28 (28%) or less, that's a green light.
If you come out with a number higher than 0.28, you should look for a way to reduce your costs (or increase your income) to come as close to 0.28 as possible.
Now consider your total debt.
Total up all your monthly debt payments (house payment, credit cards[5], student loans, automobile loans, etc.) and divide that by your gross monthly income.
If you come out with 0.36 (36%) or less, you again have a green light.
If you come out with a number higher than 0.36, debt reduction should be a priority. You want to get as close as possible to (or even under) the 0.36 threshold.
Read: How Should I Pay Down My Debt?
5: Make a Financial Plan
If you’ve built an emergency fund, know and stick to your budget, have good credit, and maintain healthy amounts of debt, congratulations!
You are one of a select few who take excellent care of their financial health.
But don’t sit back just yet; there is a piece missing: a Financial Plan.
All of the discussion we’ve had so far has focused on present-day financial health. A Financial Plan will focus on future financial health.
A Financial Plan doesn’t need to be formal, though it can be. Start simply by figuring out where you want to go by defining your goals.
Those goals might include buying a house, sending children to college, traveling, or enjoying a secure retirement.
Be specific in your goal setting.
Saying to yourself, “I want to travel,” isn’t helpful.
Saying to yourself, “I want to take a five-day cruise to a different destination each summer starting next year and ending when I’m 80,” is much more meaningful.
Now you can estimate what a five-day cruise costs and plan to set aside money for your cruise each year.
Longer-term goals like retirement might be more of a challenge to plan for.
Your goal setting there might sound more like, “I will save 5% of my gross income each year in a retirement account that I will invest in a diversified portfolio of low-cost investments.”
Some individuals are very comfortable doing such planning on their own or with minimal assistance. Some aren’t.
"Contact A CERTIFIED FINANCIAL PLANNER™ Professional, Sarah Cuddy"
If you are the type who wants some guidance in the planning process, consider engaging the services of a CFP® like me.
CFP® Professionals are specially trained in Financial Planning, Insurance, Income Tax, Estate Planning, and Investments and can work with you to craft a thoughtful and resilient plan. I’ve obtained the CERTIFIED FINANCIAL PLANNER™ designation because I believe that Financial Planning is a key component of investor success and a vital tool in building financial fitness.
Financial fitness may not be as sexy as physical fitness. But much like getting physically fit, getting financially fit can feel so good.
May you go forward in good health!
Ready to get Financially Fit?
Book Your Free One-Hour Consultation
[1]Report on the Economic Well-Being of U.S. Households in 2019, published May 2020. Find a copy at https://www.federalreserve.gov/publications/files/2019-report-economic-well-being-us-households-202005.pdf.
[2] LendingTree.com reports that the average APR for all accounts in the third quarter of 2022 was 16.27%.
[3] The process of correcting errors requires some very specific steps. This guide from the Federal Trade Commission is a good place to start: https://www.consumer.ftc.gov/articles/0151-disputing-errors-credit-reports
[4] Mortgage principal, interest, insurance, and taxes
[5] Only include payments on balances that you are paying off over time. For example, say you have $5,000 on a credit card that you are paying off over two years. Include a payment of $255 in your monthly debt payment calculations.
RB2023-0208