I wanted to pay down my credit card debt and make sure my bills were paid on time.
Saturday, April 18, 2009
In my previous post, I outlined two reasons for tracking my finances:
Seems simple right? In the first case, I was interested in raising my net worth via paying down credit card debt. In the second case, I was interested in eliminating expensive fees via controlling my cash reserves.
Did you catch the error in my logic? If you paid close attention to my previous post, you'll quickly realize that paying off my credit card was never going to affect my net worth! Naturally, I'm exaggerating a bit because, by paying off my credit card, I could avoid future interest payments of $700 per year. But here's the point: In order to raise my net wealth, I needed to spend less than I earned. In fact, I needed to spend a lot less than I earned -- it turned out that I needed to be allocating about 30% of my income toward credit card debt in order to pay it off in 12 months.
Throughout the period of paying down my credit card (ie. spending less than I earned), I was using the Microsoft Money reports to track my progress. I was extremely motivated to see my net worth go up every two weeks. But after several months, I started to wonder why I still felt broke all the time. After years of college-life and the expectation that things would improve once my income went up, it was very emotionally upsetting to feel like nothing had changed.
Why did I still feel like a college student? The net worth chart was going up, but my quality of life was worse than ever! Intuitively, I understood what was going on: all my discretionary dollars were being shoveled into the hole I had dug during my years at college! But for whatever reason, my little man-brain simply couldn't reconcile how the Microsoft Money reports could be right when I obviously had so few dollars in the bank! For example, the monthly report would tell me that I had saved $900 in a particular month... but my checking account balance had only gone up by $100.
None of the reports were coming out right. But, when I started examining them, I realized that (by default) they were designed to convey my "whole" financial picture. That's what I bought the software for -- but it bothered me that I didn't know how to reconcile reality (the change in my checking account balance) with any of the Microsoft Money reports.
After pondering the issue a bit more (and some old-fashioned head-scratching), I finally figured out the discrepancy between my head and reality. In order to produce a report that reconciled with my experience of reality, I needed isolate my cash accounts for the purpose of analyzing cash flow SEPARATELY from my attempt to analyze net worth.
Luckily, Microsoft Money makes this very easy -- I excluded non-cash accounts from the Income and Spending Report and saved it as a Favorite Report with the new title "Cash Flow by Period." I finally understood how to reconcile my emotional reality with Microsoft Money -- and with that knowledge came the ability to methodically control my cash reserves. Instead of keeping an artifically high minimum balance "just in case," I was able to write a large one-time check to the credit card company to pay down my credit card (and pay less interest) even faster. I lowered my "just in case" minimum balance to $300 and haven't gone back since!
Why was my (self-imposed) minimum balance so low? Two reasons. Firstly, because I was sick of paying interest on debt and my checking account wasn't paying ME anything to keep it there. Secondly, all the money that comes out of my checking account was carefully planned, controlled, and accounted for. I wrote, perhaps, 6 checks per month. Five of those checks would be relatively stable. Rent, Electricity, Cable, Telephone, Insurance. The only bill I had with any kind of variation each month was the credit card bill. But since I was tracking all my expenses, I could see exactly how much I was going to owe weeks before the bill would come due. It was that kind of information that enabled me to lower my self-imposed minimum balance and ensure that there was ALWAYS enough money in the bank.
For more information on financial reporting, the SEC has published a handy guide called the Beginners' Guide to Financial Statements. It's a good summary of the basic accounting reports.
Posted by andrew at 3:01 PM
Thursday, February 26, 2009
When I first started using MS Money to track my finances, I was single and my accounting needs were very basic; I wanted to pay down my credit card debt and make sure my bills were paid on time. Despite the simplicity of my needs, I had never taken accounting and there were some things I didn't understand.
For instance, I faithfully setup my checking account and credit card account in MS Money and proceeded to enter every transaction as an expense until, finally, I got my first statement from the bank. Everything looked great - all my expenses were there. But when I went to make my first credit card payment, I didn't understand how to properly enter the transaction.
From my naive perspective, paying money to the credit card company was just like any other expense -- an expense I was NOT happy to incur. So I went looking through the built-in list of expense categories looking for something appropriately named; there wasn't anything called "Credit Card Payment," so I did what seemed natural to me -- I created a new expense category. I'm betting you can guess what it was called!
With my paper-check in hand, I navigated to my electronic register and updated the electronic register utilizing my newly created expense category "Credit Card Payment." Then I navigated to the credit card account and waved my magic wand to make everything come out right.
My numbers seemed right, but months later I realized that my approach was based on a flawed understanding of what I was actually doing. My mistake was thinking that my credit card payment was an expense. The reality is that, whenever you pay down debt, it's like paying yourself -- like moving $10 from one hand to the other. It's a transfer from one account to another, and consequently, there was no detectable change in my net wealth as an immediate result of the transfer. In other words, I shouldn't have registered an expense!
My incorrect utilization of the "Credit Card Payment" expense resulted in double-counting expenses; I can't remember exactly how I was "fixing" everything with my magic wand, but whatever I was doing, it was wrong. To the best of my recollection, I was doing something along the lines of:
As a result of my discovery, I built the new model of my financial workings as seen below. It was still simple, but it met my needs. Paychecks were recorded as net income; everything I spent money on was recorded as an expense; and most importantly, every credit card payment was recorded as a transfer (I had to go back and correct several months worth of transactions). I don't know why, but once I started thinking about my credit card payments as the rough equivalent of saving money in my account, it wasn't nearly so painful to write out that check every two weeks. In fact, the realization motivated me to the point where I was "saving" $1000 a month. It took me 12 months to pay off my credit card debt, but it felt great to see my net worth going up every two weeks.
If you are just beginning a personal accounting process, here's the most basic model that you should consider using. The boundary line represents your accounting system. Any transaction that crosses the boundary should be recorded as an income or an expense. If you decide to allocate some portion of your income to debt reduction or savings, record it as a transfer.
Tuesday, February 24, 2009
Before you rush out to buy that personal finance software you've been fantasizing about, do yourself a favor and play the game of 5 Why's.
Here's how it works: I'll get you started by asking a question, then it's up to you to ask yourself 5 why's.
Are you willing to control your financial behavior in order to achieve financial gain?
Here's an example of how you might respond...
- Yes; I'm willing to eat out less often, cancel my unlimited video rentals account, cut back on my cell phone data plan, and take control of my financial life. But most of all, I want to know how much I'm really spending on "stuff." Especially stuff like late fees and credit card interest.
- Why? I want to know where my money is going so I can determine the relative costs and benefits realized by each expense. I want to determine the scope of our spending problems with respect to all of my other expenses. I want to have a rational basis for improving my financial life.
- Why? Because I've done everything I can to increase my income and, short of working two jobs or winning the lottery, I'm out of ideas. I've asked my family to cut back on expenses, but I have no way to measure their efforts. In short, I want to stop wasting our limited supply of money.
- Why? Because other financial goals that I have aren't being realized. My 401(k) isn't where it needs to be. Our emergency savings account is a joke. The college savings account isn't even growing fast enough to get Junior through Junior College. We haven't been on a vacation since we got married. But most of all, I'm sick of living paycheck to paycheck.
- Why? Because I haven't decided to make my financial future a priority. I've let things go uncontrolled because it was easy. I keep thinking "next year will be better," but it never is! I'm old enough to recognize that, if I don't act soon, I won't have any options in the future and that scares me.
- Why? Because I want to retire early and spend time with my family. I want to work less and play more. I want to know that if I die, my family will be taken care of. I'm sick of worrying that the car will break down at any minute. I'm tired of worrying about events I can't control -- I want peace of mind.
I know you don't want to do the 5 Why's exercise... but it's absolutely critical to your success. You need to understand why you are keeping track of every little expense. You need to understand why you are establishing a budget. You need to understand why it's necessary to make retirement contributions. You need to understand the things that your money management program is going to deliver. This exercise is all about you and your passions. Money management is a life-long activity and it requires your serious commitment.
Communication is critical for couples... Regardless of what specific event caused you to pursue that fancy personal finance software, you need to recognize that without the support of your partner, you are destined for frustration. What good is financial information if the other person doesn't understand what you are trying to accomplish? Use the 5 Why's to develop mutual goals and build mutual support.
The take-away... If you haven't identifed your personal financial goals, you are swimming directionless in a sea of financial demands that may eventually drown you. You have the freedom to chart your own course toward financial peace. What's stopping you?
Monday, February 23, 2009
Since this blog is about a commercial product and I plan to include screenshots in the publication, I spent some time researching the General Microsoft Trademark Guidelines today. The guidelines are pretty clear cut, but I'm somewhat surpised at how restrictive some of the requirements are. For instance, in their guidance on Screen Shots, Microsoft states that
You may not alter the screen shot in any way except to resize the screen shot. You may not use portions of the screen shots, and you may not include portions of a screen shot in your product user interface.
What if I wanted to draw a red arrow on the screen shot? I guess I'll have to do my best.
Sunday, February 22, 2009
- Track Gross Income instead of Net Income
- Track Indiviudal Expenses instead of Credit Card Balance
- Utilize Classes to break out expenses by people and projects (in addition to expense category)
- Use Bills & Deposits Planner for all periodic transactions (including savings transfers)
- Use the tax planner to optimize withholding
- Create asset accounts for all vehicles
- Create loan accounts for liabilities
- Setup your checking accounts as "Budget Accounts"
- Setup your savings accounts as "Non-Budget Accounts"
- Setup cashflow prediction based on budget
- Setup a Budget
- Utilize the Important Documents feature to create a lsit of all accounts/wills.
- Maintain a Home inventory for valuable items
- Reconcile your accounts ASAP
- Enter transactions periodically -- never let your receipts pile up for more than a month.
- Enter returns as negative expense quantities
- Consider making the last transaction of every month a transfer to/from your savings in order to balance your actual in/out flows with your budget plan.
- Define a minimum account balance for each account.
- Stop using cash-money as soon as possible!!
Posted by andrew at 7:55 PM