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