Personal cash management is the key to achieving financial freedom.
Here are 10 cash management strategies you can start implementing today to get there. But there are also plenty of pitfalls and bad advice you must avoid at all costs.
Welcome to Throwback Thursday, where we take a look at a past Agile Lifestyle feature that’s still as timely and relevant as ever. This article has been completely updated and expanded with the latest research and information.
Here’s why I don’t like the term “personal finance.”
The personal finance gurus often endorse strategies that are counterproductive to your financial health.
The biggest sin in this area is peddling homeownership as the solution to everything. These advisors act as a de facto sales arm of the mortgage refinancing industry.
(Refinancing, by the way, is the biggest kick-the-can-down-the-road scam ever perpetrated on honest working people.)
Feel like servicing debt for your entire life? How about refinancing another 30-year mortgage every couple of years to “save” on your interest rate.
Remodeling? Just add it to your refinancing!
Owning your own home is just one of the myths of happiness perpetuated by the personal finance industry. Another is that you can retire on the meager earnings in your 401(k).
The mutual fund industry is “the world’s largest skimming operation, a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation’s household, college and retirement savings,” said one Illinois lawmaker. Personal finance advisors rarely talk about index funds, the low-cost alternative to actively managed mutual funds. Why? They don’t make advisors any money.
So if the personal finance industry has become too scammy, then what’s the alternative?
Why I Prefer Personal Cash Management
I prefer the term cash management because it immediately focuses you on what you should be caring about: Straight cash, homey. Real, honest-to-goodness legal tender. Not highly illiquid “assets” like your home, your car, or your possessions.
From a cash management perspective, yes, these things could be converted to cash. But until you actually do it, they drain money from you—they’re expenses.
For example, the debt-financed home you live in is, at best, cashflow neutral. Even if you buy a house like we did and avoid all the common traps, you still might not come out ahead. In the end, you might sell the house for the inflation-adjusted price you paid for it.
Don’t believe me? CBS News reported that in the period between 1890 to 2005 (right before the housing bubble) home prices grew at less than 1% a year after taking inflation into account. 1% a year! And those were the good times!
The same people who are howling about how low CD interest rates are right now are the same people touting homeownership as an investment—makes you wonder if they can do math, right?
More likely, your home is cashflow negative due to interest payments, homeowners insurance, property tax, repairs, and all the associated costs of homeownership. You’re also taking the downside risk that your home value will tank (remember, all your risks have to go somewhere).
So quit worrying about this amorphous thing called personal finance and start managing your cash instead. It’s a lot more grounded in reality.
How Does Cash Management Help Your Personal Agility?
Agile thinking is all about responding to change. We can divide the changes in our lives into roughly two broad types: positive change and negative change.
(That’s painting with the broadest brush in the art store, by the way. Not recommended, but grant me some leeway to make my point.)
Responding to positive change is taking advantage of opportunities, like how the Amazon Kindle platform is making it easier than ever to become a published author.
Responding to negative change is about being prepared for setbacks, financial or otherwise. Personal cash management is important in good times, but it’s even more critical when things take a turn for the worse.
Bottom line: A healthy grasp of cash management strategies helps you in good times and bad by preparing you to be nimble, lean, and agile enough to respond to change positively.
The Top 10 Cash Management Strategies to Transform Your Relationship With Money
#1: Automatically Track Your Budget
I might have agreed with him in the days before Mint. But nowadays, automating your budget is so easy, you have no excuse not to.
Once you sign up with Mint and authorize your bank, credit card, and loan accounts to communicate with Mint, all of your transactions will automatically import into the system.
Mint will even try to categorize your purchases. For instance, it knows that when you go to McDonald’s these transactions should be categorized as ‘Fast Food’.
After your transactions are in Mint, it’s a simple matter to set up a budget and track your spending habits (good or bad) using categories.
To keep things dead simple, I recommend you only set up three categories (the fourth is created automatically):
- Home. This is your rent or mortgage, along with home-related costs like renter’s or homeowner’s insurance.
- Utilities. This is typically everything that gets billed to you monthly, like water, gas, electricity, cell phone, and cable.
- Food & Dining. Both groceries and dining out, including bars & alcohol.
- Everything Else. Like it sounds, this is your category for shopping and every miscellaneous expense that comes up. This doesn’t need to be set up specifically.
That’s it. The rest is making sure that as you spend, you categorize Home, Utilities, and Food & Dining expenses properly. Everything else automatically falls into the Everything Else category.
Over time, Mint starts to learn what is what and automatically code things for you. It’s like magic.
After a few months, you will have a highly accurate picture of where all your money goes.
If you can’t do that bare amount of work to understand your financial life, then you may not have a pulse and should seek medical treatment immediately.
#2: Lower Your Expenses
You automated your budget with Strategy #1. Now it’s time to pare down your household expenses.
Most people try to jump to this step before tracking their expenses and understanding their budget first. That doesn’t work. Good cash management strategy requires you to have an accurate picture of where your cash is coming from and going to before you make changes to your spending habits.
Once you have an accurate picture, lowering or even eliminating the unnecessary fluff from your expenses becomes a lot easier.
Do you rent or finance too much home? Are you eating out too much? Does that cable bill need to go? You can answer each of these questions after going through the step above.
A rule of thumb I use to budget is the rule of thirds. Each of the following should be one-third of your total expenses per month:
- Home should be a third of your expenses
- Utilities + Food & Dining should be another third
- Everything Else should be the last third
If one of these categories is out of whack, consider scaling back until the slices of the pie are in balance. For instance, most of you are spending way too much on housing relative to your lifestyle (you know who you are).
If your Home expenses are 50% or more of your budget, that’s a sign that you need to find a better fit elsewhere. Time to think about selling or moving out. Do you own your house or does your house own you?
#3: Decouple Your Expenses From Your Income
What’s the first thing most people do when they get a raise? Buy more junk, of course. Except the UN World Happiness Report tells us that accumulating consumer junk isn’t a major factor in making our lives happier.
So why do we do it?
Make no mistake about it: Lifestyle inflation is a communicable disease. You see your friends and neighbors buying nicer stuff and you feel compelled to go out and do the same.
Any time you get a raise or a bonus or switch to a higher paying job, keep your expense levels the same. Don’t fall for the relative income trap.
Always, always, always aggressively save the difference between your expenses and your income.
The bigger the gap, the better. I recommend saving at least a quarter of your household income if possible.
There’s a good reason to save this differential in the next strategy, but we’ll see why we should save so much when we get to Strategy #10.
#4: Build an Emergency Fund
How many of you got caught flat-footed when the Great Recession hit in 2008?
I know I did. I’d just started my first year of law school AKA three years of accumulating six-figure debt. I had about $5,000 to my name. If I had been jobless out of law school (like 40% of my classmates), there’s no question I’d be financially ruined right now.
The rule of thumb is to have six months of living expenses in a very liquid account in case of emergency. Personal finance blog Yes, I Am Cheap reports that in 2012, 28% of Americans had no emergency fund, while another 49% had only three months of cash reserves.
Talk about living on the razor’s edge.
The paycheck-to-paycheck lifestyle is not only irresponsible, it’s not agile. Any kind of negative change, like an unexpected layoff or increase in tax payments, can torpedo this type of lifestyle in a hurry. Even minor shocks, like an unexpected car repair or medical emergency can send the paycheck-to-paycheck person into a spiral of debt.
Sandy at Yes, I Am Cheap recommends a course of action if your emergency fund is looking thin (or nonexistent):
Begin with something tiny like 2% of your paycheck. For every $100 that you make, only $2 will go to savings. Fill out a direct deposit form with this new savings account getting what we’ll call the ‘painless percentage’ and then promptly forget about it. Wait about one month and see if you miss the money coming from your paycheck. If you don’t them bump your savings rate up by another percentage point and continue doing so until you reach a comfortable level.
Utilize the painless percentage if you’re the sort of person who needs gradual change. If you’re like me and you like to rip the band-aid off, I would put $5,000 in cash into a no-fee checking account immediately.
#5: Get Out of Debt ASAP
Consider this scenario:
- Pam has $100 in take-home pay. Is it better for her to invest that $100 in the stock market or use it to pay down her credit card debt?
That might be tough for you to answer. Let’s ask the question another way and see if the answer is more obvious:
- Pam has $100 in take-home pay. Is it better for her to invest in something that historically pays 8% a year or something that for sure pays 20% a year?
Seems obvious now, right? Yet I know a great deal of many smart, talented people who do strange things with their money, like buy stocks when they have enormous credit card debt hemorrhaging cash from their bank account (and remember, cash is the name of the game here).
Let me go even further. If you are in your twenties, I would put all my money into getting out of credit card and private education debt before contributing to a 401(k) and/or traditional IRA.
I know that investing pre-tax dollars is very enticing and the math favors it, but look, you can’t touch that money without penalty until you are 59 and a half years old. Furthermore, there’s no guarantee your company’s 401(k) isn’t drastically mismanaged with high fees—some to the tune of $150,000 to $200,000 per household.
There’s a lot that could happen between now and 2050. You want the flexibility to adapt to change.
Nothing cuts down a decision tree faster than owing a huge amount of debt to someone for the next 15 to 20 years. And your retirement will benefit the quicker you get out of debt.
#6: Negotiate a Raise
Okay, we’ve covered the top strategies for expenses. Let’s start talking about the income side of personal cash management strategies.
This is tough, no question. I will not trivialize how difficult it is to ask for a raise in a climate where most people are grateful to even have a job. But because you are reading this article, I know you are an A-player and a high achiever. And that means there’s a very good chance you are underpaid.
The key to any negotiation is to focus on the benefits to the other side. It’s too easy to walk into a salary negotiation and make it all about yourself. You need to convey the following 3 ideas to get the raise you deserve:
- How much value you add to the department. The more discrete the examples, the better.
- How comparable people in your field are compensated. Research on PayScale and make sure to match your search as close as possible. Added bonus: the implied threat that you can and will entertain offers from other employers.
- And that you want a raise. Don’t forget to actually ask for a raise.
If you’re feeling stuck, you can always focus on what makes you different from your colleagues. If you’re the youngest member of the department, you can emphasize how social media or tech savvy you are (assuming you are these things). If you’re the oldest, you can emphasize your experience and track record.
In other words, there are no losing hands when you are negotiating a raise.
Unless you genuinely suck at your job, in which case, time to find a better Hedgehog.
#7: Switch Employers
Your employer has a psychological barrier to paying you a significant salary increase. It’s called anchoring. Because they know you are willing to do the work for X dollars today, they aren’t inclined to give you X + 15% next year for roughly the same work.
When you get to this point (and you’ll be able to tell because you can’t get much better than a 2 to 4% increase from your boss), it’s time to jump ship.
With a new employer, you will have a clean slate. No prior salary to anchor to means you can get paid a figure closer to what you’re worth.
Sure, the interviewer at the new company will try to trick you into telling them your previous salary, but they have no legal right to do so.
The best defense to an interviewer fishing for salary information is to tell them that you are still under an NDA (non-disclosure agreement) with your current employer. Say that your NDA requires you to keep salary and other employment information confidential.
In my experience, this is accurate the vast majority of the time—which makes me wonder why it became common practice to divulge salary information in interviews in the first place!
Put it another away, if the shoe were on the other foot, would the interviewer want details about their company’s compensation scheme going out to competitors? Of course not! So tell them you’re only doing what an loyal, ethical, and law-abiding employee would do.
#8: Better Yet, Become an Entrepreneur
As long as you are employed by someone else, you will never be compensated what you are worth.
That might seem harsh, but it becomes obvious once you think about it.
Why does a corporation employ you at all? Because that corporation believes it can pay you X dollars to harness your productivity and make X dollars plus a profit.
If you’re paid exactly what you’re worth, the company would merely break even and wouldn’t be able to stay in business. And if you’re ever paid more than what you’re worth, rest assured you will get laid off pretty soon unless you have a powerful union on your side.
In exchange for never getting paid what you are worth, you get stability and a steady paycheck. At least, that’s the way it’s supposed to work.
But we’re seeing that this day and age, no company is safe from uncertainty, poor management, and technological disruption.
How much do you trust your executives? I’m sure if you were working at Enron or Lehman Brothers in their heyday, you would say you trusted them quite a bit. See how that turned out.
The only certainty right now is harnessing successful entrepreneur traits. Even if you’re working a 9 to 5 job today, you can start taking a more entrepreneurial approach to your career. You can build a second stream of income on the side, or fight for more control over how you use your time at work.
#9: Boost Your Credit Score
Ask 5 different personal finance advisors how your credit score is calculated and you will get 8 different answers. It’s that opaque.
Your credit score is a tautology. By that I mean your credit score is supposed to indicate how creditworthy you are. But in order to get credit, the banks look at your credit score. So how do you start building credit in the first place?
The answer is to get a no-frills, no-perks, no-bonuses credit card with a low credit limit that hopefully has little to no annual membership fee. Because the age of your oldest credit line is a factor, the sooner you do this, the better.
As your credit score improves, you can apply for better credit cards with huge bonuses that can net you free travel or hotel stays. Blogs like The Points Guy and Million Mile Secrets are devoted to this subject.
I’ve personally flown multiple trips solely on points, including an international trip to Peru in 2013 with flight and hotel covered by credit card sign-up bonuses. I’ve stayed at 5-star hotels in Beijing—with butler service, no less—using points.
I understand how this advice might sound contradictory to what I said above about controlling your expenses and lifestyle inflation. The point isn’t to go racking up charges on things you wouldn’t otherwise buy. The point is that you’re going to be spending money anyway and these bonuses are out there for the taking.
Travel credit cards are the closest thing to free money out there right now for people who want to see the world—and that’s practically everybody.
Strategy #9 only works if you have the ability to pay in full every month. Otherwise, see Strategy #4 above.
#10: Create a Personal Endowment Fund
All the scrimping and saving and tracking and earning needs to lead somewhere, right? Otherwise, what’s the point? Why shouldn’t we live paycheck to paycheck?
Here’s how I define the ultimate end goal of personal cash management:
To never work for money because I have to.
Note that the goal is not to “retire” in the sense of “stop working.” I hope I will be healthy enough to work on the things I love for the rest of my life.
The goal isn’t to stop making money either. But it would be nice to not have to worry about it.
The only way to reach this goal is to create a Personal Endowment Fund that pays you a baseline income every year for the rest of your life.
If this sounds farfetched, then let me talk about a concept you’re probably more familiar with: a trust. Many foundations, charities, and universities are funded by a trust. Here’s how a trust works:
You start with a principal amount, say $100,000. You invest the principal in a mix of investments that yield 5% a year, or $5,000. Then you pay yourself 4%, or $4,000.
The beauty of this is if you’re doing it right, you’ll never run out of money (even adjusting for inflation). That’s how charities and museums that were funded hundreds of years ago continue to operate from their original endowment today.
If you start with a higher principal in your Personal Endowment Fund, then this concept starts getting exciting.
If you have a Personal Endowment Fund of $500,000, then 4% a year is $20,000. That’s a livable amount of income in many parts of the world, and even some parts of the United States. Remember, you’re still working if you want—you simply don’t have to in order to survive.
4% of $1,000,000 is $40,000 a year. That’s starting to look like the median salary of your average American, and enough income to live like a king in places like Thailand and Costa Rica. The difference is that you’re no longer actively working to make that income. Instead, your Personal Endowment Fund is working passively for you, generating an income for life.
Building a Personal Endowment Fund that can produce basic income for the rest of your life is the goal of personal cash management. Through a combination of simplicity (reducing expenses) and entrepreneurship (increasing income), this is the heart of my financial freedom strategy in the agile era.
Whew. That was a massive post.
Please do me a favor: if you derived any value from this article, one good idea, or one chuckle, please click one of the sharing buttons below/floating to the side here. I would greatly appreciate it!
A version of this article first appeared on January 30, 2013.
Image by stevendepolo.