The Silent Partner: Cash Flow

Last week we learned that building net worth is a top goal for your personal finances. How do you accumulate net worth? Since net worth relies on assets, the key to growing net worth is to grow assets. Assets like investments help because they grow in value, but what if your investments take a downturn? Then the only way to grow your assets is to add more money. For that reason and to make investment purchases to begin with, you need cash flow. What is cash flow?

Cash Flow = Income (-) Expenses

Income

Income accounts for all money coming in, hence “in” “come.” This could be anything from working wages to monetary gifts to investment growth (take bank interest, for example).

Expenses

Expenses take money out of your wallet. If you need to pay for it, and it does not go back in your wallet, then it’s an expense. Rent, groceries, shopping, pet care are just a few examples. If you calculate cash flow on a monthly basis, remember to include any annual income (such as a bonus) and annual expenses as a monthly amount.

Cash Flow Sample Calculation

Monthly Income ($3,200):

  • $3,200 Paycheck (gross or before taxes and deductions)

Monthly Expenses ($2,800):

  • $1,500 Rent
  • $ 500 Taxes
  • $ 200 Car Loan Payments
  • $ 200 Groceries
  • $ 150 Health Care Insurance and Medical Costs
  • $ 150 Auto (Gas, Maintenance, Vehicle Registration)
  • $ 100 Personal Spending

Monthly Cash Flow = Income (-) Expenses = $3,200-$2,800 = $400

Positive or Negative?

As with net worth, the key to cash flow is to stay positive! Limit expenses to no more than your income in order to live within your means. Not living within your means will require borrowing money, which ends up costing more (sometimes much more) than the paid price. And paying back debt eats away at your income too. So if you encounter negative cash flow, consider lowering expenses or increasing income to get to a positive cash flow.

For those with positive cash flow, the remaining amount is probably used for savings, right? But are there enough savings to reach your goals? Rather than looking at cash flow as available savings, consider subtracting savings along with necessary expenses, and then treat what’s leftover as your spending allowance. Here’s a better equation to follow:

Discretionary Spending = Income (-) Savings (-) Necessary Expenses

Net worth combined with cash flow are a great starting point if you’re figuring out where you stand financially. Anyone can be a financial ace with a bit of math and some money!

Homework: Calculate your cash flow. Is there anything you need to adjust? How are you doing on savings and expenses?

Winter Break: Ace Academy will skip the next two weeks’ lessons and be back in session during the first full week of January. Happy Holidays to all!

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Your Financial Score

How do you determine how well you are doing financially? There are many money “scores” out there, including credit rating (a.k.a. FICO score) or financial independence score. But the best way to get a baseline score and track how well you are doing year after year is to calculate your net worth.

Net Worth = Assets (-) Liabilities

Assets

What comprises assets? These are the things you own that you can assign value. For instance, how much can you sell your house for today? How much would someone pay to buy your car? How much do you have in savings accounts? These are all considered assets because they add value.

Liabilities

Liabilities account for any debts owed. For instance, if you sold a home with a mortgage, would you be able to capture all the money from the sale? No. A mortgage is borrowed money that you have to pay back. The amount you earn is what remains after the mortgage debt is paid off. Therefore, in this case, the mortgage is a liability, since it takes away value from what you own. And liabilities don’t only apply to tangible items, like homes or cars. Student loans and credit card debt count as liabilities too.

Net Worth Sample Calculation

Assets ($480,000):

  • $400,000 House
  • $ 40,000 Car
  • $ 40,000 Savings Accounts

Liabilities ($230,000):

  • $200,000 Mortgage
  • $ 20,000 Car Loan
  • $ 10,000 Student Loans

Net Worth = Assets (-) Liabilities = $480,000-$230,000 = $250,000

Keep Score

Now that you have a starting number for net worth, repeat the same calculation with updated numbers next year, and the next year, and so on. This will be your very own financial scorecard. And net worth should follow the same rules as any game. Stay positive and keep it up!

Tune in next week to learn about cash flow and how it relates to net worth. Or subscribe below to automatically receive weekly lessons in your inbox!

Homework: What is your net worth? Jot down all your assets and liabilities, and see what number you come up with!

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Buying A Home: What Is In A Mortgage?

Are you considering buying a home someday? Unless you have all the cash to buy that home outright, chances are you will end up borrowing some money. A mortgage is a loan specifically used to purchase a home. Consider it the middle man if you are not buying the home with 100% cash. The mortgage company pays the cash for the home, and you pay back the borrowed money along with interest to the mortgage company over time. You become mortgage-free once you pay off the full loan or when you sell the home and return what is owed to the mortgage company.

Zillow data from 2016 revealed that 42% of US homeowners are mortgage-free, meaning the majority of Americans still rely on mortgages to pay for their homes. If that majority includes you, it’s a good idea to get acquainted with some mortgage key terms.

Mortgage Key Terms

  • Down Payment. Why bother with saving money when you can just borrow the money to purchase a home? In most cases, you will still be asked to put a portion down at time of purchase, known as a down payment, to show the mortgage company that you are serious about the purchase. If a borrower tries to flee and dodge payback responsibilities, at least the mortgage company can minimize losses through the down payment they received. The amount required for a down payment can vary with different qualifying programs, typically ranging anywhere between 5%-20% of the home purchase price.
  • Interest Rate. The downside to choosing a mortgage over cash is that you pay more for the house in the long run, due to interest that you must pay on top of the principal loan amount. However, interest rates on mortgages tend to be lower than other loans, such as credit cards. Depending on IRS rules, mortgage interest may even be tax-deductible, so you might be paying less interest than you think. Rates are subject to change, so consider locking the interest rate when you are approved for a loan. The type of loan can be a fixed rate mortgage or adjustable rate mortgage, or ARM for short. If you don’t want to risk the possibility of increased interest on your loan, a fixed rate mortgage will allow you to keep the same interest rate for the life of the loan. If you believe interest rates could decrease, so that you pay less interest during the life of your loan, you would opt for an ARM.
  • PMI. PMI stands for private mortgage insurance and applies to mortgages with less than 20% down payment. This pays for the mortgage company’s insurance in the event that a borrower becomes delinquent on payments, and the mortgage company is left with a debt to pay. If you have PMI because your down payment was less than 20%, not to fret. You can call your mortgage company to eliminate PMI once you reach 20% equity on your home. Equity is how much of the home you own.
  • Mortgage Term. The term on your mortgage is how many years you are expected to pay back the mortgage company until you return 100% of the loan. The most common terms are 15 years or 30 years.
  • Impound Account. Mortgage companies allow borrowers to bundle their property tax and homeowner’s insurance payments into the monthly mortgage payments. It’s entirely your choice whether or not to use an impound account, and there is no interest charged for doing so. Property tax and homeowner’s insurance bills typically hit once or twice a year. For many people, it’s easier to have the money collect in a fund to pay for these bills, rather than keeping track on their own how much to save throughout the year, so that they can afford to pay a big chunk once or twice a year.
  • Foreclosure. This is a worst case scenario, in which a borrower cannot keep up with mortgage payments, and the borrower loses the home to the mortgage company. Unlike credit cards, which allow the borrower to pay a portion of the total charges each month, a mortgage payment must be paid in full and on-time each month.
  • Refinance. If you already have a mortgage, but want to change the term or want to pull money out of home equity or interest rates are lower, you might consider a refinance. This just means you are changing one or more factors on the loan.

A mortgage will factor in the principal loan amount, interest rate and mortgage term to dictate a monthly payment. Most mortgage companies will only qualify borrowers who can prove that the mortgage payment is 35% or less of their income. Your credit score, or trustworthiness, also plays a factor in how much you are qualified to borrow.

Although they are not to be taken lightly, mortgages help many live their dreams of becoming homeowners. Sometimes mortgages allow people to afford homes that make money when the homes are sold. Other times, mortgages allow people to pay off their homes and never make another payment to live there. Whatever the reason, a mortgage can be a great tool to reach those dreams!

Homework: Use an online mortgage calculator to view sample monthly payments by entering a home purchase amount, down payment, interest rate, and term. If you (or your parents) have an existing mortgage, examine the mortgage statement. Is it time for a refinance?

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