Financial planning: What is it and why is it important?

While making investments are a big part of a sound financial strategy, there are other considerations. What are your long-term goals versus your short-term needs? What is your budget? Have you planned for an emergency?

Solid financial planning is the absolute basis of what everyone who visits our website should be doing. You cannot generate any significant amount of wealth if you don't have the basics covered. This article should serve as the basis for everything else you read about on this site.

Financial planning: What it is and why it is important

A financial plan is a process where you evaluate your current financial situation, determine your long-term financial goals, and set in place strategies to help you reach those goals. Financial planning is a process you can undertake on your own, or you can seek the help of a certified professional, such as a financial planner.

Essentially, financial planning will help you to reduce your stress about money. And it not only helps your current situation but can also benefit you well into the future and even prepare you financially for retirement. Another option includes online services such as robo-advisors, which can make financial planning more accessible—and affordable—than ever.

Why financial planning is important

It is important to create a financial plan because it helps you get the most out of your assets, ensuring that you reach your financial goals and providing you with the confidence to tackle any rough patches along your way.

How to start planning your finances

To create a sound financial plan, it is important that you first take a few things into consideration. Here are three to get you started:

1. Calculate your net worth
2. Determine your cashflow
3. Define your financial goals

Here is a closer look at each:

1: Calculate your net worth

It doesn’t matter if you are rich and famous, strong financial planning strategies start with taking stock of your own net worth. One way to do that is to take a more in-depth appraisal of your:

Assets. Your assets will likely include things like your property and your vehicle, as well as anything else of value in your possession. Cash in the bank and funds invested in an RRSP can also be included here.

Liabilities. Typically, liabilities can include an outstanding mortgage, credit card and student debt, and a car loan, among others. In certain instances, you might have access to a moratorium or a grace period.

If you want to calculate your net worth, you might think about the following formula:

Assets – liabilities = net worth

2: Determine your cash flow

Another consideration you will have to make when creating a financial plan is to know where you spend your money and when you usually spend it. One good way to do this is to document any and all transactions, meaning when money comes in and when it is spent. This will be particularly useful when determining how much money is required for necessities each month, as well as the money remained for either savings or investments, so that you can make financial adjustments.

3: Define your financial goals

The staple when financial planning is to ensure you clearly define your financial goals, which could include:

• Purchasing a larger property
• Paying for post-secondary education for your kids
• Starting a business
• Preparing for retirement.

While you are the only one who can prioritize these types of financial goals, a financial planner will be able to determine a solid savings plan and investments that will help guide you on your journey.

How do you develop a financial plan?

Developing a financial plan will help you to balance your short-term and long-term monetary goals, as well as deal with any unforeseen events.

Here is a quick look at the steps involved in creating a financial plan:

1. Set goals
2. Budget
3. Employer match
4. Emergency plan
5. High-interest debt
6. Invest
7. Protect and grow

Let’s take a closer look at these to give you an idea of what they mean and why they are so crucial when planning your finances:

1. Set goals

Your financial goals help guide a good financial plan. In other words, your saving will be that much more intentional when you approach financial planning considering how your money will work for you. This can pertain to everything from purchasing a home to retiring early.

To set goals, you can ask yourself where you would like to be in five years, then 10 and 20 years. At this stage, you should also consider whether you want to own a vehicle, a home, be debt-free, or have children, as well as how you envision retirement.

Asking these questions, and setting these goals, you help you to better determine and finish the subsequent steps in your financial plan.

2. Budget

Budgeting should help you determine your cashflow each month and your savings and investing plan. At this point, you will need to figure out how and where to send those funds. A budgeting worksheet is a good way to help you easily visualise your how, where, and when you regularly spend your money.

Budgeting can also be a good indicator when figuring out where to direct more funds into your savings and pay down debts. Like setting goals, it will also help you in the immediate, medium- and long-term plans.

A popular example of how best to budget is the 50/30/20 principle. This principle breaks down like this:

3. Employer match

Most professional financial planners will ask you if you are privy to an employer-sponsored retirement plan) and if your employer will match any portion of your contribution to it.

While these types of plans typically reduce your take-home pay in the present, they could be well worth it since the matching amount from your employer is essentially free money.

4. Emergency plan

Having an emergency plan is integral for any sound financial plan. For instance, putting away even $500 in the beginning for smaller emergencies and repairs will be beneficial, to avoid running up debt on your credit card. When you can afford it, you can increase that emergency fund to $1,000, and continue to increase it until it equals a month’s worth of living expenses, and so on.

Another way to further protect your budget is to build credit, providing you much-needed options such as the ability to get a good rate on a car loan, for instance. And by providing you with cheaper rates on insurance and allowing you to bypass utility deposits, it will also help you increase your budget.

5. High-interest debt

Paying down high-interest debt like payday loans, rent-to-own payments, credit card balance and title loans will help you create a stronger financial plan. You usually end up paying two to three times more than what you borrowed since the interest rates are usually so astronomical.

If you are struggling in this area, a debt management plan or a debt consolidation loan will help you tie each of these expenses into a single monthly bill with a decidedly lower interest rate.

6. Invest

While investing may sound intimidating, it could be no more complicated than putting money into a 401(k) or opening a brokerage account. Some examples of investing include employer-sponsored retirement plans or college-saving plans. Because these types of investment depend on where you live, it is important to research your jurisdiction to evaluate the places where your money will do the most work for you.

7. Protect and grow

In large part, financial planning is about protecting yourself and your family from financial struggle, both predicted and unforeseen. As you make your way through your career, you can continue to protect and grow financially by going back to basics, such as:

• Contributing more to your retirement accounts
• Increasing your emergency fund until you have at least three months of living expenses (for essentials)
• Securing insurance to protect yours and your family’s financial stability, in the event of an illness or an auto accident.

What are the common mistakes of financial planning?

Creating a sound financial plan will help you to build your wealth and protect you financially when an unforeseen expense or emergency arises. While financial planning is crucial, there are common mistakes that can land you in financial peril.

Common financial planning mistakes include:

1. Not accounting for inflation
2. Not saving for health-care expenses in retirement
3. Investing clumsily
4. Mistaking investing for planning
5. Investing too little when young
6. Mistaking tax saving for insurance

Here is a closer look at these common mistakes so that you can better avoid them:

1. Not accounting for inflation

Failing to account for inflation may slowly erode your savings and wreak havoc on your financial plan. It is critical to consider your increase in expenses against the fluctuations in inflation, i.e., the increasing costs of common goods and services.

Additionally, relying on safe investments will mean your portfolio gives returns at a lower rate than the rate of inflation. Some examples of these safe investments include saving accounts and government bonds.

2. Not saving for health-care expenses in retirement

When preparing for retirement, it is important to consider long-term expenses such as health care. Since these expenses increase as we age, it is also important to incorporate those expenses into a sound retirement plan.

3. Investing clumsily

While investing aggressively can make sense in some respects, you should ultimately use logic when investing and know where the risk is coming from. If you invest too aggressively, exposing yourself to more risk than you can afford, you can lose money and turn yourself away from investing in the future.

On the other hand, investing too conservatively can also come with down sides, such as losing the value of your money. Make sure that you invest across investment options that have different degrees of risk.

4. Mistaking investing for planning

Financial planning is not only about investing. Investments are just a single part of a sound, overall financial plan. Daily budgeting, insurance, and tax choices are all effective ways to create a long-term financial plan.

5. Investing too little when young

When you are saving more than you are earning, you can make a strong investment plan. The earlier you start investing and saving, the more time you will have to double or even triple your money.

A good savings plan not only considers daily expenditures but also the amount of money you pay in taxes. Therefore, it is a good idea to start as early as possible.

6. Mistaking tax saving for insurance

Insurance is not an investment; it is an expense. One of the worst ways to spend your money is to purchase insurance to save tax. (Unless, of course, you actually need the insurance.) It is better to think about the utility of whichever insurance you are getting rather than thinking too much about the tax benefits.

These are the common mistakes people make when creating a financial plan. Being aware of them, however, will help you build a good long-term strategy. Remember: the best financial plan takes into account unforeseen expenses (such as health care) and may involve a little risk.

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