Budgeting 101: Why Planning Ahead Pays Off

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1 family wealth perspectives Budgeting 101: Why Planning Ahead Pays Off You re about to discover n An easier way to save money n How to make your savings grow faster n Information about credit cards and how to protect yourself There is no dignity quite so impressive, and no independence quite so important, as living within your means. What is a Budget? In simplest terms, a budget is a tool for managing money. It s a written record of: The money you receive The money you spend (Income) (Expenses) = Money left over for goals (Savings) A budget tracks your money over a period of time, either monthly or yearly, and helps you figure out how much you can afford to spend, save and invest. -- Calvin Coolidge, 30th U.S. President Budgeting 101 The whole notion of budgeting may seem boring to you, but if your money seems to disappear before you can save any of it, or if you sometimes have trouble paying your bills, then budgeting can help. In fact, the tips we re about to share with you could help you find money you didn t know you had! The best reason for having a budget is so that you can achieve your financial goals. These include your short-term goals, such as buying clothes, music, concert tickets or gifts. And it includes putting money aside for the bigger, long-term goals you dream about, like a car, vacation, graduate degree, starting a business or buying a house. NORTHERN TRUST 1

2 what a simple budget looks like income fixed expenses short-term goals long-term goals Wages $750 Entertainment $250 Clothes $250 New Car $17,000 Allowance 100 Gas 85 CDs 45 Spring Break Trip 1,800 Gifts 50 Phone 45 Concert Tickets 105 College Spending Money ($300/month x 9 months) 2,700 $900 $380 $400 $21,500 Calculations: Total monthly income $900 Less fixed monthly expenses $380 Subtotal $520 Less short-term goals $400 Savings available (monthly) for long-term goals $120 As you can see, at this rate of earning and spending, this person will have to save for months or even years to reach his long-term goals. Or he can decide to earn more income or spend less on monthly expenses, to boost his savings. Do you have a sense of your income and outflow? Make a list of your income and expenses for the past month. Do your expenses exceed your income or does your income exceed your expenses? If you don t have money left over for short- or long-term goals, is there a way to earn more money or reduce your expenses? How many months or years will it take to reach your long-term goals? The purpose of budgeting isn t to save every single penny. It s to become aware of where your money is being spent and how you can work towards achieving your goals. Here are some tips that can help. Tips for Saving n Pay yourself first. This simply means putting aside a small amount of money each month, before you start paying bills or spending. When you get your income (from your job, allowance, gifts, etc.), take a small amount out immediately before spending anything, and set it aside in a special savings account. n Become aware of the opportunity cost of purchases. For example, you can buy a $50 concert ticket right now. Or you can invest that $50 and in 10 years it would grow to $142 (11% growth rate). Having investments grow over time can help you achieve your bigger goals in life, such as a graduate degree, car or a house, that take a long time and a lot of money to save up for. n Little things add up. You may not realize how much the small purchases you make every day add up over time. For example, you can spend $4 on a latté every day or put aside that $4. By investing just $4 a day in the stock market, you could earn more than a quarter million dollars in 30 years. Other small charges that really add up include late charges for not returning a rented movie, $8 $10 to eat lunch out every day vs. $4 $5 if you bring it from home or paying for parking and gas when you could have taken the bus. NORTHERN TRUST 2

3 The Power of Saving, Investing and Compound Interest Compound interest has been called the Eighth Wonder of the World. It has the power to multiply a small amount of money into a fortune over time. Although we ll use small numbers in these examples ($100), you can see how the same principles work if you had $1,000, $10,000 or even more to invest. Just how magical can compound interest be? It depends on three things: n How much money you invest; n How much time it spends growing; and n The rate of growth. Example: Growth of a $100 investment 10% annual rate of return As you can see, at 10% interest, you double your money in just eight years. In fact, investors frequently use the rule of 72 to figure out how long it takes to double your money. Divide 72 by the interest rate you are earning on your investments. For example: 72 12% APY = double your money in 6 years TERMS YOU SHOULD KNOW Annual Percentage Yield (APY) the interest rate paid on your funds Even more magical is how this compounding of interest adds up over longer periods of time even without adding anything more to your original investment. Compounding gets more powerful the longer it is left to work. You can easily accumulate hundreds of thousands of dollars. Year start with 10% interest $100 $10 1 $110 $11 2 $121 $ $ $ $ $ $ $ $ $ $ $ $ $ $1, $2, $11, NORTHERN TRUST 3

4 The rate of growth of your investments also plays a big part in how much you ll accumulate over time. Let s look at three examples: n 5% growth rate which is what you might earn in a money market savings account, CD (certificate of deposit) or with bonds; n 11% growth rate the historical average growth rate of the stock market for the last century; n 15% growth rate what you might earn if you are an extremely successful investor. The rate of growth (interest rate) will have a huge impact on your savings. At 15%, you ll have about four times as much money after 15 years than at 5%. At 15%, you ll have twice as much money after 20 years than you would at 11%. Growing at 15%, a single investment of $100 can turn into $100,000 over 50 years. Growth of $100 by Interest Rate Year 5% 11% 15% 5 $128 $169 $ $162 $284 $ $208 $478 $ $265 $806 $1, $339 $1,359 $3, $432 $2,289 $6, $552 $3,857 $13, $704 $6,500 $26, $899 $10,953 $53, $1,147 $18,456 $108,366 Obviously, the more you invest, the more money you re likely to end up with, too. In fact, if you started out with $1,000 instead, in 50 years, with a 15% return, your $1,000 would be worth over $1 million. Investing Regul arly Can Boost Your Savings By adding to your original investment, either on a yearly or monthly basis, you can dramatically accelerate this growth. By just adding $100 to your original investment each year, you reach $6,500 in 20 years, and accumulate $168,706 over 50 years. The point of all this is to start investing regularly even if it s just $100 a year as soon as you possibly can. Then keep adding to it over the years. Fixed $100 investment vs. investing $100 regularly 11% annual rate of return adding $100 Year $100 only every year 5 $169 $ $284 $1, $478 $3, $806 $6, $1,359 $11, $2,289 $20, $3,857 $34, $6,500 $58, $10,953 $99, $18,456 $168,706 NORTHERN TRUST 4

5 How to Use Credit Wisely Living within your budget along with saving and investing on a regular basis are two of the three pillars for managing your finances better. The third is learning to never pay more for anything than you have to. In other words, avoiding paying interest charges on whatever you buy. Credit cards can be a useful convenience if you use them wisely and don t spend more than you have to. Having credit allows you to: n Spread the payment of costly items over time, if needed; n Buy over the phone/internet; n Pay for things in an emergency; n Replace your funds: if lost or stolen, unlike cash, credit cards can be replaced; n Develop a good credit history which is necessary for future credit needs, such as buying a car, renting, owning a house, or even getting a new job. Today it s easy to qualify for credit cards. You probably receive many invitations in the mail and online to apply for a credit card, with special perks like airline reward miles, low introductory rates and other incentives to get you interested. But keep this in mind: credit card companies are in business to make money. Most credit cards charge a 16% to18% interest rate (some department store cards charge as much as 29%), which they refer to as the APR Annual Percentage Rate. Look at how this interest rate can inflate what you pay for a purchase, if you carry the purchase on your credit card. Buy a $475 car stereo with a 16% APR (16% APR divided by 12 months equals 1.33% monthly percentage rate) and you ll pay: If the bill is paid You owe The first month $475 The second month $ The third month $ The 12th month $ The longer you put off paying, the more you ll pay in the long run. NORTHERN TRUST 5

6 Common credit card Fees It is also smart to read the fine print on credit card applications as it often contains information about additional fees, such as: n Annual or membership fees n Interest on balances n Fees for balance transfers Get What You Want Out of Life Budgeting, saving, investing and spending wisely can make a big difference in your life. It can help you achieve your goals and avoid the stress of having bills pile up or having to ask others for money. It s the foundation for building your personal wealth. To find out more, contact a Northern Trust professional at a location near you or visit northerntrust.com n Fees for paying late n Fees for going over your credit limit n Fees for not using your card (account inactivity) n Foreign transaction fees n Commissions for cash advances n Fees to pay your bill by phone Other issues to watch for n Teaser introductory rates n Initial annual fee waiver n Different rates for balance transfers n Increasing APR% for late payments What should you do? Ask for a lower rate or to have a fee waived if you think they are excessive. NORTHERN TRUST 6

7 INFORMATION REGARDING HYPOTHETICAL PROJECTIONS: The projections or other information regarding the probabilities that various investment outcomes might occur are hypothetical in nature, do not reflect actual portfolio investment results and are not guarantees of future results. Information presents only examples of possible outcomes. Please be advised that certain performance results shown reflect hypothetical portfolio performance based on various asset allocation assumptions among multiple asset classes or investment styles that were selected with the benefit of hindsight. Leading indices have been used to approximate the returns of each asset class or investment style. They do not reflect actual portfolios that were managed according to the proposed allocations noted for the time periods shown, and thus, do not fully reflect actual investment risk. If the hypothetical asset allocation portfolios would have been actively invested for the time periods shown, they may have been subject to significant economic, market or other conditions that could have materially impacted the portfolios performance. Were an actual portfolio allocated as indicated, it might have experienced a significant decline in portfolio value. Management fees, trading costs, or other expenses have not been deducted from the hypothetical portfolios returns. No guarantees can be given about future performance and this illustration shall not be construed as offering such a guarantee. Results also may vary with each analysis and over time. Past performance is no guarantee of future results. Periods greater than one year are annualized. Performance assumes the reinvestment of dividends and earnings and is shown gross of fees, unless otherwise noted. Returns of the indexes and asset class projections do not reflect the deduction of fees, trading costs or expenses. It is not possible to invest directly in an index. Indexes and trademarks are the property of their respective owners, all rights reserved. A client s actual returns would be reduced by investment management fees and other expenses relating to the management of his or her account. To illustrate the effect of compounding of fees, a $10,000,000 account which earned a 8% annual return and paid an annual fee of 0.75% would grow in value over five years to $14,693,281 before fees, and $14,150,486 million after deduction of fees. For additional information on fees, please read the accompanying disclosure documents or consult your Northern Trust Representative. There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives or any fund or strategy will be met. Risk controls and asset allocation models do not promise any level of performance or guarantee against loss of principal. All material has been obtained from sources believed to be reliable, but the accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein. Opinions expressed are current only as of the date appearing in this material and are subject to change without notice. Securities products and brokerage services are sold by registered representatives of Northern Trust Securities, Inc. (member FINRA, SIPC), a registered investment adviser and wholly owned subsidiary of Northern Trust Corporation. Investments, securities products and brokerage services are: NOT FDIC INSURED No bank guarantee May lose value NORTHERN TRUST 7

8 IRS CIRCULAR 230 NOTICE: To the extent that this communication or any attachment concerns tax matters, it is not intended to be used, and cannot be used by a taxpayer, for the purpose of avoiding any penalties that may be imposed by law. For more information about this notice, see LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. Northern Trust 50 South La Salle Chicago, IL This article is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity. Any opinions expressed herein are subject to change at any time without notice NORTHERN TRUST 8 Q22708 (8/08)