By Brad Sherman
Learn more about Brad on NerdWallet’s Ask an Advisor
Our habits play a crucial role in our ability to meet our goals and become who we want to be. Bad habits — whether it’s biting our nails, overeating, smoking or something else — create roadblocks on the path to becoming our best selves.
And it’s no different when it comes to our finances. Bad money habits can have damaging, long-term consequences for our financial security. But developing healthy financial habits can do wonders for helping us achieve our long-term goals like saving enough for retirement or paying for a child’s college education.
The earlier you develop healthy financial habits, the better your chances of successfully meeting your goals. Here are four financial habits you should start working on today:
1. Separate spending on ‘needs’ and ‘wants’
This is the first step in developing healthy habits. You need to understand where your money is going and then figure out where you need to allocate it to make the best use of it.
Sticking to a spending plan and avoiding impulse buying is crucial for building a healthy savings plan. Create a simple budget that shows you how much money you are bringing in and helps you understand your monthly spending. Add up all of your expenses that you would consider a need — this includes your monthly savings amount, rent, car payment, cable and internet bill, food, etc. (By including your savings amount in your need category, you create an automatic savings plan for yourself — more on that below.) Subtract that total from your income, and what is left over is your free cash flow.
The remaining money is the amount you have at your disposal for your “want” expenses. At the very least, make sure you are not spending more than that. At the end of the month, if you still have money left over, stick it in your savings or investment account. This removes the temptation to spend it and lets you start the next month fresh again. If you consistently have money left over, increase your savings amount.
2. Set up automatic savings
Creating a consistent savings mechanism will ensure you are saving a minimum amount each month or paycheck, making progress toward your longer-term goals. Whether you are saving into an investment account or your bank savings account, set up an automatic contribution from each of your paychecks so that the money is “out of sight, out of mind” and you won’t be tempted to spend it.
Why is this so important? Without having an automatic savings plan, you could be saving $500 one month and then $0 the next. Although this is better than not saving at all, it is not a good practice to adopt. And remember, you can start small. Even if it’s $100 a month, saving consistently will pay off immensely down the road.
3. Participate in your employer-sponsored retirement plan
Saving for retirement is one of the most important financial habits you can build for yourself. The power of tax-deferred investment growth over your entire career can really add up. Another benefit with 401(k)s and other retirement plans is that the money you contribute is pretax, which effectively lowers your taxable income, reducing your tax liability today.
If your employer offers a matching contribution to your 401(k) based on your contribution level, it’s especially important to contribute enough to take advantage of this benefit. The employer is basically offering you free money that you would be turning down. For instance, an employer may offer a retirement savings plan to which you can contribute up to 5% of your salary and it will match up to 3% of that. If you don’t contribute at least 3%, you are in effect saying no to a 3% raise.
If your employer does not offer a retirement savings plan, look into opening a self-directed retirement account such as an IRA so you can benefit from tax-advantaged retirement saving.
4. Start investing now
Time is the greatest advantage investors have when it comes to saving and investing early and consistently. With the power of compound interest, even small amounts can really add up over the years. With compound interest, your interest amount is added to the principal, increasing the amount of interest you earn, even if the rate of return does not change. To take advantage of compound interest, the earlier you start saving, the better.
If you can boost your savings rate, you’ll be even better off in the event of a long period of low investment returns, according to Michael Batnick, director of research for investment firm Ritholtz Wealth Management. “Saving more money can offset lower returns because you’re compounding on top of compounding,” Batnick writes. He points to a comparison of two portfolios over a 20-year period, both starting with contributions of $5,000 a year. The portfolio earning an average of 4% annually, with contributions increased by 10% each year, will have $100,000 more in it compared with a portfolio earning 6% a year, with contributions raised by only 5% ($393,153 vs. $293,534).
Prioritize your goals
If you already have these good financial habits, that’s great. If not, the best time to start developing them is now. Everyone will have their own goals and needs, and, unfortunately, not all of those can be satisfied at the same time. You’ll have to prioritize your goals, but once you do, you can start building healthy habits that will allow you to reach them. Separating your needs from your wants, saving early and often, taking advantage of tax-favored retirement savings plans, and investing now can help you build a solid financial foundation and get you where you want to go.