The needs analysis of your life

In the second instalment of our experts' advice on conducting a life audit, we investigate the best way to carve up income to spend on expenses such as your mortgage, car, insurance and retirement, writes Brendan Peacock

How much of your earnings you spend on you house and car can vary, says Lionel Karp, a consultant for Chartered Wealth Solutions, and a former financial planner of the year.

"Houses and cars will usually take up most of our expenditure. The secret is to purchase what you can afford according to your income. Rather start off with a smaller house and car and build up some form of reserve before you run off and purchase bigger houses and fancy cars. If you see you are getting yourself into debt due to the fact that you have overextended yourself, stop right there. Make a conscious decision that enough is enough. Try downgrading the items that are causing the problem. So many people just carry on without the slightest idea that they are getting more and more into trouble. If it means a smaller car or fewer holidays, then accept the situation."

Karp said some expenses were not negotiable, so you needed to decide what they would be. "They could be school fees, medical aid and bond repayments. You know far in advance what your commitments are. Re-look at every variable expense and check whether you can get better quotes for everything. Speak to your bank and seek advice. Just don't leave the situation to get worse."

Paul Leonard, executive director of Consolidated Financial Planning, said: "I have found that a priority to one person is often not important to another. There is also a difference in priorities between cultures in South Africa. I can, however, give you an idea that may help people to prioritise for themselves. A useful exercise when the household is feeling the crunch is to categorise expenses according to 'needs' versus 'wants', and 'fixed' (the amount is the same every month) versus 'variable' (the amount varies from month to month) expenses.

"It is generally easier to cut back on wants than on needs, and it is easier to cut back on variable expenses than fixed expenses. Therefore it is probably easiest to cut back on variable wants first, then on fixed wants and so on. List your expenses and then write a number - 1, 2, 3 or 4 - next to each expense. Then look through the list and cut back on the ones first, then the twos and so on."

As examples:

• Some examples of "1 variable wants" could be: eating out, going to the movies, fancy brand-name clothes, holidays, and even domestic help;
• Some examples of "2 fixed wants" could be: satellite TV, your gym membership (you could exercise at home or go for a run), and magazine subscriptions;
• Examples of "3 variable needs" could be: groceries (you could opt for a more modest menu), telephone and cellphone, electricity, water and basic clothing; and
• Examples of "4 fixed needs" could include: your short-term insurance, life insurance, bond instalment, school fees, rates and medical aid. Your mortgage bond instalment and car loans are also examples of "fixed need" expenses.

"As a last resort," said Leonard, "you could also move home, sell the car and scale down.

"It's amazing how much you can cut back and save to ease the stress when you take some time to look at each expense in this way. I challenge you to do this and then present these items to your children and ask them whether they think these are needs or wants; you'll soon find out whether you are as smart as the fifth-grader."

When it comes to disposable income, how much should we budget to land up with? "It depends on an individual's lifestyle goals and what it will cost to pay for those goals compared to what the person earns. Ideally, one should do a financial planning exercise to get the balance between spending and enjoying your money today and investing some so that you can continue to enjoy your money tomorrow. Spending too much now means that you will experience a reduction in lifestyle tomorrow, and vice versa. The sooner in your career you develop the habit of investing for long-, medium- and short-term goals, the smaller the slices of your income that have to be set aside to achieve your goals. The reason for this is that the sooner you start, the more time your money has to compound and work for you. Leaving it later means that you will have to do more of the work yourself. The sooner you start investing and getting your money to work for you the higher your average lifestyle (quality of life) will be when looking across the whole timeline of your life.

"I could do illustrations and calculations for you which would illustrate this using a couple of scenarios. If you have any spare cash, I would advise you to max out your retirement fund contributions, using the tax breaks available to you. Thereafter, increase your instalments towards wiping out your debt," said Leonard.

What is the best way to set up an emergency fund, and how much should be put away each month, if it's possible to do so? Leonard suggested depositing extra money into your bond. "The money should be accessible to you in the event of an emergency. If you struggle to implement this kind of discipline, then a separate account with a restriction period (for example a 32-day notice deposit, or one-month fixed deposit) may be the right option. It means the person is forced to take a month to 'cool down' if they suddenly feel the urge to splurge.

"Most often when we stop to think about a potential impulse purchase, we end up not buying the item."

Said Karp: "Each one of us has a different dream, and not everything we do has to be money-related or cost the earth. Work to your own goals. In the ideal world I believe a minimum of 15% should be set aside towards savings. This is easier said than done. Of course the earlier you start, the more compound interest starts to work for you. The rule for any spare cash is to pay off debt. I know some advisers believe that by having debt, you can claim the interest for tax purposes. Investigate each case and ensure you are actually not paying a fortune on interest just to save on tax in the long run.

"The first account that needs to be started with any spare cash is an emergency fund. This is the account we fall back on for the unforeseen expenses. I think anything between three to six months' income should be kept in this fund.

"You need to be able to access these funds quite quickly, so a money market account would be an ideal place for this investment. Banks and unit trust companies have money market funds and they should have very low charges, if any. Ideally, if you can pay off debt you can start putting a small amount into the money market to build up your emergency fund. Once you have reached your short-term goal, then you can work towards your long-term goals."

How do you know when you can treat yourself to a (significant) purchase without guilt?

"Pay now and play later. Defer the gratification. In other words, save up first and then buy the item for cash. Set a goal of buying the lifestyle toy for cash and then work towards that goal. Set savings targets, enjoy the journey and excitement of working towards the goal. See the item as a reward for yourself and work towards the goal rather than impulsively buying it today and funding it with income you have not yet earned," said Leonard.

"The easiest part of being able to treat yourself and your family is when you know you are working towards your goal, enjoying your planning, knowing where you are placed, seeing the rewards and your bank balance grow while your debts become smaller," said Karp.