FOOL'S EYE VIEW
A New Year Financial Healthcheck

By James Carlisle
January 3, 2002

As the nation trudges back to work (or not if you were planning to do it via a train in the south-east), we're left contemplating our New Year's resolutions. They're funny things really; it seems as though you have to have one, but they rarely seem to last beyond March. Is that just me? I did even worse this year. My resolution was (sorry, is) to lose a bit of weight and get fit. I've already had two fried breakfasts this year...

I'm certainly not going to discourage anyone from healthy resolutions -- your health is far more important than money -- but why not also resolve to sort out your finances this year? Money may not be able to buy you happiness, but having your finances in a mess can certainly cause a lot of misery. So let's run through the Motley Fool's five-step plan to getting your finances in order.

1. Get rid of your debts

The first thing you must do is clear any non-mortgage debts, because they charge more interest than you could ever hope to get on any savings or investments. So you need to clear away overdrafts, credit card balances and any personal loans.

Start with the ones that are charging the most interest and consider consolidating them all into one loan with a lower rate of interest. The less interest you're paying, the more quickly you can pay down the debt. There's more help on getting out of debt in the Motley Fool's Get Out Of Debt centre.

2. Build up some cash reserves

Once you're out of debt, you need to stay out. That means that you pay for holidays, car repairs and any other expenses along the way with spare cash -- not more debt! -- and that means having a reserve of cash. How much cash do you need tucked away? That's a bit tricky, but you can make it easier by splitting it up into different categories.

First of all think about any planned expenditure. If you can't pay for holidays and new washing machines out of your income, they need to be saved up for.

Secondly, consider 'semi-planned' expenditure. That means things like car repairs -- you know you're going to have to pay for them sometime, but you've no idea when and not much idea of the cost. How much did you have to spend on this sort of thing last year? And the year before? You should aim to have enough cash tucked away to deal with several of these eventualities cropping up at once.  

Finally, think about totally unplanned expenditure. Not surprisingly, this is the hardest part to consider. We're talking about losing jobs and unplanned pregnancies here, that sort of thing. These are things that you probably can't meet out of income, because it might mean losing your income completely for some time. You should probably aim to have between 3 and 9 months' income tucked away for this sort of thing, depending on your attitude to risk. It will also depend on your notice period at work -- if you stand to get three month's pay, then you'll need less put by than if you could lose your job in a matter of weeks.

And with all this cash sitting around, you need to make sure it's earning a decent rate of interest. So make sure it's in a high-interest account. Check periodically to see that the interest rate is bearing up, too. A good place to start is our Online Banking centre. You might also consider a cash ISA to save on tax.

3. Get the right insurance

The trouble with emergency cash reserves is that the amount you need gets impossibly large if you want to deal with every eventuality. And cash in the bank isn't the best use of your money. The solution is to strike a balance with some insurance. That way, you effectively save up for life's nasty events along with millions of other people, helping each other out when needs be. Oh, and the insurance company that organises it all makes a profit along the way.

The fact that insurance companies make profits means that it costs you, on average, to have the insurance. So you don't want to make the mistake of insuring for anything and everything -- it'll end up costing you an arm and a leg. You want to use insurance sparingly. That means only covering yourself against the risks that you can't cover out of your reserves.

The other key point with insurance is to make sure it does what it says on the tin. Or rather, to make sure you know what it says on the tin. There are thousands of different policies covering thousands of different risks out theree You need to make sure that the one you choose covers -- and only covers -- what you need it to. Your policy isn't much good if it doesn't pay out when you need it to. And it's too expensive if it pays out when you don't need it to. There's more about the different types of insurance product in the Fool's Insurance centre.

4. Investing for the future

With your debts cleared and enough cash to make sure that you'll stay that way, you can think about investing for the future. The biggest future expense you'll have is funding your retirement. Arguments rage about whether pensions or ISAs are best for this. But whatever you go for, you want long-term investments to be on the stock market, spread across a broad range of shares. You need to keep your costs low, too. Stakeholder pensions and index-tracking ISAs are the ones to consider first.

How much you need to save for retirement is another of those tricky questions. But it's dealt within this series of articles. You can also try putting a few numbers into our compound interest calculator.

5. Buy your home

The final leg of the five-point plan is to buy your home. Why? Well, think of it this way. If you don't own your home, then someone else will. And you'll have to pay them enough rent to make sure that it makes sense for them to own it! Landlords aim to make a profit. So why not be your own landlord? It's more efficient that way. Since you know that you're not going to start squatting or run off without paying the rent, you don't have to charge yourself extra, or for that matter, charge a deposit, to cover those things.

Get your personal finances in order NOW: Get Out Of Debt | Online Banking | Insurance | Stakeholder Pensions | Index-Tracking ISAs | Mortgages