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Budget vs. Financial Plan: Here’s Why You Need both

You probably know what a budget is, even if you don’t stick to one. The term “financial plan” might be a bit more confusing, because most people have never actually seen one. This article aims to define both things and to show you how they can work together to make your life better.

Financial planning explained

The goal of a financial plan is to align your financial activities with your goals. The main goal that pretty much everyone has is to maintain their lifestyle into the future.

You can think of this as maintaining the same type of home, vacations, restaurants, hobbies, and other things that you enjoy both while you work and when you retire. That’s a pretty big goal, so your financial plan needs to account for several things. Here are the big three:

#1: Borrowing

Not all debt is bad. In fact, money you borrow to purchase a home is almost always good. The trick is to understand the difference between good and bad debt, to avoid pitfalls, and to structure things so that you don’t spend more than you need to.

A classic example is having mortgage payments and credit card payments at the same time. Your mortgage interest rate should be in the low single digits, while your credit card interest rate is probably 20% or more. Often, in a situation like this, it makes sense to use your mortgage to pay off your credit card and trigger instant savings.

A good financial plan will also look at the choices you’ve made with your mortgage – issues like fixed versus variable rate, the potential for breakage fees, and how fast you are planning to pay it off.

Optimizing these borrowing decisions has the potential to put more cash in your pocket on a month-to-month basis, and save you hundreds of thousands of dollars over your lifetime.

#2: Investing

Investing might be the most commonly recognized part of a financial plan. Indeed, it is the foundation of your plan, and essential to creating a retirement nest egg.

What should you invest in? Broadly speaking, the answer is stocks and bonds, which have generated growth for centuries. However, rather than trying to pick individual stocks and bonds, or paying someone to try to do that for you, a large body of research has shown that “indexing” produces better long-term results. Indexing means simply mirroring the performance of the overall market as represented by a major index like the S&P 500 in the U.S. or the S&P TSX in Canada.

Not only does indexing tend to perform just as well or better than any mutual fund or stockbroker, it comes with a major advantage: it’s cheap. In fact, the money you save in fees almost guarantees that you’ll do better than other alternatives over time. If you have mutual funds that you got from a bank or financial advisor, fees could literally take half your life savings with you barely even noticing, because they’re skimmed off the top before your returns are calculated.

Aside from fees, the other potential wealth killer is taxes. A solid financial plan will tell you how much to invest in various tax-sheltered accounts like RRSPs, TFSAs and RESPs to help you hit your goals with more money in your pocket.

#3: Insurance

A good financial plan will reduce your stress, and that’s good for your health. But we’re still stuck facing a hard fact of life: At some point, almost every household will experience an accident, illness or even a death. When it happens, the insurance component of your plan is there to make sure that a health crisis doesn’t also become a financial crisis.

Remember that the ultimate goal of your plan is to maintain a consistent lifestyle both now and in the future. Insurance can cover the bills for as long as you need to still reach that goal.

There are three types of insurance that can act as a safety net for your plan. Critical illness insurance can provide a tax-free lump sum for drugs, treatments, and other expenses that aren’t covered by government plans if you become seriously ill. Disability insurance can replace your monthly pay cheque if an accident or illness takes you away from work. Finally, term life insurance can support the loved ones who rely on you if you are ever unable to provide for them.

Where your budget fits in

Your budget is part of your financial plan, and you can look at it from two angles.

On one hand, there’s what you want to spend on enjoying life. That’s the housing, travel, food, and hobbies your plan is trying to protect and sustain over the long run.

On the other hand is how much you can afford to put towards your plan – the debt payments, investment contributions, and insurance premiums that make it all possible.

This is where you start getting into a classic financial trade-off: do you choose the joy of $4 lattes right now or the joy of retiring a few years sooner?

There’s no right or wrong answer here. A financial plan is like a crystal ball that can show you where your budget is likely going to take you so you can make the best decisions. For example, if the lattes are flowing fast and furious but you’re not saving very much money, your plan will let you know if that means retiring at 80.

Life is a balance. You want to have fun and you also want to be responsible. You want to enjoy the here and now and you want to know the future will also be good. Our advice? Make a budget, build a plan, and march forward with your eyes wide open.