The Definitive Guide on How to Manage Your Money

Nobody teaches you how to manage your money in school. And once you get your first job and start making real money, you're completely unprepared for the reality of money management.

In this guide, we'll go through everything you need to know to make sure you're in control of your money and not the other way around. You'll learn:

  1. How to easily create a budget by aligning your spending with your values, while getting out of debt as quickly as possible and starting to save money for your future.
  2. How to save and invest for retirement with a 401(k) or IRA, along with how to save for other long-term financial goals like higher education or buying a car.
  3. How to use credit cards as tools to make your financial life easier and more rewarding, all while understanding your credit score and improving it to get the best loan interest rates available.

1. Set a budget and get out of debt

Before you do anything, track your spending

You can't manage your money if you don't know where it goes.

Tracking your spending is one of the simplest and most effective ways to take control of your money. Many people start with setting a budget, but if you don't know how much you really spend on eating out or clothes every month, you'll have a hard time hitting your numbers. That causes a lot of people to give up on their budgets prematurely.

Tracking spending is pretty easy. Any time you take out your wallet to pay for something, you should be making a note of it. You can organize your expenses into categories such as:

  • Housing: Rent, mortgage, home repairs, property taxes, HOA fees
  • Household items: Toiletries, cleaning supplies, tools
  • Utilities: Gas, electricity, water, sewer, cable, internet, phone
  • Groceries: Any food you buy to eat at home
  • Transportation: Bus and subway tickets, car-related expenses, ride-sharing
  • Eating out: Restaurants and bars
  • Healthcare: Doctor visits, dental care, medicine
  • Personal care: Clothes, haircuts, gym membership, personal hygiene
  • Entertainment: All the fun stuff you do
  • Travel: planes, trains, buses, hotels
  • Insurance: Health, homeowner's, renter's, life, auto, disability
  • Gifts: Weddings, birthdays, anniversaries
  • Charity: Tax-deductible donations
  • Savings: Retirement, emergency, goal-specific

To get started, dig up those credit card and bank statements, open a fresh Excel file, and type in everything you spent the last couple of months and what each expense went toward. You could also use a pen and paper, specialized budgeting software, or whatever works for you. Just be sure to record all your spending in one place.

You'll quickly start to see some patterns in your spending, but tracking expenses becomes even more effective when you do it in real time. Just knowing you'll have to write down what you buy could make you think twice about how you really want to spend your money. And writing down each expenditure as it happens makes you more conscious of your spending habits.

Cut expenses and create a budget

After a month or so of tracking your spending, you should be able to use that information to create a budget you'll be able to stick to.

Finding areas where you can cut expenses and increase your savings should be relatively clear after you've tracked your spending for a few months. The key is to make sure your spending is aligned with your values.

Let's say you notice you spend a lot on eating out, for example, but you don't really value eating out that highly (perhaps you do it more for convenience than for enjoyment). You could try budgeting for fewer restaurant meals and more groceries and then do your best to cook more at home.

Even after you make your budget, you should continue tracking your spending. After all, how will you know if you're sticking to your budget if you don't track your expenses?

When budgeting, be sure to make room for paying off debt and saving. Many experts recommend saving 10% to 20% of your take-home pay for goals like retirement, a down payment on a house, or a car purchase. But if you can save more, you should.

Get all the money you can from your employer with a 401(k) match

If your employer offers a 401(k) retirement plan, it probably offers a matching contribution, too. If you're not contributing to a 401(k) with a match, then you're leaving free money on the table.

Let's say your employer offers a 100% match on contributions of up to 4% of your salary. You won't find a better return on investment than that; you're effectively getting an immediate return of 100%. That's why I recommend you contribute at least enough to your 401(k) to receive your employer's full match before you save for anything else.

It might even make sense to prioritize 401(k) contributions over paying off your loans. Even paying off high-interest credit card debt will get you a lower return on investment than you'll get through an employer match on your 401(k), assuming you can expect to pay off that debt within a couple of years. Paying off a credit card with a 20% interest rate means you'll receive a 20% "return" on your investment because you'll save that amount in interest.

If the idea of contributing to your retirement savings before you've paid off high-interest debt makes you uneasy -- even if the math makes sense -- then you can certainly come back to this step later. Personal finance, as the name says, is personal, so you have to make it work for you.

Pay off your high-interest debt as quickly as possible

Before you can start saving money in earnest, you have to get out of debt. Otherwise, interest will eat away at your budget month after month, and you'll find it a lot harder to start saving.

What constitutes a "high" interest rate is really up to you. (Remember, personal finance is personal.) I'd consider it anything higher than what you can reasonably expect from an investment portfolio, which might be 7% or 8% if you're aggressively investing in stocks, but it might be much lower than that if you have more conservative investments.

Common types of high-interest debt include:

  • Credit card debt (10% to 30%; average of 16.71%)
  • Personal loans (10% to 32%)
  • Unpaid medical bills (12% or more)
  • Student loans (4.25% to 13.75%)

Note that car loans, home mortgages, and home equity lines of credit aren't on the list. That's because secured debt -- i.e., a loan that's backed up by collateral such as your car or house -- generally carries a lower interest rate and thus doesn't necessarily need to be paid off ASAP.

There are two common strategies for paying off debt:

  • The snowball method, made popular by Dave Ramsey, has you rank your debt balances from smallest to largest. Any extra money you have left over after making the minimum payments on all your balances goes toward the smallest balance. Once that balance is paid off, you "snowball" the payments you were making on that balance toward the next smallest balance. This method allows you to pay off small balances quickly, providing a psychological boost as you see debt payments disappear.
  • The avalanche method is for more disciplined, self-motivated people who want to save the most money. You start by paying off the debt with the highest interest rate, regardless of the amount owed, and then you work your way down to the debt with the next-highest interest rate. With this method, you may not get the satisfaction of knocking out smaller debts quickly, but you'll save more money in the end.

2. Start saving

Set up an emergency fund

Once you've paid off your high-interest debt, you can start putting the money you were paying to your creditors into your savings. Setting up an emergency fund can prevent you from having to go into debt again.

Start small by putting $500 to $1,000 into savings. That amount will cover most minor emergencies like a car repair or dental operation. Note that an emergency fund is not for taking advantage of flash sales or paying home-maintenance costs (those should be part of your budget).

Over time, you should build your emergency fund until it can cover three to six months' worth of expenses, which can help bridge the gap between jobs if you find yourself unemployed. That amount could also cover major medical bills, along with the deductible on your health insurance plan.

Where to keep your emergency fund

The most common place for emergency funds is a savings account. Some people choose to keep emergency funds at a bank that's different from the bank they use for their everyday checking account. This adds a layer of inconvenience to ensure they don't use emergency funds for non-emergencies.

You may be interested in using a Roth IRA as a way to store emergency funds. (More on Roth IRAs and retirement accounts later.) If you don't have enough money to both build an emergency fund and save for retirement, then the Roth IRA can help you do both. Unlike a traditional IRA, a Roth IRA allows you to withdraw your contributions at any time -- like when you have an emergency -- although you can't withdraw any of the earnings until age 59 1/2 without paying a penalty.

There's a cap on the amount you can contribute to an IRA each year ($5,500 in 2018, or $6,500 if you're aged 50 or older), and if you don't contribute one year, there's no option to make up for it later. That's why it makes sense to put emergency funds in a Roth IRA: If you end up needing that money before retirement, then you lose nothing to penalties; if you don't end up needing the money, you'll still enjoy tax-free growth on your savings, and you'll have extra money in retirement.

If you have a qualifying high-deductible health insurance plan, you can store some of your emergency funds in a Health Savings Account. Health Savings Accounts offer tax-free contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses. So if you're putting funds aside for a medical emergency, you'll save yourself a lot of money with an HSA.

Contribute to your IRA

The next step on your financial journey is to start saving for your future. For most people an IRA is the best option available.

An IRA, or individual retirement account, is a personal savings account that has certain tax advantages. As long as your funds are in an IRA, they won't be subject to capital gains taxes or dividend taxes. IRAs open up far more investment options than an employer-sponsored 401(k) plan. You can invest IRA funds in individual stocks, mutual funds, exchange-traded funds, bonds, CDs, and more.

Those benefits have some restrictions, though. The government puts a contribution limit on IRAs. That limit is $5,500 in 2018, and you can contribute an extra $1,000 if you're 50 or older. You'll also have restricted access to your funds until age 59 1/2.

You'll have to determine whether to use a traditional IRA or a Roth IRA.

  • A traditional IRA allows you to deduct your contribution from your taxable income in the current tax year, but you'll have to pay taxes on the funds you withdraw in retirement. If you withdraw funds before age 59 1/2, you could also owe an early-withdrawal penalty of 10%.
  • A Roth IRA requires you to pay taxes on your contribution, but you pay no taxes on your withdrawals in retirement. You also get the benefit of being able to withdraw contributions at any time -- as you might if you're using the Roth IRA as an emergency fund (or if you retire before you're 59 1/2).

There are merits to both types of IRA, and the choice relies on your personal goals and expectations for the future. You might even split your contribution between a traditional IRA and a Roth account.

Not everyone can take advantage of the traditional IRA deduction, as the government has imposed income ceilings on deductible contributions. If you can't deduct the full amount of your traditional IRA contribution, you should use a Roth account. The government also imposes limits on who can contribute to a Roth account, but you can work around those limits with a backdoor Roth contribution.

Finish maxing out your 401(k)

It's usually best to make the maximum contribution to your IRA before going back to max out your 401(k). Corporate 401(k) plans usually have higher fees and a limited selection of investment options, whereas an IRA gives you plenty of flexibility in how you invest your funds.

That said, the tax advantages of a 401(k) are too good to pass up. A 401(k) works a lot like an IRA, but with much higher contribution limits. Employees can contribute $18,500 to their 401(k)s in 2018, and those over 50 can add an extra $6,000 per year as "catch up" contributions.

You can often withdraw funds from your 401(k) earlier than you would from an IRA -- sometimes just after your 54th birthday. The IRS says you can withdraw funds from your 401(k) immediately if you separate from service during the calendar year in which you turn 55 or later (though you can only withdraw funds from the 401(k) sponsored by that employer). Otherwise, you'll have to wait until you're 59 1/2.

Save for other big financial goals

If buying a car or a house is in your future, you should definitely be putting some money aside for that goal as well.

With interest rates relatively low at the moment, you may be better off financing a car with a loan instead of buying one with cash. If you can get an interest rate of less than 7%, then there's a good chance your spare cash will go further if you invest it in your IRA or 401(k).

That said, this is another matter of personal preference, and it also depends on what kind of rate you can get. You'll want to maximize your credit score before applying for any type of loan. (More on that later.)

If you plan on buying a house, you should try to save at least 20% of the home value for a down payment. If you buy a house with less than 20% down, you'll likely have to purchase private mortgage insurance (PMI), which adds up to thousands of dollars in extra payments over the life of the loan.

Big-goal savings usually go in a regular savings account, but if you won't be making the purchase for several years, then you might instead opt to invest the funds so you can maximize your returns and reach your savings goal sooner. Do so in a taxable brokerage account, so you can access your savings and returns when you're ready to buy.

Save for your child's (or your own) education

Paying for college is a massive expense, but good planning can help offset some of the costs.

The most popular type of college savings plan is called a 529 plan. A 529 plan is a tax advantaged savings account specifically for educational expenses. Each state has its own plan (you're not limited to your home state's plan), and each plan has a limited number of investment options, usually focusing on index funds.

You may be eligible to receive a state tax deduction for your contribution to a 529 plan, but contributions are not deductible on your federal tax return. Still, every little bit counts.

Additionally, 529 plan contributions grow tax-free, and you can withdraw the funds tax-free for qualifying educational expenses. The new tax code in 2018 greatly expanded the kinds of expenses that qualify for tax-free withdrawals from a 529. Contributions can be withdrawn penalty-free at any time, but you might owe additional taxes if you originally took a deduction.

There are other college savings plans like the Coverdell Educational Savings Account, but the Coverdell ESA has a lower contribution limit than the 529, and the new tax law negated most of the advantages it provided.

Get more from your spending with a good credit card

If you aren't using a credit card, you're paying more at the store for no good reason. Unless you have a serious problem with controlling your spending while using those tiny plastic rectangles, you should probably be using a credit card whenever possible.

Here's are some common credit card benefits:

  • Fraud protection: If someone gets hold of your debit card informatin, they basically have access to all the money in your bank account. But if someone steals your credit card, they don't actually have access to any of your money; it's ultimately the bank's money that's on the line. Banks have developed extremely effective fraud detection systems to let you know of potentially fraudulent purchases, and they will usually remove any fraudulent charges from your credit card. Meanwhile, getting money back into your bank account in the case of debit card fraud can be much more involved and take a lot longer.
  • Price protection: Some credit cards will give you a rebate if the price of an item you purchased goes down within a certain amount of time after your original purchase. Just submit a copy of the advertised price for the same product. Some credit card companies will even scan prices for you automatically.
  • Extended warranties: Some credit cards offer extended manufacturer warranties.
  • Travel insurance: High-end travel rewards credit cards often come with some form of free travel insurance for any travel you book with the card.
  • Cash back or travel rewards: Most credit cards offer some sort of incentive for using the card, like a certain percentage of cash back on each purchase, or travel rewards points that can be redeemed for free flights or hotels.

There are dozens of great credit card options out there, so do some research to figure out what the best credit card is for you.

Stay on top of your credit score

If you want to qualify for the best rewards credit cards, the lowest mortgage rates, and the best auto financing terms, you need to stay on top of your credit score. While your credit score might seem like an abstract number that swings up and down for no apparent reason, improving your credit score is actually a straightforward process.

According to data analytics company Fair Isaac Corp. (better known as "FICO"), your credit score is based on five main factors, as shown below:

Creditors want to see that you pay your bills on time, which is why payment history is the biggest factor impacting your credit score. That's also why you need to establish some sort of credit profile before you apply for a big loan like a mortgage. Without any payment history, creditors have nothing to judge you by.

Credit utilization is a fancy term for the percentage of available credit you actually use -- the lower the better. People with top credit scores have a utilization below 20%, and you'll want to avoid going over 30% to prevent the factor from having a big negative impact on your score. Importantly, your credit report doesn't keep track of your credit utilization history, so if you can get your utilization as low as possible right before applying for a new loan, you'll have the best chances for approval.

Length of credit history is based on both your oldest credit account and the average age of all of your accounts. The longer your credit history, the better, because a longer track record gives lenders a better picture of your reliability as a borrower.

New credit -- that is, the number of recent hard inquiries on your credit report -- factors into your score to a lesser extent, so applying for several new accounts within a short time frame can have a significant negative impact on your credit score, even if you keep your credit utilization low and pay all your bills on time.

You get a hard inquiry on your report nearly every time you apply for new credit -- a credit card, car loan, mortgage, etc. However, if you're rate-shopping for a car loan or mortgage, then filing several applications within a two-week period will only count as one hard inquiry on your credit report. A single hard inquiry only has a small impact on your credit score, but several hard pulls over a short time span can cause major damage. The impact of each hard inquiry fades over time and completely drops off after two years.

The last factor is credit mix. Creditors like to see that you can handle multiple different types of credit, like a credit card, a student loan, and a car loan. Ultimately, though, having a lot of different types of credit isn't as important as the other factors.

Once you understand how each factor impacts your score, you can take steps to improve your credit. A high credit score can save you thousands of dollars on a mortgage, qualify you for credit cards with the best rewards, and even improve your chances of getting a new job. Your credit will impact your financial life in many ways, so do your best to stay on top of it.

Take control

Follow the steps in this guide to take back control of your money. Track your spending and create a plan to pay off your debt. Then start funding your future. Get a credit card and start building up a strong credit report to minimize interest rates and maximize rewards.

Reading this guide is easy, but nothing will change unless you take action. Start managing your money instead of letting money manage you.

The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.