Your Most Important Financial Planning Number
I recently read an article from a financial planner stating that net worth is your most important financial number. As a reminder, your net worth is what’s left over after you subtract your total liabilities (loans, debts, etc.) from your total assets (home, car, investments, etc.).
In fact, if you’re curious how your personal net worth stacks up against others in your age group, here’s a January, 2015, article from the Motley Fool that you may find interesting.
And while I think net worth is indeed an important number, I disagree that it’s your most important financial planning number.
I believe the most important personal finance number is your “MDI.”
MDI is your “monthly discretionary income.”
For example, if your monthly after-tax take home pay is $5,000, and your non-discretionary monthly expenses are $4,000, then your MDI is $1,000.
Now let me explain a couple of things.
I’m not too concerned with your gross, pre-tax income because you can’t actually spend this amount of money. If you receive a paycheck, it’s almost always after taxes have been deducted. So in this example as well as in the financial planning I do for my clients, I’m really interested in after-tax money that you can spend.
As far as non-discretionary expenses go, it could be argued that every expense is discretionary. But when I’m talking about calculating your MDI, non-discretionary expenses include things that you’ve made a previous agreement to pay in the future. This could include rent, a mortgage, car payments, credit card payments, utilities and more. Think of these as expenses for which you receive a monthly bill.
But there are other non-discretionary expenses. Things like property taxes or ad valorem taxes that you must pay, even though they’re only paid once a year instead of monthly.
Finally, there are non-discretionary expenses like groceries, fuel for your car, and things that while technically discretionary — and often variable from month to month — it would be difficult to forgo these things completely.
Rather than get buried in discretionary versus non-discretionary expenses, the important idea here is what, if anything, you have left over at the end of every month once expenses have been paid.
The reasons I believe MDI is your most important financial number is because if you don’t have a positive MDI, you’ll wind up with “not worth” instead of net worth.
But achieving a positive MDI is only the first step.
What you do with your MDI is even more important.
Let’s stick with the example introduced above and assume you have $1,000 of MDI. What do you do next?
Well some people not only spend all their MDI, they spend more than they earn and their total expenses are greater than their after-tax income. But this doesn’t mean they have negative MDI. They actually have monthly discretionary income, but it all gets spent and then some.
The other extreme is some people with $1,000 MDI save every penny of it. While extreme, I think we can agree that this is a better approach than spending it all. However, this is problematic as well.
Even though your savings (and your net worth) are growing with this approach, what are you giving up or missing out on as a result. What is your opportunity cost for this strategy?
Clearly saving something is better than the alternative, but I believe you can unwittingly make sacrificial life choices and decisions by over-saving. This same risk is also achieved by under-spending.
Yes, I’m a financial planner who is telling you that you really can save too much. Or you might even need to consider spending more.
And this idea of MDI and achieving balance in your current cash flow and lifetime financial plan works whether you’re 45 and in the prime of your career or 75 and fifteen years into retirement.
So here’s the million dollar question(s)?
How do you determine how much savings is enough? And how much is too much?
How do you determine how much you can afford to spend without jeopardizing your comfort and confidence in the future? How can you spend purposefully instead of making spending decisions from a fear-based mentality?
Well, coming from me, the answer probably won’t surprise you . . . you need to figure out where you are today, where you want to go, and how you’re going to get there. Safely and on time. Financially speaking, of course.
This is what financial planning is.
But you don’t necessarily need to hire me or another financial planner to help you figure this out.
You’re smart. You can do this.
Maybe start with a tool like Mint. It’s free. It’s secure. And it’s a great place to start to get a handle on where you are now with regard to your income and your spending.
Then, you can turn to some calculators like those at DinkyTown to figure out how much money you’ll need based on when you want to retire, how much you want to spend in retirement and what you’re willing to save between now and then.
This is a simple approach — perhaps too simple — but I’m a big fan of simple, and it’s better to start somewhere than to not start at all.
So that’s why I think your monthly discretionary income (MDI) is the key to your financial planning and something you should pay attention to.
The key word here is “discretion” and your capability to exercise it prudently.
If you have questions about this, or would like to discuss anything else, get in touch and let me know.
Originally published at wealthcareforwomen.com