The Five Pillars of a Strong Financial Foundation
Overview
Building wealth and aligning your finances with your values doesn’t start with chasing the latest investment trend or jumping into complex financial strategies—it begins with a strong foundation. Just like a house needs a solid base, your financial life needs stability, structure, and clarity before it can grow. Without it, your financial household can crumble under the weight of debt, poor planning, or unexpected challenges. By focusing first on the fundamentals—like cash flow, saving, managing debt, and protecting against risk—you create the stability that often leads to a greater peace of mind.
So, in today’s blog post, we are going to talk about the five pillars of a strong financial foundation. These include the following:
1) Adequate Emergency Fund
2) Zero Credit Card Debt
3) Proper Insurance Coverage
4) Savings Rate of 20%
5) Up-to-date Legal Documents
The Five Pillars of a Strong Financial Foundation
Pillar #1: Have an adequate emergency fund
Why is this important?
Allows you to avoid high-interest loans when life throws you a curveball.
Further explanation:
I've written about this in a previous blog, but I want to reiterate the importance of having an adequate emergency fund.
An emergency fund is money set aside in a bank account or other FDIC-insured money market account that is not earmarked for any particular goal or purchase. So, it's not money that you're saving for your trip to Europe or the down payment on a house.
A natural follow-up is: how much money should I keep in an emergency fund? As with many areas of personal finance, the answer is: it depends. However, the general rule of thumb is to keep approximately 6 months of nondiscretionary expenses in an emergency fund. Nondiscretionary expenses are expenses that are essential to your everyday life. Some examples include rent/mortgage, homeowners’ or renters’ insurance, other insurance premiums, groceries, and more.
Now, there might be reasons why you should consider an emergency fund balance in excess of six months of nondiscretionary expenses. For example, if you're single or the sole provider for your family, or if you own a home compared to renting, or if you have a more unstable job or a job that pays a significant portion of your compensation in tips, commissions, or bonuses. All these variables must be considered when trying to answer the question of: how much?
An emergency fund is one of the first areas I address when working with a new client. I try to get clients to that six-month number as soon as possible, if they are not there already. If you're not there today, that's totally fine! Any progress that you make is a step in the right direction.
Pillar #2: zero credit card debt
Why is this important?
The interest payments can be a substantial burden on your monthly cash flow.
Further explanation:
The mathematics of interest is the first reason why I’ve included this as my second pillar of a strong financial foundation. Credit card interest rates are unbelievably high. They can range from 25% - 40% (APY). So, any balance will accrue interest at a rapid rate. And, unfortunately, it can feel like climbing Mount Everest to pay off your credit card, even if you carry a moderate balance.
Example: Let’s say you have a credit card balance of $5,000 and the interest rate is 30.00% APY. Assuming you do not make any principal payments, the annual interest payment is $1,500 or $125/month. Again, that amount is purely for interest payments; it does not even help you reduce the $5,000 balance. I know that life can be unpredictable, but paying off your credit card each month can help you avoid hundreds, if not thousands, in interest payments.
The second reason for its inclusion is that someone with zero credit card debt is likely doing a good job of living within their means. There's no path towards financial independence and freedom if you are spending more than you earn.
Lastly, paying off your credit card each month helps improve your credit score. A good credit score goes a long way to providing you access to future loans with a lower interest rate, or providing you the ability to obtain homeowners and auto insurance policies with a cheaper premium.
Pillar #3: hold the proper insurance coverage
Why is this important?
Insurance provides financial protection for events that would otherwise jeopardize your financial household.
Further explanation:
Proper insurance coverage will vary from person to person. Some people will need life insurance, others won't. Retirees typically don't need disability insurance, while those still working would benefit from having a disability insurance policy. So, it's essential to remember that your neighbor may require a specific policy, while you may not have that insurance need.
Nonetheless, let's talk through some different types of insurance, starting with life insurance.
For many, you may have a life insurance policy through your employer. These policies tend to have a death benefit equivalent to either: a) $50,000 or b) one year's compensation. Often, this is hardly enough coverage. Some variables that you will want to consider when determining how much life insurance you need include:
I. Your salary. A higher salary means a larger pool of future earnings and the need for a larger life insurance policy.
II. Your age. All things equal, a young individual will likely have a greater life insurance need than someone closer to retirement.
III. Debts and Liabilities. Typically, the more you have in debt, the more life insurance coverage is required. Many insureds want to make sure that the house can be paid off in the event of the insured’s death.
IV. Children. Those with children tend to have larger monthly expenses, thereby increasing the insurance need. Additionally, some clients may want to cover the expected future value of a child's college tuition, thereby increasing the insurance need.
Again, these four variables are some, but not all, of the variables used to determine the appropriate amount of life insurance for a particular individual.
Another common type of insurance is disability insurance.
Disability insurance is used to replace a portion of the insured’s earnings from employment should the insured be unable to work due to illness or injury. You can obtain both a short-term disability policy and a long-term disability policy. The difference between the policies is related to the period of time that benefits will be paid to the insured.
It is often recommended that all working individuals have both short-term and long-term disability policies, as the probability of a disability event is far greater than a loss of life event. Fortunately, many employers offer disability insurance as an employee benefit, making it easy and affordable to access this crucial protection.
Lastly, you will want to ensure that you have adequate homeowners' and auto insurance coverage. A common issue that I see with homeowners’ policies is a lack of dwelling coverage. Due to inflation and the rise in home prices, the replacement cost of your home is likely greater than your current dwelling coverage. Obviously, you would be subject to quite a large financial loss if you had to rebuild your home, and your insurance coverage would only replace 60% - 70% of the replacement cost.
Pillar #4: a savings rate of 20%
Why is this important?
Not only are you living within your means, but you are set up to give yourself flexibility in retirement.
Further explanation:
Your savings rate is calculated as follows:
(Your savings + employer contributions) / Total Income
Example: You earn $85,000 and contribute 8% of your salary to your employer’s 401(k) plan. Your company matches your contribution up to a maximum of 4% of your salary. You also save $200/month ($2,400/year) into a Roth IRA. What is your savings rate?
Savings rate = ($6,800 + $2,400 + $3,400) / $85,000
Savings rate = 15%
A consistent savings rate of 20% along with an appropriate level of risk in your investments will ensure that you are best on track to fund your retirement.
One frequently asked question that I receive from those who aren’t at that 20% savings rate is: How can I increase my savings rate? Some options available to those individuals include:
1) Earn extra income - either through promotions and raises or side hustles.
2) Reduce discretionary expenses (coffee shops, restaurants, gifts, etc.)
3) Reduce fixed expenses (rent, utilities, groceries) by potentially adding a roommate.
The quicker you can get your savings rate to 20% the more money you’ll have later in life.
Pillar #5: up-to-date legal documents
Why is this important?
Provides for the efficient and effective wealth transfer during the life or at the death of an individual.
Further explanation:
I want to be clear that I am NOT a practicing attorney and do not intend to provide legal advice in this section. However, I do want to discuss the basics of estate planning and the purpose of the more commonly used legal documents.
First, there is your last will, which gives you, the will maker, the opportunity to control the distribution of your property. It’s essentially the “catch-all” net intended to prevent the state from dictating how your property will be distributed. I should mention that the last will comes into play only for assets that do not have a named beneficiary or a transfer-on-death affidavit. For example, the beneficiaries named on a life insurance policy supersede anyone named in your will. So, you should be reviewing your beneficiaries at least once every few years, or sooner barring some major life event.
Next, there is the financial power of attorney. You will have a separate P.O.A. for both healthcare and financial. The purpose of a power of attorney is to enable another person(s) to act on your behalf should you be unable to act for yourself. Therefore, these documents are used while you are alive. An obvious reason to want a power of attorney is in the event that you are in a coma. The person named as attorney-in-fact in the document can step in to pay bills, withdraw money, and so on. One point of emphasis that I want to make is that you can have one individual named as attorney-in-fact for your financial P.O.A. and an entirely different person named as attorney-in-fact for your healthcare P.O.A.
The last document worth discussing is a trust. A trust is a very broad term because there are so many different kinds of trusts that can be drafted depending on your specific situation. Minor children are a common reason why individuals draft a trust. By law, children cannot manage financial assets on their own while they’re minors. Therefore, parents can establish a trust and name a trusted individual to manage the trust assets until the children reach adulthood or become financially responsible. Again, there are many reasons why a trust may be beneficial to you, but I use minor children as an example because it is the most frequent reason that my clients work with an attorney to draft a trust.
takeaways:
So, there are the five pillars that I look for when determining the strength of one’s financial foundation. Certainly, there is much more to financial planning than these five pillars. However, the best investments or greatest tax strategies do not matter much if you don’t have a good grasp of your cash flow, and your assets are not protected, either while you are alive or once you pass.
If you are wondering about your financial foundation or feel as though you could benefit from working with someone to improve your financial foundation, then feel free to email Matt (matthew@payitforwardfp.com) and schedule your initial Explore Meeting.