The rising cost of living seems to grab all the headlines and dominate our lives right now. The higher cost of essentials means disposable income is falling for many, and it has consequences for longer-term financial resilience too.
Maintaining an adequate ‘emergency’ fund for life’s unexpected events is harder and it can be tempting to cut back on areas that help secure your financial future such as pension contributions or insurance policies to protect against the consequences of death, ill health or loss of income.
It is hard to know what to prioritise, so here’s a checklist of how to look at your financial situation in the current challenging environment.
1. Keep out of expensive debt
A central foundation of a healthy financial position is keeping debt under control, and with cost pressures mounting this is a challenge for many people.
You may have heard the terms ‘good debt’ and ‘bad debt’. Good debt might be a low-cost mortgage, investing in yourself through a student loan or borrowing to build a successful business. It’s debt that ultimately improves your financial position. Bad debt on the other hand is a drain with no financial benefit – expensive personal loans, overdrafts and credit cards for instance. These should be repaid as soon as possible.
It is so easy to take on debt these days, especially around the costly festive period, with ‘buy now pay later’ (BNPL) options online. If you do use these, keep careful track and ensure you minimise interest as much as possible. Typically, you get a set interest-free period with payment only taken from your account on an agreed date if you decide to keep the items. After that ‘buy now pay later’ becomes ‘buy now pay more,’ so think carefully before using these services, especially if you’re considering them to cope with the increased cost of living. Find out more about BNPL on the government’s MoneyHelper website.
Meanwhile, mortgage debt should also be kept under control and an appropriate repayment plan should be in place if it is an interest-only mortgage rather than a repayment mortgage where you pay back both interest and capital.
2. Build an emergency fund
Once your house is in order in terms of debt you can put other parts of your financial plan into place. An important foundation is building a reserve of readily available cash to draw on in the event of an emergency. Sometimes life throws you a curveball, and a sudden event such as a boiler breakdown or essential car repair can broadside your finances. Having a fund to draw on gives you the confidence you can deal with issues that arise.
There is no prescriptive size for an emergency fund. Three to six months’ income is often referred to as a rule of thumb, but it depends on lots of variables such as job security, whether you have dependents and generally to what extent you think your life is ‘futureproofed’. Some people aspire to a sizeable amount to give them full confidence, even though sitting on lots of cash is generally inefficient as interest is generally not enough to keep up with the cost of living.
3. Protect your future
Nobody knows what is around the corner, which is why financial protection is one of the key building blocks for a secure future. Insurance policies to protect against the consequences of death, ill health or loss of income are often overlooked but they can often be essential for you and your family.
If you are employed, you may have some of these policies such as life insurance and critical illness coverage provided for you as part of a benefits package. However, you should check the details of each policy and the level of cover provided to ensure they are adequate for your circumstances. You can supplement cover and fill in any gaps with your own policies. If you are self-employed, you and your family could be left exposed if you don’t have a cover.
These insurances might seem like a monthly expense you could do without, but providing you are healthy, they can often be very cost-effective, especially if you have not had the opportunity to build up the larger financial reserves sufficient to see you through a period out of work or see your family through the loss of the main breadwinner.
4. Boost your pension with 'free' money
Whatever retirement looks like for you, investing wisely is likely to be a key factor in achieving it. Pensions are there to give you an extra ‘leg up’. When you make a contribution to your pension, the government adds money. This is called ‘tax relief’ and it is the key advantage of using a pension. Not everyone is aware of this special helping hand, but it can have a considerable impact on the size of your investment pot and the income you are paid.
The government will automatically top up your contribution with 20% basic rate tax relief. Higher-rate and additional-rate taxpayers may claim up to a further 20% and 25% respectively back through their tax return. (Please note tax relief for Scottish taxpayers differs from the rest of the UK). This means a £10,000 pension contribution can cost as little as £5,500.
If you are employed, you will also be entitled to pension contributions made by your employer, as long as you keep opted into your work scheme and make the required level of contributions yourself. You should generally prioritise this form of investing as it is often the most efficient way to provide for retirement by some distance.
5. Set your goals
In order to save and invest for the future in a methodical and efficient way, It's important to set goals for different ‘pots’ of money and consider whether they are short-term or long-term in nature. Shorter-term needs are generally considered to be less than five years, perhaps putting money aside for a new car or for a house deposit for example. Longer-term goals include getting ready for retirement or making provision for school or education fees likely to be incurred in ten or more years’ time.
Short-term needs are best addressed through saving cash and long-term ones through investing. Unlike cash, riskier assets do not offer the security of capital, but over the long term, they tend to do better and therefore they build wealth more effectively. The cost of living squeeze may mean a setback or a reassessment of priorities, but this still principle holds true, and you shouldn’t be put off the benefits of long-term investing in difficult times when the headlines are negative. In the long run, these can even be good times to put money to work provided you can afford to do so.
Don’t forget to use appropriate tax ‘wrappers’ for your investing goals such as a pension for retirement, ISAs for earlier access and Junior ISAs for children. By placing your money in pension or ISA wrappers you can save tax and make your investments work harder for you. You won’t pay capital gains tax on any profits and there’s no tax on dividends from shares or the income earned on bonds.
Give your finances a health check
Having a conversation with a financial professional can help you to take control of your finances, giving you freedom and peace of mind. Working together, we’ll help you gain a better understanding of your money.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.