So far I hope you have enjoyed the financial series. We have talked about the number one reason why most people will never reach their goals. We moved through some of the most basic and fundamental building blocks of personal finance. Now we need to pull this all together into a step by step plan of action.
First we have to decide what the overarching goal is for our financial lives. Not having a goal for anything in life is an awesome way to use your resources very, very, very inefficiently. Whether the resource is time, money, or effort. We must have a simple goal which we can make sure we are moving towards. I believe the biggest financial goal for anyone in life is to become financially free. That means having your FU Money securely in place. Once you achieve this your options become theoretically unbounded. Having that base means that you only work when you want to, on what you want to, exactly how you want to do it. For most people that is only a pipe dream, but I am going to give you the step by step practical plan to get there.
Three Phases to Financial Freedom
I divide this plan up into three basic phases:
I will go in depth into each of these and explain what the steps are and why they are important.
(Skip to the end if you just want to see the steps)
We are only as solid as our foundation allows us to be. This is true in almost every regard whether it is physically building something (such as a building or house) or metaphorically within finance or even education. When going through engineering school most people become limited by there understanding of the foundations of math and science. Without those any progress into more advanced subjects is destabilized by the lack of solid foundation. In finance, the same is true. Without a solid foundation you leave yourself open for catastrophic events that can undo everything you have built.
With regards to money, the foundation is built by achieving these three steps:
Save $1000 to $2000 for a starter Emergency Fund
Begin saving up to company match into your 401k (company match only!!)
Pay off all Non-mortgage debt (credit cards, student loans, car loans, etc.)
Save 3 to 6 months of expenses for your fully funded Emergency Fund
These four steps allow you to break the paycheck to paycheck cycle that most people are headed towards and puts you in the drivers seat of your financial life.
This is the bedrock by which you can build your foundation. It is essential to have a liquid (meaning not invested) savings of 3 to 6 months of expenses to guard yourself from the inevitable swings that life will throw at you. Whether it is an unexpected medical event or a job loss this will keep you from killing the golden goose that is laying your golden eggs, your investments. Not having an emergency fund is like not having medical or car insurance. Sure you might be fine for a while and nothing will happen. But in reality it is only a matter of time before you have to go see a doctor. No one lives their whole life without medical problems of some sort. Walking around without a way to cover yourself is just plain dumb.
Think of an Emergency Fund as insurance on your investments and overall financial health. It keeps you covered incase of the inevitable problems that will come your way.
Why Just The Company Match?
Working in a company that has a matching 401k plan is a blessing. The company has decided that it wants to help you along the way in investing for your future. Only a certain subset of companies offer such benefits so if you work for one you should consider yourself very fortunate. Usually the company will have a certain percentage that you will put in and they will match that amount. Although the matching type can vary widely between companies, it is important to take advantage of it. We want to pay off debt as quickly as possible as I describe in the next section but I know that it can be hard to pass up the free money you are being offered. So if you want to invest up to the company match in the 401k then that is fine. But ONLY THE COMPANY MATCH! Remember our first priority is to get rid of debt and get our emergency fund saved. For most people this should take a max of 24 months unless you have a very extreme situation (went 200k in student loan debt to make 30k per year as a teacher or something...). Not going hard on your retirement for 24 months while you clean up your debt is not going to make or break your nest egg. Eliminating debt will allow you to invest much more heavily in your retirement as you will read in the coming sections.
Elimination of Non-Mortgage Debt
If you have read through the rest of the financial series then you are well aware of how I feel about debt. So I will save you from another lecture and just say that if you still believe that you should get a car loan when you buy a car then you need to go back and reread the series. Instead I will focus on methods for eliminating it.
I wish that there was a silver bullet for this, but there simply isn't. Your debt problem is only going to go away with dedicated effort and resources and a little bit of sacrifice and perseverance. Nothing is going to change that fact. There are, however, certain strategies which make the paying off of debt much more efficient. There are two main strategies that I will talk about and then I will combine them into a strategy that I recommend.
The Debt Snowball Method
This one is popularized by author and speaker Dave Ramsey. The method is simple. List your debts from smallest to largest (ignoring interest rates), pay minimum payments on all others and attack the smallest one with all extra money you have until it is gone. Then take all the money you were paying per month into that along with the minimum payment on that debt and apply it to the next smallest and so on. What this does is give you quick psychological wins. Debt reduction can be a grueling process that can take years depending on how much you have. Like anything else that takes sacrifice it can be very hard to stay the course over that long of time especially if progress is not immediately noticeable. Most people embark to pay off debt but get discouraged and give up and probably end up right back where they started. What the Debt Snowball Method does is allows you to get quick wins that give you a psychological boost to stay the course. It feels great to have a debt paid off and you get fired up about knocking out the rest of them. This usually motivates people to save even more money because they see that they can really get out of debt which is the real secret to the method.
As with anything there is always downsides. The biggest one here is usually noticed immediately by the math nerds. It was that little phrase "ignoring interest rates".
The High Interest First Method
If we look strictly at the numbers, the quickest way to get out of debt is to rank your debts from highest interest rate first to lowest and pay them off in that order. This minimizes the amount of interest you pay and allows that your money to have more weight in actually paying down the principle debt rather than interest. The problem here is that if you are unfortunate enough to have a large debt (such as a student loan) that is at 6 or 7 percent and a car loan or other that is less then you can feel like you get stuck because of the sheer size of the student loan. Also, this doesn't always promote the "fired up" effect that the snowball method does so you don't get the added benefit of motivation to save more money. What I want to do is attempt to get the best of both worlds
The Young Analytical Mind Debt Payoff Method
On one hand I really like the snowball method because I do believe that psychology plays a huge role in personal finance. A much larger role than numbers people like you and I are usually willing to admit. On the other hand I can see how we do need to minimize the amount of interest you pay especially if it is really large like with credit cards which can be as much as 29.9%! So here is the YAM Method for debt reduction:
Split loans into two categories: Below 10% interest rate and above or equal to 10% interest rate
With the below 10% category use the debt snowball method (list loans from smallest to larges)
With the above and including 10% interest rates pay them off in order of highest interest first
What this does is minimizes the really high interest rates loans. For the most part these will be credit cards and other usually really bad debt that you need to get out from under of as quick as possible. After that you go into the debts that are lower in interest rates and the interest you will pay while paying them off will be negligible.
Alright so we have our foundation built now. We have paid off ALL of our debt that is not a mortgage and we have a fully funded emergency fund. Having just recently achieved this I can say this is one of the best feelings. You now have the freedom to make many choices. At this point we can begin to make some larger purchases as long as they keep on the path to financial freedom. These may include cars, houses, nicer furniture, and heavier retirement savings. But remember, we must never lose sight of the goal which is to become financially free. One of the biggest factors in doing that is eliminating debt and expenses. We have done fantastic so far, but it's not over yet because elimination of debt does include a mortgage. So here are the next steps in our plan:
5. Begin saving 15% of gross income into retirement
6. Save a 20% or more down payment for a house (if necessary)
7. Pay off house as quickly as possible
This is the point where we can begin to make some luxury purchases. We have cleaned up our financial situation, have no debt other than maybe a mortgage, and have our fully funded emergency fund in place. There are a couple of rules to these.
First, unless you have a net worth of over 1 million dollars we don't want to have more than 50% of our gross annual income tied up in things that are consumed and depreciate over time. This includes anything with a motor and/or wheels (cars, boats, trailers, motorcycles, RVs, etc.), furniture, and other belongings. So that means if you make $60,000 per year and you are driving a $50,000 car then there is something wrong! That is just too much money going in the wrong direction. Second, you must pay for all of these purchases IN CASH. No financing whatsoever. There are no excuses or caveats to this rule. It is absolute. All purchases done with money you have saved. Now, does this mean you can never have anything nice? Absolutely not! We are going to have a lot of nice things if that is what we want. We just don't want those things to have us. Everything needs to be in balance so that you are still working towards your goal of becoming financially free.
Purchasing A Home
As you have learned in my previous article, buying a home is not the end all be all. Renting is a perfectly suitable option in many cases. Nevertheless there are plenty of reasons to want to own a home. I plan on buying one myself. If you are in a position where you want to buy a home here are some simple guidelines to make sure the home will be a blessing rather than a curse:
Be completely debt free
Have a fully funded emergency fund (3 to 6 months of expenses)
Be ready to stay in the home for at least 5 years
Have a down payment of 20% or more
Make sure the mortgage payment is no more than 25% of your take home pay
Only finance on a 15-year fixed rate mortgage
These rules will allow you to purchase with more confidence that you can afford the house. To demonstrate lets use an example. Let's say your bring home pay is about $4,000 per month. This would mean you could afford a mortgage payment of about $1,000 per month. This would include principle, interest, insurance, and taxes. That means you are looking at a maximum mortgage of roughly 100k. So that will tell you how much you need to save in order to get in the home you want.
Why a 15-year Mortgage Instead Of A 30-Year?
Most people who purchase a home will get a 30-year mortgage. So why would I recommend a 15-year? Well you would think that if you half the term of the loan then your payments would double, but this is not the case. Thanks to compound interest we actually only have to pay a couple hundred more dollars a month for the 15 year. Plus over time this can mean HUGE savings for you.
Let's take an example of a $150,000 house with a 20% down payment ($120k mortgage) and compare a 30-year vs a 15-year. First thing that is different is the interest rate. The interest rate on a 30-year is actually higher than the 15-year. At the time of writing the mortgage rate in Houston for a 30 year was 3.83% while the 15-year was 3.03%. This may not seem like much, but over time this can mean big savings. Using our example here is what we come up with:
Interest Rate: 3.83%
Total Amount Paid: $202,032
Interest Rate: 3.03%
Total Amount Paid: $149,477
So by switching to a 15-year you had to pay $291 extra per month, but you saved over $50,000 in interest! Not only that, you paid off your home a full 15 years sooner! So let's say you invested you mortgage payment of $1,218 per month at 10% for the next 15 years until the other person pays their home off. You would have an additional $510,825 dollars! Now that is well worth a couple extra dollars per month if you ask me.
You can see that the sooner your pay off your home the quicker you can start investing the difference and what a difference it makes. The math is pretty simple. The sooner you stop paying interest and start to earn interest the better off you will be.
Let's take a look at our situation. You have no debt whatsoever, you have 3 to 6 month emergency fund, you have a nice nest egg started, and you have yourself a couple of nice things. Here is where the real fun begins. At this point the name of the game is compound interest. We have worked hard to eliminate paying interest. Now we can begin reaping the rewards of earning interest. At this point you have an unlimited amount of options to go after and it can seem intimidating. Many times I find people who try to get to this point before they are ready. Up until now your investing skill had little to no effect on your net worth. But now we have learn a little more about wealth building.
There are two main objectives here: maximize investment performance and minimize taxes while only taking on a reasonable amount of risk. Taxes become huge in this part as you can see a real effect of them on your performance. So first I recommend maxing out all tax-advantaged investment options. This includes Traditional and Roth IRAs, 401k, and HSA (health savings account). For most people this will be an IRA ($5,500/year) for both you and your spouse (if you are married) and $18,000 for both you and your spouse if you are married and they are available from work.
Next we need to look at investment performance. This is where people can get into a lot of trouble. For some insights on what I recommend take a look at these articles: The Calculation That Broke The Market, Humans Are Hardwired To Suck At Investing, The Simplest Investment Plan On Earth, What Driving In Houston Traffic Taught Me About Investing, and Tweaking The Simplest Investment Plan Ever. This should give you a base to move onto more about investing if desired, but keep in mind almost no one can consistently beat the market.
The goal here is to reach your FU Money. At that point you have reached true financial freedom and can now only work when YOU want to. Not when you have to. Fill out the form below to get a free spreadsheet to calculate what your FU Money is:
FU Money Calculator
Now let's summarize the plan:
1. Save $1000 to $2000 for a starter Emergency Fund
2. Begin saving up to company match into your 401k (company match only!!)
3. Pay off all Non-mortgage debt (credit cards, student loans, car loans, etc.)
4. Save 3 to 6 months of expenses for your fully funded Emergency Fund
5. Begin saving 15% of gross income into retirement
6. Save a 20% or more down payment for a house (if necessary)
7. Pay off house as quickly as possible
8. Max Out Tax Advantaged Accounts
9. Build FU Money
With this plan you have a step by step road map of where to go and always having a goal. Let me know in the comments below what you think and feel free to drop me an email if you have any questions at firstname.lastname@example.org.