Gaining control of your finances is something that we all know we should do like eating right or exercising. Some of us have it pretty ease, it’s something we enjoy. Like that one person that gets overly excited at the thought of getting up every morning at 5 AM to work out. And, then there’s the rest of us, the ones that love to hit the snooze button instead of running and the ones that can come up with a million different ways to spend money. That’s okay. We all run on our own schedule. First, you need to realize that you can, and you should get out of debt.
Doing better with money, or anything, starts with simply getting your head around where to begin. There are so many places to start that it can be hard to navigate where to go next. Simply trying to keep enough money to buffer you between months can be rough, let along contributing to your 401k, saving for goals, and ensuring enough is put away for unforeseen expenses all while trying to enjoy life. I’m drained just writing that out.
So, you’re ready to start. You need a game plan. An easy, if “x” happens, then “y” to get things moving. More importantly, you also need to know your “why”. What are these sacrifices for? No one passes on eating out with friends or going on a shopping spree because they want to. That’s weird. You do it because you have something great in mind. You’re saying “No” to one thing, so that you may say “Yes” to something better later. This is the part where you should sit down and really allow yourself time to think over some of the things you want to accomplish. If you had extra money at the end of the month, what would you do? Would you some money sat aside for an emergency? Maybe, starting to save for a down payment on a house? Wouldn’t it be easier to pass on your coffee addiction knowing that your house fund is going way up or that your vacation is already paid in full before pack your bags? This is something to get excited about! The road is going to be rough… but it’s something you owe yourself. Get back your life and control your future!
Below are the steps to help getting started out right for financial freedom and success!
Step 1: Small Emergency Fund
Have a small rainy day fund to start. This is for small, unexpected events like: car repairs, veterinary visits, emergency room visits, and everything in between. Any event that isn’t planned, but needs to be taken care immdiately will land here. It’s a not a question of “if”, it’s when. This step is crucial to keeping on track. A study shows nearly 60 percent of people would not have the money to cover even a small emergency that wasn’t within their budget. This could be as small as a $500 car repair. Don’t let a small blip blow your budget and send you running to your credit cards or a loan. Keeping a small stash of money to fall back on would let you just repair the car and move on. So, be ready! Don’t use this money for anything other than emergencies! It may be tempting to pull from it when you don’t want to cash flow a purchase, but pretend it’s not there. You’ll be happy you did when the time comes to use it.
Depending on your current salary, job level/security, and comfort level, $500 – $2000 is a good starter emergency fund. This amount is small because you don’t want to spend too much time here. You only want a little cushion before moving on. You’ll have plenty of time (and freed money) later once your debt is gone. The worse case scenario is that you deplete your emergency fund, and you have to go back to step 1. The good thing is you had the cushion! No interest or time wasted. So, keep paying minimums on your debt, and build up the fund!
Step 2: Employee 401k Match/Knocking Out Debt
This step is broken into 2 parts. It comes down to time. There is a wonderful mathematical occurrence called compound interest. It’s so popular that even Albert Einstein has a quote about it! “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” There is a power in a focused effort, but missing out on the interest that happens from investing early steals your earning ability if done over an extended period of time. Here is an example of just how much compound interest can help. In fact, you’ll find that the overwhelming majority of the money in your account at retirement is growth, and it happens with no further contributions! So, if it is going to take longer than 2 years to complete getting out debt, then you should contribute up to the matched amount with your employer’s 401k at that end of the 2 years.
For the majority of people, it will be only around 3% – 6% since that is the average most company’s match. Being so small it shouldn’t impact your timeline of getting out of debt. Best of all since it is pre-taxed, more will be contributed than you will notice is not coming in.
Step 2(a): Employee 401k Match
Does your company offer a 401(k)? A 401(k) is an employer offered retirement plan that helps you save pre-taxed money in a set of offered investment funds. If so, you need to be taking advantage of this yesterday! As stated above, most will match, or partially match, up to 6% of your contributions. This is a benefit your company offers as apart of your overall compensation package. That is FREE MONEY! It’s a no brainer.
In Step 5: Investing, there’s a deeper dive into the major categories of what there is to invest in. Get to know some of the mutual funds your company offers and do some research. Think about where you’re and look for funds that fit within your risk tolerance and timeline.
Here is a great video on retirement from PBS. It’s a great overview of what people face saving for retirement with some tips to invest smartly. A phrase you want to become familiar with is… Expense Ratio.
Step 2(b): Knocking Out Debt
Debt is everywhere. It’s so prevalent that it’s basically a norm in America now. In fact, 7 out of 10 Americans believe debt is a natural and necessary part of life. That constantly owing someone, something is natural. Below are some of the average debt amounts in America.
-Average Household Credit Card Debt: $15,609.00
-Average Mortgage Debt: $156,706.00
-Average Student Loan Debt: $35,000.00
Source: government data; current as of 2015
As always there are exceptions to the rules. In a small percentage of time, debt is helpful and almost a necessary evil such as when buying a house. Most first time homebuyers, whose average age is around 33 years old, might find it hard to come up with the 20% down payment let alone the entire asking price to settle the debt at the start. Short of such a large purchase, debt shouldn’t be necessary. Living within your means, being accountable for what you spend, is how you stay out of debt and live a lot more comfortable life.
This will probably be the hardest part of the cycle, but ultimately the most rewarding. This is the step where you knock out your all your consumer debt except your mortgage so you can move forward in life without having to consider companies like Toyota Financial Center or American Express when making decisions. Also, during this period, you are also actively avoiding any more debt. It’s like punching holes in a sinking ship, keeping away from more debt advances debt reduction as well!
During this period, the party starts to wind down and the creeping responsibilities of the adult world start to set in. Wow, can we make this any less fun? Of course, there needs to be time for rewards and breaks. This will be a long process for some so remain diligent, but remember to enjoy life still! It sounds a bit existential, but you only have one life so while you’re fixing your financial situation, go on a vacation, go eat out a restaurant or go to that concert. But, do it within the realm of common sense and reason! Think of any purchases in ratios to your monthly income to help. Say, you want to go out to eat for a date night. You make $2,000 a month and there’s a new, fancy restaurant that just opened. You look over the menu only to see that you probably won’t be leaving there without spending less than $200.00. That’s 10% of your entire budget for the month! Not only will you probably not have enough money to pay extra on your debt, you probably will barely be able to make the minimum payments on everything! This goes for all activities. Use your head and stay out of danger so you don’t run low on money at the end of the month. If you want to go on a nice vacation, stretch it out so that you’re saving a little each month alongside your debt reduction. Just remember every dollar not spent on debt is a little bit longer until you can build wealth. Or, get creative! Plan a weekend road trip somewhere close by that you may have never been that has affordable hotels or campgrounds. Now, that that’s out of the way…
There are many methods out there that you can use to get out of debt. The two most popular are the debt snowball and the debt avalanche. They are variations on the same thing.
Debt snowball – This method is interest rate agnostic. You’ve probably heard this from Dave Ramsey. You simply pay off debt from the smallest to largest amount owed.
- $100.00 Credit Card A
- Minimum Payment – $10.00 Monthly
- $500.00 Credit Card B
- Minimum Payment – $25.00 Monthly
- $1,500.00 Student Loan
- Minimum Payment – $50.00 Monthly
- $10,000.00 Car Loan
- Minimum Payment – $150.00 Monthly
With this methodology, you will pay all your debt’s monthly minimums – $235.00. All the money left over at the end of the month will go directly to Credit Card A. So, if you have $90.00 left over, you would clear out Credit Card A after the first month then move onto Credit Card B next month as that would be your lowest payment. You do this until all the debts are cleared.
Debt Avalanche – This method is interest rate dependent. You pay off debts from the smallest to largest interest rate owed.
- $100.00 Credit Card A – 19.25%
- Minimum Payment – $10.00 Monthly
- $500.00 Credit Card B – 24.00%
- Minimum Payment – $25.00 Monthly
- $1,500.00 Student Loan – 6.80%
- Minimum Payment – $50.00 Monthly
- $10,000.00 Car Loan – 7.19%
- Minimum Payment – $150.00 Monthly
With this methodology, you will pay all your debt’s monthly minimums – $235.00. All the money left over at the end of the month will go directly to Credit Card B since it has the largest interest rate. So, if you have $90.00 left over, you would clear out $90.00 extra dollars from Credit Card B bringing the balance to $410.00 while Credit Card A is untouched for now.
Mathematically, the Debt Avalanche is optimal, as you will pay less in interest between the two. The debt snowball works more on a psychological level by accumulating victories sooner as you pay those smaller debts off then progress to the larger one. I prefer the debt avalanche, but there’s good news… Neither one is wrong in the long run! As long as you’re doing this, you are way ahead of the curve. Ultimately, neither time nor money will be impacted severely as long as you’re throwing as many dollars at this as you can. There are many other choices to choose from, but these two approaches are very popular and effective.
For this part, it’s important to keep the goal in mind. You eventually want a 401K for retirement, an emergency fund, down payment on a house or targeted saving for a large purchase. So, keep the goal in mind and reward yourself during milestones to keep the good energy flowing. It’s a difficult task, but one that’s worth it!
Step 4: Large Emergency Fund
First off…. Congratulations! You’re officially a part of the small percentage of America that not only hates debt, but now doesn’t have it! Now, it’s to finish where you left off with the small emergency fund at the beggining. With all your consumer debt gone and the freed money (extra $325.00 monthly from the previous section’s example) is there to help squash the house debt in time.
If you were elected the CFO of a company, one of the things you would have to consider in making sure the company doesn’t go bankrupt is to find out how much risk is in your field. From month to month, if it’s it easy to assume how much money your company makes you would assume there’s little risk. On the other hand, what if your company was involved in a volatile industry like the oil industry. Every month can vary, a lot. How do you smooth over the months that don’t make as much? Ideally, you would tap into a reserve of cash; money saved from more profitable months.The same is true for you budget; it’s called your emergency fund. By all accounts, this money is boring. It’s not there to gain interest or building up for a vacation or new car. No; instead, this will help smooth over things like unexpected medical incidents, a lay off from work, and major car repair. It’s your buffer from life.
Depending on your job, three to six months of extra money is ideal. If your paycheck is pretty predictable then 3 months will probably cover things; however if you’re paycheck or job is unpredictable, you would want to kick that amount up towards the 6 month level.
Step 5: Investing
Next to paying off debt, this is probably the most fulfilling step you’ll do now and throughout your life, as you get closer to retirement. Up until this point you’ve been paying off debt, saving for emergencies, and living on a budget for a while now. While you’ve seen progress from your debt going down and your bank account increasing, you may have felt that you haven’t moved all that much in the grand scheme of things. But, now you’re at the place where you can start to do some investing! You’re at a place to start building wealth, and a different future.
At first, this part can be intimidating, but don’t let it stop you or, worst, jump into something that you don’t understand. Take it slow and do your homework. More and more as you start looking into this, you’ll see it’s not as complicated as it’s made out to be.
So, what do you invest in? I should be diversified, right? Yes! The market can be a wild place. On any given year, average returns can vary from a 25% to a -10% return. Luckily, it’s pretty easy in most plans to avoid “putting all your (nest) eggs” in one basket. Depending on your stage in life, your choices may differ as to how heavily allocated you are in which section. This breakdown of this category is huge, but to keep things simple and brief for now here are a couple of the major categories:
Mutual Funds (Collection of Stocks): It’s a great “set it and forget it” fund to hold while your risk tolerance is a little higher. Within one mutual fund, you will hold many stocks from across the broad market so your average returns year to year will mirror that of the market. Why is it important to hold so many? On any given day with such a moody stock market, prices can swing way up or way down, but not all stocks go the same way. On that day with a mutual fund, some of your stocks will go down while others will go up; this puts you somewhere in the middle, but follows the overall market for the most part. Think of it as a sort of stabilizer for this roller coaster ride. Overall, since they do somewhat mirror the market (meaning you may have some negative years), these funds are best held when you have time to bounce back from drops in the market.
Bonds: If stocks and mutual funds are the roller coasters, look at these as the rides that your younger sibling jumps on. These are less exciting, don’t move as much and are considered a “safer” bet. Since they don’t stand to lose as much when the market drop, similarly they don’t see as much of a gain when times are good. The general rule of thumb is as you get older the more you want to move into bonds or more “stable” funds. The reason is simple: Again, it comes down to time. The thought process is that it simply becomes more risky to expose your account to such volatility.