I received a text from a friend the other night that got me thinking. “We all know, or are learning, the importance of getting out of debt—but then what? How do we start building wealth, even if we don’t have much to work with?”
I thought it might be helpful to map out a path to financial freedom, so here is mine. Personal finance is personal, so take what works for you and find your path.
Want the quick and simple summary?
- Get out of debt as soon as possible
- Spend less than you make – grow your income and shrink your expenses
- Invest the difference
- Track your net worth – this was my secret weapon. I calculate my net worth monthly and even include a calculation of my budgeted net worth as part of my annual budget. This helps me stay on top of my financial goals.
- Look after the people who depend on you with wills and insurance that is appropriate for your situation
Want the details?
- If you are sharing your life with a partner, choose your partner well. Make sure your life goals and financial goals are aligned. Nurture that relationship, it is the foundation for all other relationships.
- This was the most important decision I ever made–that I made it at age 23 is crazy and amazing.
- Craft a personal mission statement, decide what goals you want to achieve in the short term and in the long term. Update these when things change in your life.
- I think I could have achieved financial independence earlier if I had laid out a specific mission statement with detailed goals. I knew I wanted flexibility and having “money in the bank” provided that.
- If people like your partner or children depend on you financially, get term life insurance immediately. Zanderins.com, selectquote.com and others provide quick quotes. How much life insurance do you need?
- Not everyone needs life insurance. We had small life insurance policies through our jobs. We purchased additional insurance early in our marriage when we owed more on our home than we had invested. Because we have no children, life insurance was no longer necessary when we had significant savings and were living well below our incomes.
- Make a will and the related documents including a financial power of attorney and health care directive. Free and no cost wills are available on line through legalzoom.com and others.
- Establish an emergency fund, $500 to $1,000 is adequate while you are paying off your bad debt.
- Track your expenses
- Summarize them each month by category.
- Identify any expenses that don’t bring you joy and are preventing you from achieving your goals and reduce those.
- You may need to reduce expenses that do bring you joy in order to achieve your goals (which should bring you more joy!).
- Create a budget or pay yourself first.
- If you think budgeting is for you, great, start now! Moneypeach.com or YNAB.com (you need a budget) can help. I am a budgeter (is that a word?). My budget includes detailed amounts for utilities, insurance and gifts but a lump sum for spending. Spending includes things like groceries, dining out and clothing. I don’t care whether I buy new shoes or a nice bottle of wine, but I do care about what my total spending is.
- If budgeting isn’t for you, pay yourself first – take the amount you intend to save off of the top and spend the rest as you would like. Did this seem easy? Increase the amount you’re saving next month. If you have any extra left at the end of the month, treat it as extra savings.
- Calculate your net worth – this is your financial report card and was my secret weapon to achieve financial independence. Calculate this each month:
- What I own
- What I owe
- Keep it simple, include things like real estate and cars but do not include clothing, electronics, jewelry, etc. Here’s an article that will help.
- Pay off your credit cards and other consumer debt (furniture, appliances, etc.). Treat this debt as an emergency, remove it from your life as quickly as you can. Here are my steps to slay debt forever.
- Contribute to your retirement plan at work at least up to the amount of your company match.
- Increase your emergency fund to at least three months of your essential expenses.
- Pay off your car loans.
- Increase your retirement contributions – either at work or through an IRA. How much you need to save depends on how long you want to work. If you save 5% in a Roth 401k or IRA, you will need to WORK 66 years. If you start at age 25, you will need to work until your are 91–YIKES!
|Working Years Until Retirement|
|Roth Savings Rate||Without Social Security||With Social Security Providing 40% of Needs|
All calculations assume a 5% investment return after inflation, a 4% withdrawal rate in retirement with expenses in retirement equal to your after savings take home pay.
- Save for your next car, house or other large purchase.
- Learn about investing. Invest your retirement and other savings according to your risk tolerance and time horizon. Invest in low cost mutual funds (I’m almost exclusively invested in Vanguard funds) and don’t mess with it. No market timing (it doesn’t work) or individual stock purchases are necessary. Here’s a great resource (warning there is foul language . . . ) for learning about investing.
- Pay off your student loans.
- Save for your children’s education. No one will loan you money to retire but students have plenty of options to pay for their education. Paying off your debt and saving for your retirement needs to take priority over saving for a child’s education.
- Pay off your mortgage? I put a question mark here because it probably doesn’t make financial sense to pay off your mortgage. Rates are low and you may be able to make more money investing than you are paying in mortgage interest. But, it feels really good to live in a home you actually own. You have to decide what you want. I love living in a home I actually own!
- Continue to invest – maximize tax deferred contributions (401k’s, IRA’s, HSA’s, etc.) and automate your savings whenever possible.
- If retirement is your goal, a general rule is that you need to have 25 to 30 times your annual expenses invested in order to retire. This allows you to spend 3.3% to 4% of your invested assets in the first year of retirement and increase that spending by the cost of living each year. Your money should last forever but it is best to have some contingency plans.
- Invested assets do not include your home or any other assets that are not available to pay your expenses.
- This is why it is so important to reduce your spending if retirement is your goal. The reduced spending allows you to save more now and reduces the 25 – 30 x savings goal in order to retire.
What did I miss? Which of these steps should I dig into for a future post? I welcome your comments.