It seems like probably 3/4 of the people I talk to are finally at a point in their lives when they are interested in organizing their finances, but don’t know where to start. I’ve created this post as a resource to share with them and others who find themselves in a similar situation. It’s not comprehensive, and people should still probably seek out a professional to help them, but it’s a start. Even just doing step 1 can lead to major improvements.
I’ve kept the steps simple, powerful, and easy to execute. There are two reasons for this. First and foremost, life isn’t about money. Thinking about money generally makes people feel less happy, even when they have a lot of it. You want to keep money in the background of your life where it belongs. Secondly, the best financial plan is one that you can stick to. That means making it easy to do consistently with minimal effort.
1. Automatically Save 10% of Your Paycheck
This first step is straight out of “Richest Man in Babylon,” #paythyselffirst The only reliable way to save money is to pay yourself first. Automatically have 10% of your paycheck deposited in your savings. This post from “The Balance” will tell you how to do that. Then, don’t touch that money. You’ll need it for the following steps. What’s amazing about doing this, though, (so amazing that until they try it, no one believes me), is that you won’t miss that money. Maybe you will notice that you aren’t spending as much, but you won’t miss that spending. You’ll be just as happy as ever, but with a couple hundred bucks accruing to your name each month. Later steps will cover how to start making that money work for you.
This step only takes a one-time commitment of 30 minutes (maybe less), but is easily the most important thing you can do to start building your long term wealth. And once that monthly deposit is set up, it doesn’t require any regular attention or effort. Growing wealthy can actually be very easy when you automate it.
2. Review Your Spending
Schedule 10 minutes once a month to look over your expenses. This step is also easy, and there are a lot of tools to make it easier. Apps like Mint and Personal Capital help you review your spending by categorizing your expenses and presenting them in simple, colorful graphs. The thing that I’ve noticed since doing this is that no individual expense really seems like that much money. But $15 here, $20 there can easily add up to well over $200. Sometimes that $200 is worth it and makes life a lot better. But I often find myself being a little bit more selective with those other expenses after going through my credit card statement.
Bottom line, spend money where it makes your life better, but watch out for expenses that you don’t really enjoy fully.
3. Pay Off Credit Card Debt
If you have no credit card debt, congratulations! Keep it that way and move on to step 4!
If you do have credit card debt, you actually have a risk-free investment opportunity so good that it causes most hedge fund managers to salivate. Here’s why:
Interest rates for credit cards are usually 25-30% annually. If you owe $1000, you’re paying $250-$300 each year. If you use $1000 pay off debt, you get to keep an extra $250-$300 each year. That’s an amazing investment.
For reference, if you bought a US Treasury bond and held it for 10-years, you’d only get 2.5-3% annually. In other words, for the pleasure of having $1000 of your money tied up for 10 years, you could make about $25-$30 annually. Even a higher-risk investment in the US stock market has historically returned about 10%, and you have to watch the price of that investment fluctuate like crazy from year to year.
The only investment I could find that came close to these returns was Warren Buffett’s investment partnership. According to Old School Value, his partnership produced returns of 29.5% compounded annually for about 10 years, which are the highest returns he has ever produced over a similar time period. As far as I can tell, the only way to have gotten those returns was to be a neighbor or family member of young Warren Buffett (or to be Warren Buffett). I guess what I’m saying is, unless you’re living next to a financial wizard, the likes of which the world sees once in a century, you probably won’t be able to get those kind of results in the stock market.
The good news is that if you currently have credit card debt, you can get those same returns, guaranteed, just by paying off your debt. And you don’t even have to pay tax. By paying off that debt, you put yourself at the same level as Warren Buffett.
Take that 10% of your paycheck that you are saving and use it to pay off your credit card debt. It’s simple, it’s gratifying, and it’s powerful.
4. Contribute Just Enough to Get Your 401k Match
If you have a job that offers a matching 401k contribution, contribute just enough to get the full match. Often this is only 3% or so, but it’s a guaranteed way of doubling your money, and so it’s worth doing. Do this only after you have paid off your credit card debt, though. If you’re curious about why, leave a comment or email me at nicholaspihl@gmail.com
5. Set Up, or Get Access to An Emergency Fund
The purpose of this step is three-fold: 1) To keep credit card debt out of your life, and 2) give yourself flexibility to pursue special opportunities, and finally 3) sleep better at night. An emergency fund is enough to cover three months to one year of living expenses. It is designed to shelter you from the vast majority of bad stuff you can imagine: losing your job, your car breaking down, urgent repairs for your home, surprise medical bills, you name it. And to keep you out of debt.
This step is all about surviving catastrophes and setbacks, but it also positions you well on the upside. Suppose you find a job offering 30% higher pay on the other side of the country. Having the ability to break your lease, move, and put down a deposit on a new place opens the door to a great opportunity.
Of course, some people are lucky and end up not needing their emergency fund. And for young people, that’s a lot of money to have sitting in cash, especially relative to how long it takes to earn it. For example, if you’re living on $20,000 a year and set aside $500 each month, saving enough money for 3, 6, or 12 months of living expenses would take 10 months, 20 months, or 40 months! Many young people would be better off investing that money for the long term, and getting a promise from relatives that they’ll be able to borrow five thousand to ten thousand dollars in an emergency. As usual, life is easier when you have rich relatives. Even though it’s potentially an awkward conversation to have (and maybe someday I’ll make a post about how to approach it), it’s one of the only ways to have your cake and eat it too.
6. Pay Off Non-Mortgage Debt
This step is both the hardest and most satisfying step to complete. The vast majority of people in America have some form of student loans or car loans. But that doesn’t make it okay, or smart. It’s a huge, ugly, hairy beast, and you must slay it. The good news is that you aren’t going into battle empty-handed. Steps 1-4 exist to give you the weapons and armor you will need for this feat.
Each month, take that 10% from your paycheck and put it towards paying down your debt. You’re going to use a technique called “The Debt Snowball.” What you do is pay off the debts that have the smallest balance first, and move towards the larger payments. As each of the smaller items gets paid off, use the extra money that you’re no longer paying as interest, and use it to pay down more of your debt. You can thank Dave Ramsey for this concept.
Note, some people will say that technically you should first pay off the debts that have the highest interest rates. That’s theoretically right, but goes against my behavioralist philosophy. Remember that the best plan is the one that people can stick to! Ramsey and I agree that, as people wipe out each debt, they will get excited and motivated. This will keep them going. You want some easy victories early on to build momentum. Too, as you lower the amount you are paying in interest, and increase the amount of money that you get to keep month, each subsequent pile of debt looks a little less daunting because you have more powerful tools to tackle it with. You might start out paying down $200 each month, but over time that can grow so that you’re regularly cutting down your loans by $300 or $400. That’s the power of compound interest.
What’s even better is that the cash flows you are freeing up are all tax-free! You’re richer and better off, but your tax bill stays the same!
7. Invest!
So, now that you’ve freed up some sizable cash flows, what do you do with them to keep compounding that wealth? Well there are a few options, ranging from buying rental properties to investing in small businesses, to contributing to a retirement account. For my money, I like the retirement account approach. It doesn’t require much effort or time, nor any special expertise, but this approach can still produce very satisfactory returns when invested in index funds over long periods of time.
To do this, you can work on maxing out your 401k, and/or create an IRA (Individual Retirement Account).
Your options are (and this is simplified somewhat, so don’t make a decision based on this blog post alone):
- Contribute to a Traditional IRA
- Contribute to a 401k
- Contribute to a Roth IRA
Contributions to a Traditional IRA or a 401k get the same tax treatment. They are both “pre-tax,” meaning that, as far as the IRS is concerned, your salary shrinks by the amount that you contribute. This means you have a lower tax bill now. However, as you withdraw that money in retirement, you have to pay income taxes on it.
Contributions to a Roth IRA are “after-tax,” meaning that you still have to pay taxes on that money today. The good news is that you don’t have to pay taxes on that money when you use it in retirement.
Whether you should use a Traditional IRA or Roth IRA depends on your situation. Although you should consult with a financial planner about your particular situation, the general rule of thumb is that you should use a Roth IRA if you’re making less money now (pre-tax) than you’ll be living on in retirement (ignoring inflation). For example, if you’re young and earning $40,000 year, but can see your salary increasing over time to the point where you’ll eventually want to live on $60,000 a year when you retire, a Roth IRA is a good move. By contrast, if you’re established in your career and have a high income relative to what you spend annually, a Traditional IRA (or 401k) is the choice for you.
A couple notes. First, you can only make withdrawals from these accounts after age 59 1/2, otherwise you have to pay a 10% fee (plus taxes on the withdrawal in the case of a traditional IRA or 401k). If you’ll need the money before then, with few exceptions, you should not put the money in an IRA. Second, the most you can contribute annually to an IRA is $5,500, or $6,500 if you’re over age 50. Traditional IRAs and 401ks get the same tax treatment, but the 401k has a higher contribution limit (around $18,000). This is a good article on the nitty gritty of this situation.
Now Go Live Your Life!
If you have questions, or want to argue, feel free to contact me at nicholaspih@gmail.com
PS: If you’re confused by any of this, don’t guess, ask an expert who can take the time to fully understand your unique situation and give good advice.