Everyone has different philosophies about how to get out of debt and build savings. Here is the basic strategy we recommend you follow. You may already be doing these things, but I ve tried to order all of my strategies by importance, so ideally you ll do number one before number two, etc
1. Balance Your Budget (Before paying debt or savings)
Until you are spending less than or equal to what you earn, you can t advance beyond this step. Get your spending under control, or take another job. Start by cutting into things you can control like eating out, and then look for cheaper alternatives on things you have to pay on. Got a car payment? Sell your car and take the bus. Paying $100 for a cell phone? Ditch the smart phone and get a $20 pre-paid phone. If you are spending more than you make, you need to take drastic measures. This is the least fun part, but it will pay off in the end.
2. Pay Off Your Credit Card Debt and Loans
There is no point in putting any money in savings while you are paying interest on credit card debt. The best savings accounts pay under 1% currently, while the lowest credit cards charge 6%, and more likely upwards of 20%. While it may feel more responsible to start saving, eliminate that debt as fast as you can. DO NOT PAY THE MINIMUM. Put the maximum amount of money you can towards this debt every month until it s paid off.
Start by paying off the credit card with the highest interest rate first. As they get paid off, cancel any cards that charge annual fees. There are so many credit options out there, there s no reason to pay an annual fee for most people. I wouldn t recommend cancelling every card, for your credit score it s important to keep at least one long term account open.
3. Get Rid of The Car Payment
You should not have a car payment. A car is one of the biggest sources of financial leakage we see, because the car and credit companies have convinced America that a car payment is just a normal part of your finances, and that you need a new car because used cars are unreliable.
The fact is with interest on a $20,000 car you ll actually pay $23,100 on a 6% loan over five years. In that same five years, your new car will also likely lose $12,000 in value to depreciation. That means $15,000 is essentially thrown in the trash (almost enough to buy another new car in cash!). If you are buying a new car for the warranty , can you imagine needing $15,000 of repairs in even the worst of junkers?
Buy a used car in cash. And I mean at least a 5-year-old used car that has already taken the largest depreciation hit. It doesn t need to be a junker, there are lots of cars that seem new to most people in this range. By buying a car in cash, you also save in insurance. Liability only insurance is often more than half as cheap. It s hard to believe, but you ll be able to buy a new Porsche in cash after just a few years if you just avoid buying a new Ford Focus every 3 years.
Also think about the ongoing costs of the car you buy. An SUV may seem practical, but with the extra gas you spend, you could probably pay someone with a Jeep to give you a ride when it snows. Luxury cars also come with luxury expenses, such as pricey parts and premium gas requirements.
Better yet, if you can avoid owning a car at all, by taking public transportation or biking, you ll have tons of extra money, and better health to boot.
4. Build an Emergency Fund
Once you are debt free, it s time you stay there. Build up 3-6 months of savings in an emergency fund. Find the highest interest rate savings account you can, and start putting money there. Don t go crazy with a savings account though, because interest rates are so low these days, you really can have too much money in savings.
Why is this? Because interest rates on savings accounts (in the USA at least) are under 1%, and inflation is at 3%, so you re actually losing money for every dollar in savings. But this is a necessary evil, and you still need to have some backup money readily accessible, so I recommend 3 months of your emergency fund be in a pure savings account; while you have the other 3 months in something a little less liquid that pays a higher rate (1 year CD or Money Market). This can work because you ll cut your expenses considerably if you lost your job, so most likely 3 months of full expenses can be stretched to 6-7 months.
5. Make the Credit Card Companies Pay YOU
Now that you have no debt and a safe cushion, it s time to start living like a rich person, and by that I don t mean spending luxuriously, I mean letting the credit cards make money for you instead of take money from you.
What do I mean? I mean get a credit card that pays you cash. Don t mess around with a credit card that gives frequent flyer miles, Amazon gift cards, or electronics as rewards. Do you know what you can buy with cash? Flights, Amazon gift cards, and electronics. Do you know what you can buy with frequent flyer miles? Only flights. Hopefully you see where I m going here.
A cash back card is the most flexible because you can use cash for anything. Start making as many purchases as possible on your credit card. Pay off the credit card every month in full, and you ll pay no interest, but gain hundreds of dollars a year from the credit card.
Congratulations you just gave yourself a raise without doing any extra work.
6. Plan for Retirement
This really happens at the same time as number three or four, but if you are not already, you need to start maxing our your retirement (I m a little up in the air as to whether you should be contributing to retirement when you still have debt, while you would pay more in credit interest, the compounding effects of retirement as well as the tax incentives can t be overlooked).
I recommend putting at least 10% of your income into your retirement account, or 15% if you are starting late. If your employer offers a match, always max that out, because otherwise you are leaving money on the table. This topic is a little too complex for this document (we ll expand in a future eBook), but the key is to utilize your employer s plan as much as possible, and if they don t provide one, open an IRA.
Planning for retirement can seem extremely hard, because you re not sure you ll ever see the money again. It s not fun to take money you could use for fun now and put it aside for later. But you can t count on social security or pensions. The amount of money that can be made on compounding an investment over 30 years is enormous. Also retirement becomes another asset you can tap in times of extreme need.
7. Optimize Your Taxes
This also happens simultaneously with step two, but if you are getting a huge tax refund every year, you are just giving the government an interest free loan. Reduce your employer withholdings to the minimum. It s better to pay the government then have them pay you. You can invest that money, or use it to pay down debt, which will have a snowball effect. Use an online tax calculator to figure out how much you ll owe the government, and be sure to set aside that in your budget (in an interest bearing account).
8. Start Investing
The world is your oyster at this step in the ladder. I won t give you specific investing advice except diversify as much as possible, and avoid paying fees at all costs. I recommend no load mutual funds and index funds as a good way to get started. Try to buy different types of funds, from bonds to international, the more diverse the better.
Buying individual stocks is ok, but you can add more diversity and save on trading fees by using a mutual fund. There are also are sorts of riskier investments such as those on Personal Capital (peer to peer lending), precious metals, or private startups, etc You ll lose money on some individual investments, but if you spread your risk among many diverse investments you ll end up at the top in the end. It s important to not be buying and selling constantly. No one can time the market, and if you sell when you see your assets going down, you ll almost certainly have a poor return overall. Continue investing when markets are down and you ll be happy when they are up. Consistency and diversity is key.
Buying real estate can be part of this investing, however you should calculate whether it makes sense to own a house in your area. We are told home ownership is always best, but in many areas, renting actually makes more sense financially than owning (such as cities with high property taxes, low appreciation, and low rents).
9. Insure Where Appropriate
It s probably a good idea to get long term care insurance as well as disability insurance (and obviously car and home insurance). These policies are often cheap and it s a good hedge against the worst.
Life insurance is often touted as a great investment, but I m honestly not a fan. Term life insurance is probably a good idea if you have a family and are the sole earner, but whole life insurance commits you to a monthly payment, which could probably be invested elsewhere, and can be a burden if you hit hard times. It can be part of a diversified investment portfolio, but I wouldn t make it one of my initial investments.
10. Optimize Your Finances
This can happen at any stage in the ladder, but you should definitely do it by now. Find the cheapest cell phone that makes you happy, get the cheapest cable plan you can, use coupons to save on groceries, if you like to travel keep an eye out for the best deals. If you think about every dollar you save as a dollar that can be invested, it s crazy how quick the wealth roller coaster can go.
Don t pay fees ever. Are you paying for a checking account? ATM withdrawals? Find a service that doesn t charge those. In fact, your checking account should be paying you interest. Once you are debt free and have money, you d be surprised the options that open up.
11. Other Debt
Student Loans and Mortgages are in a different category. For the most part you shouldn t be paying off loans that are fixed to an asset unless that asset is underwater (what??). What I mean is that if you can sell your house for $200,000 today (after realtor fees, etc ), your mortgage doesn t need to be paid below that. Mortgage rates are around 3.5% currently, so if you can make more then what you pay in interest on another investment, it s better to do that, because Mortgage interest is also tax deductible.
Student loans are in a similar category, although there is no asset, so these should be paid off as quick as possible, it s not as important as paying off a credit card because the interest rates are typically very low. (Certain types of loans, which have high interest rates, should definitely be paid off quickly though, the interest write off isn t worth the money you ll save in interest!).