Financial Security. We all need it. Whether you are trying to break away from the cycle of living paycheck-to-paycheck or focusing on building long-term wealth, there are a few key steps that will allow you to achieve a solid financial foundation. Once you establish (and automate!) good money management habits, future financial gains will come much much easier.
Ready to get started on the journey to financial well-being? These steps will help get you pointed in the right direction.
1) Understand Your Financial Situation
Calculate Your Net Worth: It’s very difficult to create a plan when you don’t know your starting point. You need a baseline and big-picture view of your finances. Collect together all of your high-level financial information and calculate your net worth. Make a list of your assets and debts, including the remaining balance, interest rate and any hard payoffs dates (or penalties for early payoff). This information will help you put together a plan to optimize where to target future positive cash flows and receive the highest monetary returns. Revisit your net worth quarterly or yearly to see how your overall financial situation is trending and if further adjustments need to be made.
Create a Detailed Budget: Now it’s time to dig into the details. Where is your money going every month? Don’t estimate. Gather real data from past receipts and account withdrawals or track your spending in detail for 1 to 2 months. Write down all of your income and expenses, including intermittent expenses. It’s crucial to know how much money you are earning versus spending each month. If you are spending more than you are earning, it’s not a sustainable situation. You need a positive cash flow each month or you will end up further in debt.
Make a plan and stick to it. Identify strengths and weaknesses in your budget. Take a good hard look at your budget roll-up and create new spending targets, particularly for discretionary categories, to increase your positive cash flow each month. What parts of your budget can be easily trimmed? Is your lifestyle in alignment with your income? How aggressively do you want to build wealth? Adjust your budget periodically to reflect updates to your personal situation.
2) Spend Less Than Your Earn (and focus on expanding that gap!)
You know your overall financial picture and you have a preliminary monthly budget. Now it’s time to take ownership of the situation and take real actionable steps to improve your future financial situation. It’s a simple formula: wealth is built by earning more than you are spending and saving/investing the difference. Establishing a positive monthly cash flow is imperative, as it will allow you to start saving towards your financial priorities.
There are two main areas to focus on when increasing the differential between what you earn and what you spend – Increasing Your Income and Decreasing Your Expenses. The bigger this differential is, the more you can contribute towards financial priorities (major pre-planned expenses, retirement savings, investments, etc) and the faster you will build wealth.
Some ideas to increase your income:
- Seek out overtime/bonus opportunities at your current job
- Work hard to be a top performer and earn better raises/promotions
- Explore a career change with higher earning potential
- Pick up a side-hustle or part-time job
- Rent out a room in your home
- Monetize a hobby
- Sell unused items on Craigslist or at a garage sale
Some ideas to decrease your expenses:
- Track your expenses and stick you your budget
- Reign in discretionary spending (eating out, shopping, entertainment)
- Prepare more meals at home and bring your lunch to work.
- “Do-it-Yourself” instead of hiring out services
- Avoid instant gratification. Wait before making optional purchases.
- Find more affordable housing
- Seek out free and low-cost entertainment options
- Use coupons and shop sales
- Carpool more often
- Cancel rarely used subscriptions and memberships
- Try generic brands
Many people think of “sticking to a budget” as a sacrifice. Yes, it can certainly seem like that at first, but once you identify which expenses truly enhance your life and which don’t, it’s easy to adapt to a lifestyle that minimizes the less valuable expenses. For instance, we cut cable over three years ago and haven’t looked back since. We honestly don’t miss it. Our evening entertainment is more than complete with an $8/month Hulu subscription and Amazon Prime Video. Once it becomes the new normal, it no longer feels like a sacrifice.
Decreasing expenses is unique to each individual, so what works for one person may not work for another. If you live in a high-cost-of-living locale, it may be very difficult to identify lower cost housing options. If you constantly travel for work, it may be very difficult to cook home-made meals. If you work a full-time job and have three kids, a housecleaner may be essential for maintaining sanity. That is why it’s so important to create a detailed budget and see where your money is going each month. Focus on reducing the highest cost drivers and those that provide the least personal value.
Why is this step so critical? It sets the foundation for being able to achieve all of your future financial goals. The less you spend, the more you can save and the faster you can build wealth by allocating that extra cash towards your financial priorities.
3) Create a Financial Safety Net
Establish an Emergency Fund: If you do not have any savings, establishing an Emergency Fund should be your #1 financial priority. To start, target a $1,000 Emergency Fund. That’s enough to keep you afloat in most emergencies (and keep you from taking on further debt). This should only be a temporary target while you focus on other, more pressing financial priorities, such as paying off high-interest debt. If already have some savings, no high-interest debt and have started saving for retirement, then focus on stashing away 3 to 6 months worth of living expenses in your Emergency Fund.
Review Your Insurance Coverage: You need to protect yourself and your family from unexpected situations in life, as there may be very costly consequences that derail your financial stability. A major medical emergency can cost hundreds of thousands of dollars in medical expenses, in addition to a forced long-term absence from your job. If you are not insured properly, the results can be devastating.
Evaluate if you have adequate insurance coverage:
- Medical, Dental and/or Vision Insurance
- Short-Term Disability Insurance
- Long-Term Disability Insurance
- Life Insurance
- Home or Renters Insurance
- Car Insurance
- Travel Insurance
Review/Establish Estate Planning: This is a piece of financial security that many individuals forget about. It doesn’t matter if you are 24 or 74, everyone should have a plan for their assets to ensure they transfer to loved ones and/or organizations they care about with minimal delay, legal fees and taxes. If you are married or have children, it’s even more important to address this. As a start, review beneficiaries listed on life insurance policies and financial accounts, but I recommend meeting with an estate planning attorney to map out the details. There are a lot of complexities beyond the financial implications when it comes to estate planning. Learn more here.
4) Eliminate High-Interest Debt
Not all debt is created equal. Some debt, like credit card and cash advance loans, are notorious for having high-interest rates of 10%, 15%, even 20%+. That means if you have a $1,000 balance on a credit card with a 20% interest rate, you are paying an extra $200 per year. A $100 sweater is actually costing you $120 in this scenario. It’s not worth it. Toxic debt threatens your long-term financial security and needs to be eliminated ASAP.
Take the information collected in step 1 (net worth and detailed budget) to prioritize your debt payoff and eliminate the highest interest rate loans first. Make extra payments on your debt with the positive cash flow from your budget. Anything above a ~7% interest rate is a candidate. Paying off high-interest debt is a guaranteed high return on your money.
Why is it important to keep a $1,000 emergency fund? To keep you out of additional debt. It gives you a little wiggle room to handle unexpected emergencies without adding to the balance of a high-interest credit card, plus there are some scenarios where a credit card may not be a payment option. If you need to use a portion of your emergency fund, do it and rebuild the fund before tackling debt payments again.
NerdWallet has a debt calculator to analyze the extent of your debt and methods for handling it.
5) Start Building Wealth
Once you have your day-to-day finances under control, are prepared for emergencies and have paid off all high-interest debt, you’re in a fantastic position to build long-term wealth. Start setting new financial priorities that will maximize the return on your money. Consider building up your emergency fund into 3 to 6 months worth of living expenses and saving in tax-advantaged retirement accounts. Reevaluate your situation at least once a year and adjust as needed.
With a consistent net positive cash flow, you now have the ability to save more, invest more and grow your net worth. Plan ahead for major expenses, like a home renovation or vehicle purchase, and save enough to avoid future loans. Only use credit cards if you can pay off the balance in full each month. Keep a focus on your income versus expenses and make sure lifestyle inflation doesn’t derail your good financial habits. Make your money work for you.