My Approach to Being Financially Free
I'm not selling anything. I'm just trying to spread my personal message. I've figured out the secret to a happy life...
Living a life of financial freedom doesn't mean winning big at the track, hitting the lottery, or having a rich uncle (or aunt). It means being true to yourself. That, a little bit of planning, and a lot of discipline. Here's how it works:
Let's make some assumptions:
- You earn $50,000 a year.
- You put 5% pre-tax into a retirement fund.
- You pay nomimally 18% taxes. In New York, that's the average rate for the typical person, including federal, state, and local taxes.
- You have a $1,000 per month mortgage payment (and escrow, insurance, etc).
- You have $1,000 in monthly living expenses, bills, and entertainment.
- You have $10,000 in credit card, car, or student loan debt.
- You pay $1,000 per month towards that $10,000
How much do you have left in your bank at the end of the year?
- $50,000 - retirement ($2,500) = $47,500
- $47,500 - taxes ($8,550) = $38,950
- $38,950 - mortgage ($12,000) = $26,950
- $26,950 - expenses ($12,000) = $14,950
- $14,950 - debt ($12,000) = $2,950
You're left with about $3,000 to save every year. And, because you've heard that you should have a six-month cushion of all your expenses (a total of $36,000 per year) to fall back on in case things go south, that means you should have over $18,000 in the bank. How long is it going to take you to save $18,000 if you've only got $3,000 at the end of the year (assuming the car makes it through the winter and the house makes it through the hurricane?) Six years. Minimum. Probably more like 10 years, since the hot water heater will need to be replaced and you'll want to buy a new iPod.
Let's take the same person with no credit card, no mortgage, and no student loan. Their monthly expenses are $1,000. So they need to have only $6,000 in the bank for a six-month cushion. They make about $2250 each month after retirement, taxes, and expenses, which means it takes them three months to save up more than what they need. At that point, they can take the extra $26,950 that they have every year and...I don't know...buy iPods and yachts and trips to Paris or whatever.
I don't know about you, but I want to go to Paris on a yacht with iPods in all colors of the rainbow.
So how do you get there? Here's where the planning comes in. Three rules:
- Live on a cash basis. No credit. No borrowing. Nothing that has an interest rate associated with it.
- Pay off your debt first. Save later. Why save $3,000 a year for 10 years if you could save over $2,000 a month for three months?
- Be brutal about what you don't need to spend money on (this is the discipline part).
Slash as much as you can from those monthly expenses, and save as much money as you can. You're going to pour this extra money into your debt reduction plan...
First, make a list of all of your debts that come with an interest rate. Credit cards. Car loan. Student loans. Home equity line of credit. A loan from that semi-rich uncle or aunt. Write them down in order of which one has the lowest balance (aka - the amount you actually owe). Pay no attention to the interest rate. (Read that sentence again - pay no attention to the interest rate). Financial advisors will tell you to pay off the one with the highest interest rate first, but that only works if you've got gobs of money to throw around. Start with the one that will be paid off first. Put your mortage last. Oh, and did I mention, stop putting money into your retirement? Please don't think about saving right now (you'll have plenty of time and money for that if you keep reading). Caveat - put as much in as you need to to take advantage of any employer matching programs, but NO MORE!
Let's say you've got $7,000 in credit cards, a $2,000 car loan, and a pesky $1,000 in student loans that just won't go away. Put as much money as you can save each money towards that student loan, including the normal $50 a month payment that they ask for. Why? Because it's the one that will be paid off first. You'll pay the minimums on the other loans (and you're not using that credit card, right?). When the student loan is paid off, take all of the money that you were paying on the student loan and put it towards the next highest loan. In our case, that would be the car loan. Pay it off and now your car is yours.
Now, you've got the student loan payment of $50 a month, the car payment of (let's say) $250 a month, and all that money you've scraped together. Pour all of that (all of it) plus the normal credit card payments, at those credit cards. You'll pay these off so fast your wallet will spin.
At this point, you've got beacoup bucks lying around (well, maybe not, but you've eliminated that $1,000 per month debt payment and $10,000 in debt). Now pour all that money plus the $1,000 mortgage payment at the mortgage. Yah, I know. You're screaming "but what about the tax write off?!?!?" Why spend $8000 a year in interest to get a $1200 a year tax savings? PAY IT OFF!! You've got $2,000 a year going towards that mortage, and if you're not too far into it, that means you might quickly realize additional savings in things like Private Mortgage Insurance and other fees the mortgage company is charging you for not having a lot of equity. Plus, if you sell your house before paying off the mortgage, you'll get more cash from it.
If you do this accelerated payment schedule, you'll pay off your debt in about six-seven years. You heard right. Six-seven years. Maybe less, maybe more, but typically, it's six-seven years. Debt free. No mortage, no credit cards, no car loan, in six years!
NOW the fun begins. At this point, you've been paying lots of money towards debt each month, shaved spending, and lived on a cash basis. You probably don't miss pizza night and Blockbuster night and Applebee's as much as you think you might have. Let's say you shaved $100 a month off your living expenses. Now, instead of $1,000 a month, you spend only $900. So a six month cushion is only $5,400. You can probably save that in TWO MONTHS! Remember at the beginning when I said it would take at least six years to save your $18,000 cushion? Well, here you are, six years (and two months) later, your cushion is saved, and it's a lot less than $18,000 AND YOU'RE TOTALLY DEBT FREE!!!
[Insert evil laughter.]
Think about it: You've still got that $50,000 a year job (and we're ignoring inflation and raises for now), $10,800 a year in living expenses and...and...well, just taxes, I guess. So now you can crank as much money as you can (up to legal limits, of course) into your retirement. Go ahead! Splurge! I know financial advisors will say "but you've lost six years (and two months) of compounded interest!!!" Remember, we were originally only putting in $2,500 a year (that's per year) into our retirement funds. We can now afford to put in $2,500 per month if we wanted to.
Even if we pay full 18% taxes on our $50,000 income, which we won't if we're contributing to our retirement pre-tax, we still have over $30,000 in the bank at the end of the year, after paying our living expenses (which we reduced to $900, remember?). For one year, we can put $2,500 each month into our retirement, and that's the whole $30,000. If we'd only put $2,500 a year in for six years (and two months), that's only $15,000. Six years of compound interest at 6% APR would give us only $17,500 in our account. At 9% interest (good luck finding that rate of return these days), it would only be a shade over $19,000. To match our $30,000 contribution, we'd need to get over 28% APR return for SIX YEARS!!!! So don't tell me I'm losing out on compound interest! I've got an iPod, dammit!
The bottom line is that we'll say after seven years, you have no debt, no credit cards, no mortgage, and reduced monthly living expenses. You can afford to contribute towards a retirement or savings like you've never thought you would be able to before. You only need to work for a few months to save a six month cushion of daily living expenses. And if you can or want to, you can change jobs. Go be a salmon fisherperson in Alaska at $100 bucks a day for six months, and you'll still make over $13,000 a year. At that point, you're not going to pay much (if any) in taxes (thank you, standard deductions!), and remember - your living expenses are about $10,800, so you could make ends meet like this. Especially if you like salmon!
And that brings me to the reason for doing this myself. (The plan, not being a salmon fisherperson.) Having the pressure of a M-F 9-5 job with a pager and a cell phone to earn 28% and 30% tax bracket incomes to support a mortage, debt, and living expenses sucks! If I could afford to work only six months (or less!) out of the year as a box slinger at UPS or an accountant for H&R Block, or even work a retail store where I could just say "don't put me on the schedule for three months" every now and then, I would! I'd have enough money and time to do whatever and go wherever I wanted in the world.
And that, my friends, is what it's all about.
So please, I urge you: Accelerate your debt payments. Only use cash. Agressively pay off your creditors. THEN you can think about saving (and having to save less) and doing fun things and enjoying life. And never, ever, shake a baby.
Note: Though I am not a licensed financial advisor, I am a smart guy. And I know how to use Excel. Your mileage may vary, and all numbers and calculations are figurative only, but I think you get my point.