There are a lot of people who will tell you how to get out of debt. Get on a budget. Spend less than you make. Pay off your debts, using the cash from the debts you pay off to pay down the next debt. But what if you have paid off your last debt? Is that the end of the road, where you now live happily ever after? Absolutely not. This is where things get fun.
For years you have suffered because you were paying interest payments to Visa and Mastercard. You were paying interest to a car finance company. You were paying interest to a bank holding your student loan debt. You had to pay out twenty, thirty, maybe even forty percent of your paycheck in interest each month. This means that you were working between eight and sixteen hours per week for the finance companies and the credit cards. Now that you have paid off your debt, you now get to keep your entire paycheck. (Except for the 4-20 hours per week you work for the government since you’re still paying taxes, but we won’t talk about that. Go to www.fairtax.org if you really want to take home your entire paycheck.)
So at this point you could expand your budget such that you pay cash for things as they come up. You would then be paying out all that comes in, which would be fine for a while. But what about the times when you have a big bill come due? Like when your car breaks down and you need a new, $2500 transmission. Or you need a new roof on your home, so you need $10,000. If you have been spending your whole paycheck each month, there will be no money available for these expenses, so you’ll go back into debt and the cycle repeats.
You could plan ahead for these expenses by taking some of the money you were sending in to pay off debt and direct a little from each paycheck into a bank account. If you did this before you expanded your spending up to the level of your full paycheck, you would never miss it. You would then have cash sitting there, ready for the unexpected big events that occur. This would be good, but why settle for good when you could have great. What if instead of paying out interest, you could actually generate more money from the money you have sitting in the bank? And I don’t mean the paltry 0.1% your savings account is earning. I mean enough to actually make a difference in your life.
The next step after you pay off your debt is to start investing from each paycheck, both so that you’ll have the cash available for the unexpected expenses like a car repair, but also for the large, but predictable future expenses like college for the kids and your eventual retirement. With an investment portfolio, you’ll be getting income both from your job and from your investments. It’s like you work once and get paid fifty times. This makes it much easier to both pay cash for things, so that you won’t get into debt again, and to build wealth for when you are no longer able to work.
Here are the steps to take once you have paid off your debt to supercharge your financial life:
1. Build up an emergency fund of $6000-$12,000. You need to have cash available to take care of expenses that occur. This needs to be in a bank money market account (or split between a money market fund and a CD, at most) because you will need to be tapping into it from time-to-time. If you invest everything, you’ll end up selling assets all of the time, resulting in taxes and fees. You need to have enough cash to handle any emergencies that arise. Once you’ve paid off your last consumer debt (credit cards, car payment, etc…), direct the money you were paying for debt to a bank account and fill it up. You should have at least a couple of thousand dollars in the bank even when you are still paying down debt to avoid losing ground.
2. Fund your retirement by putting 10-15% of your paycheck away into a 401K, an individual IRA, or another suitable place. You will need to retire someday and you’ll need a lot of money. This is easy to do if you put a little away over 40 years, but hard to do in five or ten years. Just put away 15% from each paycheck before it hits your hands and you won’t need to worry about retirement. This money should be invested in large cap, small cap, international, and income funds. Choose the funds with the lowest fees, preferable index funds of ETFs. Because retirement funding is so critical and there are huge advantages to starting early, start directing money to your retirement portfolio even before you’ve paid off lower interest debts like car loans.
3. Fund your children’s college by putting money into education IRAs or 529 plans. Just like retirement, college requires a lot of money and it is easier to save up over a long period of time than over a few years. You should therefore be directing money you can spare after you’ve funded your retirement accounts into college savings. Start when the kids are small and you’ll already have a few years of college expenses set aside when they’re ready to go. If using an educational IRA, invest mainly in growth mutual funds when they are young, shifting to income funds and finally cash as they get closer to college age. If you have enough income to float their college expenses if your need to (from your job or your other investments), you can stay more aggressively invested in stocks since you can just pay for their college from other sources if the market takes a dive on any given year and then take money from the college account when the market recovers a bit.
4. Build up a taxable portfolio in equities. If everything else is fully funded and you still have money remaining from your paycheck, or if you receive a bonus check each year, giving you extra money beyond your normal paycheck, you should build up a portfolio of common stocks, either through mutual funds alone or a mixture of individual stocks and mutual funds. The mutual funds should be index funds or ETFs to keep fees low and to keep trading, which results in capital gain taxes, to a minimum. If buying individual stocks, buy growth stocks that you don’t plan to touch for a long time with little or no dividend to keep taxes low. Put income securities in your tax-sheltered portfolios such as a 401K or IRA.
Follow these four steps, constantly directing some of the money from your paycheck into saving and investing, and you’ll be on the path to life changing wealth. It will start slow at first, but just as the interest on credit cards goes from manageable to unbearable, the income you get from investing will eventually grow to the point where it is a bigger factor in your life than your paycheck. It all comes from living on less than you make and putting money away.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.