(This is the third post in a series on cash flow. The first post in the series is located here.)
In the last post we looked at the cash flow of the typical middle class family, which is a cash flow that will put them into debt despite having a good income. Today let’s look at what the cash flow diagram of a couple in their twenties should be if they want to become financially independent. This is the best time to get your cash flow right so that you’ll never go into debt in the first place.
Let’s assume our couple has no kids yet and have a couple of student loans. While getting the student loans was probably not a great idea, sometimes it is a necessary evil. If they make just a few other good choices, they can still turn their finances around and be debt free quickly.
The diagram above shows the cash flow for our twenty-something couple. (Click on the diagram for a better view if needed). Note the following:
Box A, Income: Our couple has two jobs, with a $20,000 and a $40,000 income. One person seems to have gotten something from his/her college degree, where the other just took what he/she could find. This happens fairly often, but even taking a job that may not pay so great can help you financially when combined with another income that can carry most of the load, plus it is better to be working and getting experience since that is how you get a better job later. If you look at the total expenses at the bottom, you’ll see that the couple spends $40,600 per year, so most of the second person’s salary can be used to retire debt, save up for bigger expenses like a home, and invest.
Box B, Cash-On-Hand: Our couple used their initial salaries to build up an emergency fund of $9,000. That should be enough to cover things that come up like medical co-pays and car repairs. This money keeps them from putting these expenses on a credit card and starting into the debt cycle. It is also money that will be there if one of the two lose their job and it takes a few months to find another one. They keep most of the money in savings that earns more interest.
Box C, Obligated Expenses: Our couple has chosen to rent an apartment for $600 per month. They are saving up for a down payment on a house, so they are taking an apartment that is safe and clean, but without all kinds of extras. They will have plenty of time in their lives to have luxuries – right now they just need somewhere to live. Note that they have also chosen to live somewhere that makes sense for their salaries. Beyond rent, their only obligated expenses are some taxes on their cars and their student loans. Note that there are no car payments since they used some of their initial paychecks to buy a couple of used cars for $3,000 each. They have about 1/3 of their income obligated before the month starts.
Box D, Necessary Expenses: In this box we have the things that they need to buy but that they have some flexibility in the amount paid. Here they are working to keep expenses down. They eat in most meals with perhaps $50 per month for a couple of modest meals out. They spend a couple of hundred dollars in clothing, just replacing what needs to be replaced. They are young, so they only have $1000 per year in medical expenses for normal care and the occasional flu. Their necessary expenses are about 1/6 of their take-home pay.
Box E, Optional Expenses (Luxuries): Here are the luxuries that they choose to enjoy. Note that they keep these small relative to their income – around 10%. This leaves money for investing and saving. They chose an inexpensive hobby – backpacking. Other choices would be running, camping, card games, biking, shore fishing, reading, disk golf, and gardening. Things like golfing can come later when they have higher incomes and more money in investments.
Otherwise they have a small amount of spending cash each month to spend however they choose, some money for movies and going to hear live music at coffee shops. They also have a little money for special occasions like birthdays and festivals. They take a modest vacation each year, costing $2,000, maybe to visit parents. Because they are keeping their luxuries low for now, they have money to invest to generate an income for luxuries later.
Box F: Required Investments: The don’t have any children yet, so they don’t have any college expenses to save for, but they will want to retire some day. They put away 15% of their income into retirement accounts, with 8% going into 401k’s to get the company match, then the rest going into individual IRAs where they have more investment choices. By investing early for retirement, they’ll have no problem reaching their goals and having plenty of money to live on in retirement.
Box G: Saving and Investing: After paying for everything else, they still have $10,400 left over. Note that despite only having a $60,000 income, they are able to free up over $10,000 per year by 1) buying used cars so they have no car payments, 2) limiting things like meals out and expensive entertainment, and 3) taking modest vacations until their income increases. They put $5,000 away each year for a home, allowing them to put down a down payment of about $30,000 in six years, or 20% for a $150,000 home. They might decide to put this money on the student loans instead, then use the money they free up from the loans to build up a down payment more quickly. They also put away $1500 per year into a car fund so that they’ll have the money to buy new used cars in four or five years.
That leaves $3,900 to put into investments each year. This is the money that will allow them to become financially independent in their mid-forties. It also gives them more security since they have resources to tap into beyond their emergency funds if needed. Over time, these investments will add to their yearly income, increasing their cash flow. After just five years, they might be able to generate a yearly income of around $2,000 from investments.
Looking at the upper right, we see that they have $17,400 in free cash flow. which includes their luxuries and their savings/investments. This is cash that would be available to cover things that come up if needed since they have flexibility. Because they have limited obligations, they have a great deal of control over their income. Compare this with most people who have everything obligated before the month even starts. Note that if they wanted they could choose to cut way back on luxuries and savings for a year or so and knock about $15,000 off of their student loans, maybe paying one off. This would free up more cash flow that they could then direct towards saving up for a home or investing more. Just killing off the smaller one would add $5,000 to their free cash flow.
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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.