Financial Independence, or FI, is the freedom from depending on your paycheck every month to cover all your expenses. Sounds pretty great, right? But is it really possible?
In my previous posts I’ve talked about how great FI is. But how do you actually start the process of working your way to FI?
It’s actually quite simple. You just need a plan.
Here are the 5 steps to put your plan in place.
Contents and Quick Links
Focus on paying off bad debt
What is the difference between good debt and bad debt you may ask?
Bad debt: This type of debt doesn’t help you. Debt that that you have to pay interest on and does not qualify as an investment fall under this definition. Credit card debt, car loans and student loans can be considered bad debt.
Good Debt: This type of debt will help you earn more money and increase your net worth. Your mortgage on a house that is appreciating is the perfect example of what can be considered good debt. Of course, if you bought your home at the top of the market with a high interest rate, that’s not helping you.
Note: Some people consider student loans as good debt. Here’s how I would look at this. Did you acquire student loans by going to an out-of-state or private university for an undergraduate in history that you have no way to practically use? Or did you go to a local university or trade school to learn a skill set that will earn you more money than your prior potential?
There are two schools of thought on how to pay off your debt, there’s the Dave Ramsey snowball method, or the avalanche method.
List all your debts in order of smallest to largest, not worrying about interest rates. Each month, pay the minimum balance on all debts. With the money you have remaining, put all of that towards the smallest balance. In other words, attack that smallest debt and knock it out quickly. Once you pay off that debt, move on to the next. Now you have everything you were putting into the small debt payoff to be applied to the next debt. As you go down the line, you see a snowball effect such that your debt gets paid off more quickly.
List all your debts in order of largest to smallest interest rates. Each month, pay the minimum balance on all debts, then throw all your remaining money towards the debt with the highest interest rate. The thought here is that by paying off the high interest debt first, you will decrease the overall amount that you will need to pay.
You get to decide which method works best for you. Sometimes it’s nice to take care of the little debts first so that you can see your overall debts diminish and feel more motivated to keep up the momentum. Or, maybe the larger interest bearing debts need to be addressed first just to minimize the overall amount that you have to pay off.
It could be that the biggest interest bearing debt is the one that takes the longest to pay off and you risk losing motivation or feeling defeated when you don’t see progress. Since it depends on your unique situation and preference, pick a method that will keep you motivated to keep moving forward.
Build an Emergency Fund
Recommendations vary based on how much this account should hold, but money should be accessible, not tied up in investments, and should cover 3-6 months worth of expenses. This could be a standard savings account through your bank, but here are some better options:
Standard savings account through the same bank you have your usual checking account.
Pros: Easy to set up (if you haven’t already) and access.
Cons: Very low interest yield, typically around 0.1%, much less than the rate of inflation. You can do better. If you have a large sum of money sitting in an account, it should be earning you interest.
Online high interest earning savings account:
Pros: Federally insured up to $250,000, easy to access through withdrawal or funds transfer. Interest rates are typically around 1%-2%, which is more than 10 times that offered from your bank’s savings account. This is possible because there is less overhead for these companies to operate online accounts.
Cons: An online only account can feel risky to some people. While they are insured and easy to set up, some people like to have a brick-and-mortar business to visit.
This is the savings account I personally use for my emergency fund:
An investment portfolio of stocks and bonds:
These can be exchange-traded funds (ETFs) or a Roth IRA.
For more info visit:
Pros: Much higher interest rate returns.
Cons: More risky and susceptible to market ups and downs, not as easily accessible, can come with management fees and capital gains taxes on interest earnings.
Note: Returns can be greater than 20% in an ETF or Roth IRA. However, in a market downturn, you also risk losing greater than 20%. You can control the level of risk by adjusting the balance of your portfolio between stocks and bonds and also aim for 30% extra investment over your emergency fund goal. For instance, if you calculate that for 6 months worth of expenses you need $12,000, add 30% cushion to this and aim to invest $12,000 + $3,600, for a total of $15,600. This can help buffer market fluctuations in the event that you need access to your funds in the middle of a downturn.
It’s a little tricky deciding which to do first, pay off debt or establish an emergency fund. The last thing you want is for disaster to strike, illness or loss of job, and not be able to cover your expenses. One way to protect yourself it to initially work on both at the same time. Set aside a certain amount to go toward paying off debt, then keep some extra handy in case you need it. This doesn’t have to be a full 4 months of living expenses, but you want a cushion to help you out if you need it.
Build an Investment Account
This is the money you build up to use specifically for alternative investing, be it real estate or personal business. I absolutely love real estate so I save money specifically to be used for buying rental properties. First, I have a standard checking account for my duplex and all rent money is deposited into this account. Then, I keep a minimum value in this checking account so that it is readily available in the event of a sudden expense, such as a broken water heater. Lastly, anything over this amount gets moved over to an ETF. I don’t need that money to be as readily accessible, I can make offers on homes and still have time to sell off stocks in time for the escrow payment.
Establish your plan
Once you know what your expenses are and you calculate your savings rate, you are ready to make a plan.
Haven’t tracked your expenses yet? Visit How To: Track Your Personal Finances
Don’t have a budget yet? Visit The Beginner’s Guide to Creating a Budget You Can Stick To
Haven’t calculated your savings rate yet? Visit How to Calculate Your Savings Rate – And Why You Need To
You can download workbooks to track your monthly expenses and create a budget over at the FREE resource library!
How much money can you put towards your debt and how long will it take to pay it off? Once your debt is cleared, how long will it take to establish your emergency fund?
Decide at what age you would like to retire and then work backwards to determine how much you need to be saving, and how you want to be saving, to make that happen. Once you know this, you have a plan and your money has a purpose.
Fist off, if you aren’t maxing out your employer contributions, do that now. It’s free money!
On the path to FI you’ll want to consider maxing out your employer 401(k) account, then opening a separate IRA/ROTH IRA account and maxing that out as well.
Here are some resources to help decide what account is right for you:
Emotional shopping, similar to emotional eating, is the need to reward yourself with something nice because you work so hard during the week. When you have money left over at the end of the month or after a windfall, there is often the urge to spend it right away before it disappears. Without a plan in place, extra money is just that, extra money. This is why it’s called expendable income!
But your money should not be expendable! With a plan in place, and the ultimate reward of FI as your end goal, that extra money has a place to go. It has a defined purpose for paying off debt, building up an emergency fund, or investing for growth in long term ETFs, an IRA or investment account for your side hustle.
Regardless of what step you are at, move that money where it really belongs. Your money has a purpose and when you put it to work for you, it will bring you fulfillment and happiness now, and well into the future.
Tracking your progress also becomes a fun challenge. Can you beat your last month’s savings? Can you top your goals? Did your net worth jump up more than you expected? With the plan in place, you know it’s possible.
These steps will take time! Just having a clear overview of the steps you need to take will help you move forward.
- Visit the resource library and download the Checklist to FI printable. This will help you stay on track, monitor your progress and stay motivated to move through the steps.
- First you need to track your expenses and know how much you spend every month vs. how much you earn. Visit How To: Track Your Personal Finances to do this.
- Once you know where your money goes every month, establish a budget so that you can control those expenses where you direct the money you have left over for your financial goals. Visit The Beginner’s Guide to Creating a Budget You Can Stick To.
- Based on your budget, determine how much money you have left over for debt payoff and savings. When you compare this to your income, you have your savings rate. How to Calculate Your Savings Rate – And Why You Need To to calculate this. If your savings rate is too low, go back over your expenses and look for ways to cut back. Also consider ways to earn extra income.
- Then you need to list all of your debt and decide how you want to tackle it. Snowball or Avalanche method? Visit How To: Payoff Debt – Like a Boss
- Download the workbooks for these steps over at the resource library.
- Start tackling that debt and add a little to an emergency savings account.
- When debt is wiped clean, start working on that emergency account.
- Now you get to make your plan! How soon do you want to retire? This will help determine how aggressive you need to invest, how you will invest and whether you should consider a side hustle.
- Once that is taken care of, move on to long term savings and investing. Now you are on the path to FI!
- Where are you on your path to FI? What areas do you struggle with? Let us know by commenting below!