Last year, I was invited to contribute to a collaborative book on personal improvement. Each contributor – there were ten or so of us – was charged with writing a section on one aspect of self-improvement. Mine, naturally, was personal finance, so I started to write a ten step guide to turning one’s financial situation around. Earlier this year, the publisher went out of business. After sitting on my portion of the book for six months, I’m sharing the basics of the book section with you. Enjoy!
76% of Americans are living paycheck to paycheck.
50% of Americans have less than three months of living expenses in total savings.
26% of Americans have no savings at all.
Most Americans are walking a dangerous tightrope. A single injury, a single job loss, a single unexpected child, a single automobile accident could very easily unravel their life, causing them to lose their homes, their automobiles, and leave them unable to even get the simplest of loans.
On a deep level, many of those struggling like this are mindful of the challenges. The thought of money is a stressful one and they try not to think about their financial reality. The result of that internal conflict is a feeling of stress, both professional and personal, that pervades life.
The truth is that it’s not all that hard to fix your financial situation. It just requires a healthy dose of mindfulness and a willingness to rethink how you spend money and what value you’re actually getting out of that spending.
I speak from experience here. Just nine years ago, I was near the breaking point, with credit card debt, automobile debt, and student loan debt piled up so high that I couldn’t even pay my bills. I was almost constantly stressed and I could feel my dreams for the future slipping through my fingers.
These ten steps explain exactly how I turned all of that around. Today, I’m debt free. I own my own home. I have enough money saved that I could basically make any career choice I might dream of making without any real risk to the day-to-day life of my family. I spend my time doing work I enjoy doing – and if I didn’t enjoy it any more, I could easily walk away.
Sound good? Let’s look at how to make it happen for you. Before we get started, though, here are six important points to think about.
Financial improvement works hand-in-hand with mindfulness and improvement in other areas of your life. Mindfulness is incredibly valuable when it comes to reshaping your finances because it means that you have a greater capacity for questioning your own spending habits and can catch poor spending choices in the moment.
The greatest value of financial improvement is personal freedom and peace of mind. As you achieve each step in this journey, you’ll find that your money stress will shrink and your peace of mind will grow. You’ll also see unexpected degrees of freedom opening up in your life, as career choices and personal choices that would have never been an option for you are now realistic and even desirable choices.
These steps reflect my own road to financial independence. Over the past nine years, I have followed each of these steps in turn and currently find myself in the process of achieving the final step. These steps worked wonderfully for me. They followed a sensible logical path and each step built on the one before it.
Different people will have already achieved different steps, so feel free to jump in at the appropriate place. If you read the heading for a particular step and know that you’ve already achieved it in your life, move ahead to the next one. Different people enter this journey at different places.
These steps are relatively low risk. The steps I’ve outlined here describe an approach that minimizes personal risk, which is perfect if you have a domestic partner and particularly if you have dependents that rely on you. A person who is single can make the choice to be a bit more aggressive by moving the order of the steps around a little, but everyone should start at the first step because, without that step, none of the others will really work.
If you aren’t willing to question everything you spend money on, you’ll find it hard to succeed. Many of the suggestions below – and many of the suggestions you’ll find elsewhere if you dig around for personal finance help – are going to seem “beyond the pale.” The suggested change will seem so unnatural compared to how you currently live your everyday life that you’ll just shrug it off. When you find yourself doing that, you’ve reached a perfect point for self-reflection. Why are you shrugging off that idea? What are you holding so dear that you won’t even think about it? In order to succeed financially, you must question everything.
Step One – Cut Spending Until You Can Spend Less Than You Earn Consistently
If you want to succeed at turning your financial life around, you have to be spending less than you earn. There’s no way around it. The only way to save money is to spend less than you earn and save the difference.
Here’s : the average American household saves only 5% of their income. The bottom 40% of Americans save less than 1% of their income, while the top 1% of Americans save more than half of their income.
If you want to succeed financially and be free of debts and free of money worries, it has to start by spending less than you earn and saving the difference. The more you can save, the better.
Yes, this step is undoubtedly difficult if you’re not earning a healthy income. Yes, this step is going to force you to make some choices that you might not like making. It’s really hard to give up something cool today in order to have money in the bank tomorrow.
Here are five actions you can take to get a grip on this step.
First, understand what you’re actually spending. Use a budgeting program like to track your expenses for a month or two. Then, take a look at where all of your money is going. Where are you spending it? What are you spending it on? How much of it is necessary?
Second, take a serious look at your big expenses. Could you live in a smaller home or smaller apartment to save money on your rent or mortgage? Maybe you could sell your car and either move to using mass transit or using an old car for a while. Could you eliminate (or seriously trim) your home internet bill? Your cable or satellite bill? Your cell phone bill?
Third, take a serious look at your food spending. Many people drastically overspend on food without realizing it. Eating out – even at cheap places – is shockingly expensive. Work on adopting a smart meal planning system that maximizes smart spending at the grocery store.
Fourth, clean out your closets and sell off some things. If you haven’t used something in a year, it’s probably a smart move to sell it off while it still has value (excepting sentimental items, of course). It’s time to sell off those DVDs, those old video games, and all of that other stuff that’s clogging up your closet. Then, take that money and immediately get rid of a small debt, which then reduces your monthly bills, making it easier to consistently spend less than you earn.
Fifth, use a mental trick to keep yourself from making unnecessary purchases. I’ve found success with the “thirty day rule,” which means that I wait thirty days before making any unnecessary purchase over $10 or so. If I still want it in thirty days, then I know it wasn’t an impulsive decision. Another approach is to ask yourself whether you’d rather have the item you desire of the equivalent amount of cash. Would you rather have an iPad or $500 in cash? If you’d take the cash, you probably shouldn’t be spending that much on the item.
Last but not least, don’t make yourself miserable. If you’re cutting back on things and find yourself regretting and resenting those cuts, you’re not going to make the lasting changes you need to make. Cut back on the things you care less about so that you don’t have to trim as much on the things you really do care about. My approach? I try cutting lots of things, but if I find that I don’t like the change, I don’t feel bad about switching back to my old pattern.
Your energy should be focused on getting your life to a point where it’s natural to have more in your checking account at the end of the month than at the start of the month. When that’s normal, then it’s time to move on.
Step Two – Build a Small Emergency Fund
An emergency fund is a cash reserve that you have around in case of an unexpected event that you can’t handle normally, like a car repair or a job loss. It’s not there to help you out when you overspend.
Many people believe in using credit cards for this. I don’t. Credit cards leave you entirely at the mercy of the bank’s willingness to extend credit to you at the very moment you need it the most. If your credit card is maxed out, you’re in trouble. If you’re dealing with identity theft problems, you’re in trouble. If your credit rating is poor, you’re in trouble. In the end, nothing beats cash.
Another question people have is whether or not they should be paying off debt before having an emergency fund. The problem with skipping an emergency fund and moving straight to big debt payments is that if an emergency happens, you find yourself making negative progress on the debts, which can be incredibly disheartening.
A good target for this step is to build a $1,000 emergency fund in your savings account. $1,000 is an adequate amount to cover most emergencies that will come your way. Naturally, it won’t cover a true disaster like a long-term period of unemployment, but it will ensure that your progress on debt repayment won’t vanish if your brakes start to fail.
Whenever you need to tap the emergency fund, you should make sure to refill it before continuing your progress on later steps. In other words, if your emergency fund doesn’t have $1,000 in it, you should hold back on extra debt payments.
Step Three – Start Building New Income Streams
This step should be done concurrently with Step Two. Your goal here is to make yourself less financially dependent on your primary job.
What’s an income stream, you ask? An income stream is any consistent method you have for earning money. For many people, a job is their primary income stream. Many people also have second jobs, side businesses, or freelancing gigs.
Additional income streams are valuable in many ways. Obviously, they increase your earnings, making it easier to spend less than you earn and also making it easier to achieve other financial goals. They also provide security, as the loss of one income stream becomes much less of a setback if you have other streams to rely on. Not only that, a particularly successful income stream gives you career options that you don’t otherwise have.
Once you’ve reached a point where you’re consistently spending less than you earn, you should turn some of your spare time and energy toward building income streams. Here are a few ideas that might work for you.
Get a part-time job. This mostly just requires time, as most part-time jobs involve an exchange of time and energy for income. There are many part-time jobs available for people interested in working limited hours (it’s the full time jobs that are tricky).
Sell your skills. Do you have any professional skills or additional trade skills that could be utilized on a freelance basis? Look for freelancing positions where you can put your abilities to the test, earning some extra cash and potentially bolstering your resume.
Start a Youtube video channel. Decide on a topic you love, fire up your camera, and share some stories or some tips on how to do it. Upload them to Youtube, turn on advertising, and then share the videos with friends and with people interested in the topic. The more you do it, the better you get at producing interesting videos, which will attract more and more viewers, which means more and more ad revenue.
Start a blog. Most of the same advice that applies to the Youtube channel applies here. Find a topic you’re passionate about and start sharing stories and tips related to that topic. Here’s my primer on starting a blog as a side business.
Step Four – Build a Debt Repayment Plan and Pay Down Your High Interest Debts
If your life is in a state where you are spending less than you earn each month and you have a nice little emergency fund built up, it’s time to start tackling your debts.
The first thing you need to do is establish a debt repayment plan. A debt repayment plan, in simplest terms, is a list of your debts ordered by interest rate, from highest to smallest. This happens after you make an effort to reduce the interest rate on your debts by consolidating debts and transferring balances.
Each month, you make minimum payments on all of your debts, then you muster the biggest possible extra payment you can and apply it to the highest interest debt you have. Eventually, you pay off that debt, so then you cross it off the list and move onto the next debt. The goal, of course, is to pay off all the debts.
Note that this step involves high-interest debt. I define high-interest debt as being all debt with an interest rate above 8%. High-interest debt repayment takes priority over other financial considerations because it’s essentially impossible to get investment returns that can overcome the corrosive effect of high interest debt.
There is one exception, however. If your employer offers matching funds on your work’s retirement plan, you should make that a higher priority than debt repayment. Sign up for your work’s retirement plan and contribute enough to get every dime of matching funds that your employer offers. It’s free money that you just can’t pass up.
Step Five – Start Saving for Retirement
Once you have your high-interest debts under control, it’s time to start saving for the future in earnest. This is the point at which you should begin to save for retirement as though you’re retiring at a reasonable target retirement age. I usually recommend that people shoot for retiring at age seventy due to the much longer lifespans that people enjoy today.
Note, of course, that “retirement” doesn’t have to mean the traditional picture of retirement. It simply means the date at which you expect your retirement savings (along with Social Security) to kick in, giving you much more flexibility in terms of how you intend to spend your time.
Your first tactic here should be to use a good retirement calculator to figure how much you should be saving. I like the myself. Just set the target age to 70, set years in retirement to 20 or 25, and fill in your current age and your starting balance. In the annual contributions blank, put in 10% of your annual income and then hit the “Calculate” button.
Hopefully, the resulting number is one you can live with in retirement. Remember that you’ll also have Social Security income as well. If it’s not enough, then you’ll need to bump up your annual contributions.
Once you have a sense of what your annual contributions need to be, you need to make sure you’re contributing enough to retirement each year. The amount of advice out there on retirement savings is nearly endless and everyone has an opinion on it. The truth of the matter is that simply saving plenty of money is the most important thing, no matter how you do it.
Once you reach this point, I strongly urge you to read a solid guide on retirement savings. Sure, a book on retirement savings might be a dry read, but it’ll be an incredibly valuable one. My go-to book on retirement savings is The Bogleheads’ Guide to Retirement Planning – give it a read when you’re looking seriously at saving for retirement.
Step Six – Build a Large Emergency Fund
Your retirement savings are churning along. You’re spending less than what you earn every single month. Your high interest debts are gone. What’s next?
At this point, it’s time to start protecting yourself against the big things in life, giving yourself a lot more flexibility and peace of mind. It’s time to build a bigger emergency fund.
You should target two to six months of living expenses in your savings account. I suggest having two months for yourself and increase that by another month for each other dependent in your household. So, if you live alone, you would want to target two months of living expenses, but if you have a spouse and three children, six months makes more sense.
The reasoning here is similar to the points stated earlier about emergency funds. Cash trumps credit.
Some people might be tempted to invest this money into something with additional risk, but the point of this money is not to invest it. The point of this money is to keep it secure, safe, and easy to access in a pinch. You don’t want to see your investment bottom out with a 40% loss (like a stock investment in 2008) and then need that money (like the many people who found themselves unemployed in 2008 and 2009). Save your investing impulses for the next stages of your financial journey.
As before, when you need to tap this fund, you should focus on filling it back up before resuming later financial steps.
Step Seven – Save for Major Expenses to Avoid Future Debts
The next thing on your plate are the big expenses that life deals to us on a regular basis.
I recommend saving up for any major expenses that you see coming over the next five to ten years. Are you going to be replacing a car? Save for it. Are you going to be buying a home? Save for it. Are you going to take on a major home renovation? Save for it. Are you going to be launching a business? Save for it.
The exact method of savings is up to you, but you should strive to ensure that you won’t be taking on any new debt in the next five to ten years from anything you can possibly foresee.
Step Eight – Pay Off All Remaining Debts
Once you have a healthy emergency fund and some savings to prevent future debts, you have some nice security and are likely enjoying some significant peace of mind.
This is the point where many financial plans begin to differ. Some will suggest focusing on investing for the future at this point, while others will focus on saving for future expenses.
My approach is to pay off all debts. The reason that I’m such a big fan of debt freedom is just that, freedom. Once you have your debts paid off, you’ve maximized the gap you have between your income and your expenses, giving you a ton of life options. Want to try a different career? Want to move to another part of the country? Whatever you’re dreaming of, it becomes much easier with minimal monthly bills.
My focus is freedom. I will usually choose the most direct and safest route to freedom, and that’s through paying off debt. There’s little risk in that plan and a lot of personal reward.
Step Nine – Start Saving for Children’s Education
For some of you, this might seem surprisingly late. Shouldn’t a child’s education take a higher priority?
The truth is that the best thing you can do for your child is to secure your own future. Your children will have many more sources for money for college – loans, grants, scholarships, their own income, and so on – than you’ll have for retirement. Not only that, debt freedom will give you an incredible amount of flexibility to help them if you choose to do so. This college savings guide from CNN Money explains it well.
You should be on track to secure your own retirement and be free from debt before you start considering helping your children with school. Even then, it’s a personal decision that you need to make. You do not have to save for their future.
If you choose to do so, you should open up a 529 college savings plan immediately for each child you have. The Wall Street Journal has that will meet your needs.
Step Ten – Ramp Up Savings for the Life of Your Dreams
At this point, the future is up to you. What do you want to do?
Do you want to retire as early as possible? If that’s the case, maximize every dollar of retirement contributions and save even more in taxable accounts.
Maybe you want to make a major career shift? In that case, invest in a college savings account for yourself (assuming education is needed) and in a taxable account to cover the expenses during the transition.
Everyone has a different dream. Our dream happens to involve retiring early and spending our fifties and sixties doing volunteer work and working on personal fulfillment projects like writing novels.
What do you want? The world is your oyster at this point.
You’ll notice as you read through this that each step builds upon the steps before it and that, in the end, everything ends up relying on that single mantra.
Spend less than you earn.
Achieving that is trickier than you might think. It requires being mindful of every purchase and being willing to question every dollar that you spend.
The entire world of personal finance revolves around a “spend less than you earn” core. You must figure out how to make it work in your life in order to build wealth and financial freedom. If you learn nothing else about personal finance, keep that one idea firmly in your mind.