In this post I want to share with you the step-by-step process I used to go from broke (and almost bankrupt) to debt free and on the path of financial independence. In the “My Story” series I told you all about the mountain of debt that I created in my 20s. And in Part 4 I shared my moment of truth when I decided that I was going to turn my financial life around and not look back.
So how did I do it? My wife calls it “Self-Inflicted Poverty” and she uses that phrase every time I say we cannot afford a certain home remodeling project 🙂 I call it “Automated FI”. You see, I’m just not good at following a detailed written budget … it’s not what works for me. When Mrs. BK2FI and I first started on the path to FI, we tried a written budget, including those fancy software thermometers that visually show you how much you’ve spent in various categories throughout the month. It simply didn’t work for us. It led to a lot of arguments about money, and Mrs. BK2FI grew tired of the constant questions about what she bought at the store each day. Realizing that we weren’t going to stay on the path to FI if we didn’t make a change, we decided to experiment with different ways to automate the money management.
The Envelope System
The envelope system of budgeting is championed by financial gurus such as Dave Ramsey. Dave recommends a written budget where “every dollar has a name.” Once you create the written budget, Dave recommends that you place the variable expense money for such categories as groceries, dining out, clothing, household supplies, and gifts into separate labeled envelopes. Each time you need to spend money from those categories, you simply reach into the labeled envelope. When the envelope is empty, you’re done spending for the month in that particular category. “What a great idea,” I thought. “Surely Mrs. BK2FI will go for it.” I couldn’t wait to share this exciting method with her. First, I made a spreadsheet that listed our average spending in every budget category. Next I analyzed the transactions in each budget category to determine how much money we were wasting and where we could cut back. Finally, I established new spending limits for each variable budget category.
Armed with my new budget goals, I sat down with Mrs. BK2FI and enthusiastically shared my spreadsheet. I showed her how much money we had been wasting in our life, and asked her if she could get on board with the “envelope system”. After some convincing, she said she was certainly willing to try it. I was very excited! Mrs. BK2FI even agreed to put together our envelopes for us. “Great,” I thought. “She is really getting on board with this!” I was so proud. But then she showed up with her envelopes. I couldn’t believe my eyes. Was that?? Yes, it was. Mrs. BK2FI proudly presented her debt free envelopes. They were change purses designed by Vera Bradley. My jaw dropped. Mrs. BK2FI was missing the point. It just didn’t seem smart to start the debt free challenge by going out and buying designer envelopes. After much discussion, Mrs. BK2FI convinced me to let her keep them. She explained that she was not going to be standing at the Food Lion check out sorting through tattered paper envelopes. I decided that if making the envelope system fashionable would keep Mrs. BK2FI in the game, then it was totally worth it. I have to say, the system worked very well. For the first time in my life, I was getting ahead. There was money left over at the end of the month and I was finally able to fund my debt snow ball. You see, I had taken all my debts from smallest to greatest and listed them in a spreadsheet. Each month we took our excess cash and threw it at the smallest debt on the list. When that one was knocked off the list, we started attacking the next largest debt. We also used work bonuses to retire the listed debts. We were confident that we were going to stay on track and get out of debt. After a while we were very comfortable with envelope budgeting and even started combining envelopes such as groceries and household supplies. Eventually, we became so disciplined that we moved on to the system we use today….
The Fixed/Variable Expense Account System
- The fixed expense account
Mrs. BK2FI and I have used this system for many years and we love it. We have two bank accounts that serve different functions. First, we have a fixed expense account. Earnings from work go into this account. We use this account for regular, fixed (or otherwise necessary) expenses, including:
- Mortgage payments
- Utility Bills
- Medical Expenses
- Charitable Giving
Because I love to automate, most of my fixed or necessary expenses are paid automatically from this account through online transfers. While these categories are deemed “fixed” or “necessary” we have still worked hard to reduce many of our expenses that are paid from this account (as I will share in other posts).
2. The variable expense account
While we have saved a ton of money by reducing our fixed expenses, the variable expenses are the ones that can get completely out of control if you don’t have a system in place to manage them. Our system is very simple. Twice per month we transfer the same amount of money into the variable account. Thereafter, all discretionary expenses such as groceries, household supplies, dining out, entertainment, and clothing are paid from this variable expense account. When the money is spent, we stop. It’s that simple. You don’t have to keep receipts. You don’t have to reconcile a written budget. You don’t have to have family meetings to discuss expenditures because you are always living within the confines of the variable expense account. You simply rinse and repeat twice per month. You could also opt for weekly transfers if that works better for you. Once a month is probably too infrequent, as it might lead to running out of money too early in the month.
Other Self-Inflicted Poverty/Automated FI Ideas
The envelope system and fixed/variable expense account system were our first Self-Inflicted Poverty methods for becoming FI. As you can imagine, we have learned a lot over the years and have come up with many others. Here are a few ideas:
- Automatic Transfers to Savings
Once you are out of debt, try setting up automatic transfers from your paycheck or checking account for all of your savings goals, including:
- Emergency Fund
- HSA Account
- College Funds
- Non-retirement account savings
If you own a business, you can take this even further by establishing an artificially low paycheck for yourself that forces you to live on less than you make. My partners and I run a very conservative business. We choose to take less than half of our earnings throughout the work year, then take the rest of our compensation at year-end. This discipline has many benefits beyond savings goals. For example, our company always has plenty of money. We never stress out about overhead expenses during the year. We don’t have any money fights. Even better, we can make business decisions in a more calm and deliberate fashion because we are not worried about money.
Whether or not you are self-employed like me, the goal is the same. Accomplish “self-inflicted poverty” and make your savings goals automatic by limiting the amount of money that ends up in your checking account each month. If you automate those transfers through payroll deductions or ACH drafts on your checking account, you will quickly get ahead. If you don’t have the money in your hands, you can’t spend it.
2. Decrease Your Mortgage Amortization
Like most couples in America, when Mrs. BK2FI and I bought our first home, we took out a 30 year, fixed rate mortgage. It is the industry standard and it allows a young family to get into a home with a very reasonable payment. That’s the good part. On the downside, the 30 year mortgage costs you tons of money. If, for example, you finance $250,000 using a 30 year mortgage at a fixed rate of 4%, you will pay $179,000 in interest!!! Let that sink in for a moment.
As we progressed through the stages of financial independence and, therefore, had more cash flow, we became more aggressive on our mortgage debt reduction efforts through refinancing. At first we moved to a 15 year amortization. A couple of years back we went all in and changed to a 10 year amortization! Now, I know there are many financial bloggers who would disagree with this aggressive mortgage reduction. Many say that you should keep the low cost 30 year mortgage and invest the difference in payment. The thinking is that you can obtain a greater rate of return in the stock market than 4%. Although that is mathematically true, it is emotionally difficult to follow through on in the real world. Most people don’t have the discipline to take the monthly payment savings from a 30 year mortgage and invest those funds. Usually, that money ends up getting spent another way.
For us, having 8 years to go on our mortgage means freedom is in sight. We know that our monthly cash needs will drop dramatically once the mortgage is retired. The 4% Rule math gets a lot better when you don’t have a house payment!
3. Maximize Your Tax and Retirement Savings
Another method of Self-Inflicted Poverty/Automated FI is to maximize tax savings by taking full advantage of every provision of the tax code that allows you to save pre-tax dollars. The most famous tax savings vehicles are the 401k and IRA. Contributions to both of these retirement vehicles reduce your taxable income dollar-for-dollar. Even better, you get to save 100% of each dollar you place in these investment accounts instead of using after-tax dollars!
A lesser known tax savings account is the Health Savings Account or HSA. Under applicable law, you are allowed to contribute up to $3400 individually, or $6,750.00 as a family, to an HSA each year. The contribution reduces your taxable income much like a 401k or IRA. But the HSA is even better than a 401k, IRA, or Roth IRA in one important way … you never pay taxes on your HSA contributions or investment returns as long as you use the funds for qualified medical expenses. To maximize the benefits of your HSA follow these steps:
Step 1: Don’t use your HSA debit card. Instead, pay for your medical expenses out of your checking account.
Step 2: Keep all of your receipts for medical/dental/prescription expenses and let them build up until you retire.
Step 3: Allow your HSA savings to compound using low cost index funds.
Step 4: Take the money out tax free in retirement as long as you either (a) use it for a current medical expense; or (b) have an old receipt in storage to match to a future withdraw. That’s right. Your medical expense receipts don’t age out. You can store them up, then use them in retirement to permit tax free withdraws of income from your HSA account.
These are some of the many ways we have used Self-Inflicted Poverty and automation to get out of debt and successfully pursue the path of financial independence. I’d love to hear your ideas!