In personal finance, as in life in general, you have to be you. I didn’t make much progress in my career back when I was trying to strictly imitate others. It finally occurred to me that the only way I would succeed is if I did it my way. Role models are great. Books and blogs are inspiring. But in the end you have to find your own path. Mr. Moneymustache and the Mad Fientiest have incredible personal finance blogs that have certainly motivated me and countless others, but the winding road I have traveled toward financial independence doesn’t resemble their paths in many ways. If Mr. Money Mustache saw some of my annual spending totals he would punch me in the mouth! And there is no way Mrs. BK2FI would ride a bicycle to buy groceries (she asked me to share that). If the Mad Fientist reviewed my investing history and all of the mistakes I’ve made, he wouldn’t let me in the lab with his guinea pig! Even so, I figured out what worked for me and my family and have stayed the course toward financial independence for 15 years!
Much like the famous Tour de France, the road to financial independence has many stages, and it is best to focus on one stage at a time to avoid getting overwhelmed. No matter the stage, I have always followed the same three steps to conquer it:
- Read – study all of the great resources that are out there, including both educational and motivational material.
- Listen – take time to find relevant podcasts and youtube videos from others who have been through the challenges you are facing.
- Personalize – after you study and listen to all the other writers and speakers on the challenge ahead, figure out which methods and tools work best for you.
The stages on the road to financial independence include the following:
Stage 1: Stop Borrowing Money and Get Out of Debt
You can’t effectively fill in a hole while you’re busy digging it deeper. When you start the financial independence race, it is important that you STOP borrowing money unless you are buying a home. Even then, I recommend a 15 year mortgage so that you can retire that debt as quickly as possible. In my case, ending the borrowing spree was easy because I didn’t having any credit left by the time I hit rock bottom. However, as I have cleared stages along the path to FI and restored my credit, I have resisted borrowing money unless absolutely necessary.
After you stop borrowing, you should focus all of your available dollars toward paying off unsecured debt. However, before you get started on the challenge of wiping out your debt, it is wise to set aside enough money so that a small emergency such as a heat pump or car repair doesn’t throw you off course and force you into borrowing more money at high interest rates. I’ve made that mistake myself. I can vividly recall standing in an auto repair shop trying to cover the repair by spreading the costs across three different credit cards that were nearly all maxed out! How much money do you need in your “mini-emergency” fund? That depends on your particular circumstances. Is your car on its last leg? Is your heat pump making funny noises? The point is to make sure you don’t get derailed early in your debt reduction journey because of a small emergency.
There are many strategies to reduce debt. Some people use detailed monthly budgets and keep all of their receipts to compare their actual expenses to the budget. Others use software or website services to automatically track income and expenses, such as Quicken, Personal Capital, and Mint. Still others use multiple bank accounts to separate fixed expenses from discretionary expenses and make regular monthly transfers into the discretionary account to control spending (more about this method in later posts). Financial gurus such as Dave Ramsey suggest an envelope system, whereby the line items from the written or electronic budget for clothing, groceries, dining out, and general household spending are placed in separate envelopes each week (or month). When the envelopes are empty, the spending stops. Studies have shown that people spend less money when they use cash. The pain threshold is much higher when you have to pull out a crisp twenty and lay it on the counter. Ultimately, the best method is the one that works for you and keeps you on course. In my next post I’ll give you the step-by-step details on how I’ve managed my cash to get out of debt and build wealth.
Stage 2: Financial Stability
After you have successfully cleared Stage 1, you should build up a fully funded emergency fund. The rule of thumb advice is 3-6 months’ of living expenses. Others suggest as much as 12 months’ worth of expenses. What is the correct answer? You probably guessed this one … it depends on what works for you. Factors to consider include, among other things, the nature of your employment, the stability of your income source, and the likely length of unemployment you would face if you suddenly found yourself out of a job. I can tell you from personal experience that you sleep much better at night when you have an adequate emergency fund for your family’s needs.
Stage 3: Saving for Retirement
If you’ve reach Stage 3, great job! You should be proud of your major accomplishment! Sit down and take a breath … celebrate your victory! When you’re done, get ready for the fun stuff. Although debt reduction and saving both positively affect your financial statement, I find that saving is the most rewarding side of the equation for sure. What percentage of income should you save each year? That depends on how long you want to work. The chart shown below reveals how many years you have to work based upon your personal savings rate and expected rate of return:
For example, if you save the routinely recommended 10% of your income and get a 6% rate of return, you will have to work approximately 40 years to retire! On the other hand, if you nsave 50% of your income, you can retire in less than 15 years!
The “4% rule” is probably the most popular measure of retirement readiness. Academic studies such as the famous Trinity Study have demonstrated that you can safely fund a long term retirement by living on an amount equal to 4% of your nest egg each year. For example, if you need $40,000 of income per year in retirement, you simply divide $40,000 by .04, which results in a nest egg requirement of $1,000,000! Stated another way, you need approximately 25 times your annual expenses (i.e. 25 x $40,000= $1,000,000) to retire.
If you can live on $24,000 per year, then you would need a nest egg of $600,000 ($24,000 x 25= $600,000).
Like all financial decisions, they are yours to make. Some people love their jobs and can’t imagine ever retiring! Others wake up depressed everyday when they hear the alarm clock and know they have to face their office cubicle/prison another day. Personally, I would like to be able to retire at 50. I am in my mid 40s now and, as you know, I’m running behind on my early retirement quest due to the disastrous financial mistakes I made in my twenties (see My Story). In any event, I am definitely on target to meet my goal!
Stage 4: Saving for Colleges
Once you are hitting your retirement savings goal every month, it is time to turn your attention to college funding. The reason for establishing good retirement savings habits before tackling college savings is obvious — no child should want a college fund if it means their parents will some day be needing to move in with them due to lack of retirement savings! Do you have to fund a college fund for your kids? It’s up to you. I have friends who proudly proclaim that they won’t fund their kids’ college even though they means. They argue that it is better for kids to borrow for college and feel the full weight of that responsibility. Personally, I incurred approximately $100,000 in school loans, which really put me behind in life and contributed to my financial failures in my twenties. Lord willing, I hope to be able to provide college funding for all 3 of my kids so that they will be able to hit the ground running on their FI savings effort as soon as they get that first job after college.
Stage 5: Financial Independence
Last, but certainly not least, is the financial independence stage! You are financially independent when you have sufficient passive income and investments to fund your standard of living without having to perform paid work. At this point, you will have total freedom to use your new found time. Do you want to pursue that lifetime passion that doesn’t generate income? Go ahead! You can do that. Would you like to do volunteer work? Go for it! Personally, I want to flip houses, blog, write books, travel, write and perform more original music with my friends, and do mission work in my community and around the world.
Many bloggers talk about having “FU Money” that empowers them to quit a dead end job, bargain hard for a promotion, or take a year off of work to travel the world. While having “FU Money” is a great feeling, having BU Money is even better. When you have saved 25 times your annual expenses, you will finally have the freedom to really be you and pursue your dreams and passions!
Conclusion: Do you have BU Money? Why not start on the path to financial independence today? Just remember the three steps to conquer every stage: Read, Listen, and Personalize! Hope to see you at the finish line.