This money should be kept in an easy access, liquid account such as a money market account or an interest bearing checking account. This money should not be locked away in a CD or in long term investments. This money is for emergencies only. For example, if you lose your job and you need it to pay the heating bill, not to upgrade to an HD TV.
If you have to spend out of this account, you should return to this step and replenish the account to $1000 before moving forward.
Also, you need to be tracking your monthly income and expenses in a simple budget. If you have Microsoft Money or Quicken, great. If not, it doesn’t matter. Use Excel or just write it out on paper. The point is that you need to come to the table on a recurring basis to build this budget. Be detailed and accurate but don’t overcomplicate it so that it becomes a task that you are unwilling to do.
Here are some sample entries to include on your budget:
· Income – the main source from your job.
· Other Income – perhaps you have an auction on eBay this month or a birthday coming up.
· Gas – of course you could cut back here and start taking a bike to work.
· Food – perhaps break this out by groceries and eating out food otherwise known as food-ertainment.
· Entertainment – those movie tickets are not free.
· Miscellaneous – you should always factor in a 5 – 10% miscellaneous category.
· Mortgage or rent – hopefully this won’t exist much longer.
· Utilities – gotta have lights.
You’ll probably come up with more pertinent expenses to your situation which is great. Get as detailed as possible. At the same time, don’t overcomplicate it so that you are driven away from doing this monthly.
2) Get rid of the credit cards, swear off taking out personal loans and frivolous lines of credit, stop leasing cars and pay off all of your debts, smallest to largest.
This has been named by Dave Ramsey as the debt snowball – you quickly knock out the lowest debt and then with that extra payment you attack the next largest, so on and so forth until all of your payments are attacking the largest debt and with the compiled money, you are able to pay it off quickly. At the end of this step, you will have $1000 in the bank and no debt except for your house.
3) Next, you should ratchet up the emergency fund up to 3 to 6 months of your expenses.
This step is solidifying the base of your finances a little more. With no debt, you should pour a little more conrete on the foundation for finanical emergencies. A typical number would be $6,000 to $10,000 but the exact figure will depend on your personal expenses.
To determine this number, you need to make sure you are on the budget. With this budget, you will be able to see your exact monthly expense figure. You will also be able to see a moving timeline of your expenses and you can calculate an average from this. Perhaps for half of the year your expenses are approximately $1,500. For the other half they are $2,500. Your average monthly expense and what you base your 3 to 6 month emergency fund on should therefore be $2,000. In this case, $6,000 to $10,000 would be an ample emergency fund. Your budget will tell you truly what 3 to 6 months of expenses are for you.
4) Next, you should max out all of your retirement savings, chiefly 401k and Roth IRA.
Make sure you contribute at least up to your company match – this is pure gravy and if you can, contribute at least 10%. Your 401k is pre-tax thus all of the savings you invest here get the benefit of a full dollar invested – there is no tax bite taking away from how much you can put down here. These savings grow tax free.
The yang to this yin is the Roth IRA. Here you can contribute post tax but your contributions are not taxed when you begin withdrawal. Having both the 401k and Roth IRA at retirement is a nice compliment because one grows tax free; the other is tax free withdrawals. This would be a sort of hedge if your tax bracket didn’t decrease in retirement as you probably expect it will.
5) Begin mutual fund investments.
Although this is not the only asset class to invest in, it is simply the simplest one to get involved in and relatively, one of the most passive. Yes there are market risks and yes, unless you are heavy on income producing funds you are typically investing for capital gains which can prove to be volatile in the short term. But, acclamate the beginner to the investment world and later if you wish to diversify across asset classes, such as real estate and small businesses, it will be a natural progression.
You will be knocking out your house in the next part and you are already contributing a healthy percent to your retirement savings so, 10% is a decent figure to contribute to mutual funds at this stage. Later, you will be able to ramp it up if you wish.
Select 4 funds, each with a different, diversifying investment strategy such as growth, income, value, an index fund, with a great 5 and 10 year track record (preferably 10 – 15%) and begin socking away some money in these vehicles.
6) Now, pay off the house as rapidly as possible.
At this point, you have no debt, your emergency fund is firmly in place and your retirement savings are accounted for. Scrape together everything you can, down to the last penny and attack the house. With no debt and great savings already in place, you can rapidly pay down your mortgage, far ahead of the 30 year schedule most people are on, and be in a great financial situation. In as little as 5 years you can be entirely debt free, everything including the house.
7) Now if you have a junior or a little missus junior, you should start contributing to their college savings.
The best thing going right now for college savings is the ESA – an educational savings account. Essentially, this is the 401k of college savings, pre-tax investments are made here. To determine how much you should sock away, figure out what the little one’s tuition will cost in 18 years (or whatever little time you have left), factor in the college tuition inflation rate of 4 – 6% and the rate of return you should expect. The end result, you should know how much you need to sock away each month to send junior to Harvard or perhaps a quality, state college.
Now, with the completion of all of the preceding steps, you have the ability to get rich and then perhaps super-rich. Your solid, financial foundation has been poured, you have money socked away for emergencies, you have retirement savings in place, your house is paid off. You can now study up and invest in other assets such as more mutual funds, single stocks, real estate, options, dividend stocks, small businesses and web sites. Be smart and do your homework ahead of time before getting into riskier investments. At the same time, your the foundation has been laid and you are in a great position to build wealth.
A great book to read at this point is Robert Allen’s Multiple Streams of Income: How to Generate a Lifetime of Unlimited Wealth! Second Edition
. You should continue to build in your mutual funds but at the same time you should expand to other asset class horizons.Warren Buffett says, put all of your eggs in one basket and then watch that basket very closely. I still believe in asset diversification but I do not believe that it merely means spreading your money across many different types of mutual funds. I believe you should spread your money across the major asset classes; stocks, real estate and businesses.
Another great book to read is Robert Kiyosaki’s Rich Dad, Poor Dad: What the Rich Teach Their Kids About Money--That the Poor and Middle Class Do Not!
and if you want to get the skivvy on basic personal finance, check out Dave Ramsey’s book, The Total Money Makeover: A Proven Plan for Financial Fitness
.Also, for starting a small business and investing in different asset classes, check out the other posts in this blog ranging from "Why You Should Turn Your Hobby Into a Small Business" to a dividend and call option investing strategy.
Happy reading!
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