Debt and savings are directly linked. Every dollar you have to pay toward debt is a dollar you can’t put into savings.
Making your money work for you—investing plenty of savings in instruments that will pay returns that one day will support you—is key to building financial freedom. The only way you can get off the day job treadmill is to get out of debt and stay out of debt. In that respect, debt really is slavery: for those of us who are not wealthy at the outset, indebtedness means we must keep working to pay our bills. At the same time, debt sucks our savings away from us, keeping us trapped on the treadmill of never-ending labor.
My argument is that you don’t have to be rich to be free. Instead, you need to build a comfortable lifestyle that does not require large amounts of cash flow, you need to be out of debt, and you need to establish several sources income (dividends from savings; side jobs) to help you build wealth.
The truth is, too many Americans literally are saddled with debt. The consequences of this have become obvious since the crash of the housing market: something between a fifth and a quarter of Americans owe more on their mortgages than their homes are worth. This issue has become so aggravated that many people who can in theory afford to continue making payments are choosing to simply walk away, rather than continue to throw good money after bad.
So: obviously, the best course of action is to avoid debt. When buying a house, select one whose cost is low enough that you can pay it off in 15 years or less. And in day-to-day life, never charge more on a credit card than you can pay with your current month’s income.
All of which is easier said than done.
If you’re already in debt, step one on the road to financial freedom is to unload all revolving debt. Get rid of any department store and credit card debt—if it’s not mortgage debt, pay it off now. Any number of personal finance gurus provide lots of advice on how to get quit of debt. Dave Ramsey is probably the most popular, with his “snowball” approach to pay-off. I’m partial to “snowflaking,” proposed on the now dormant blog, I’ve Paid for This Twice Already. PT’s strategy sets a certain monthly payoff amount that exceeds the minimum required payment, and then she adds every bit of “found money” and every windfall, no matter how small. These “snowflakes” are paid against the debt immediately, as they happen.
In fact, getting out of debt is not so complicated that you have to subscribe to a guru’s system. All you need are will power, a goal, and consistent, regular payments against principal. The strategy goes like this:
1. Quit charging. Even if it means you have to parcel out your paycheck in cash secreted in envelopes to cover budget items, do not put anything on a charge card that has a balance due.
2. Pay substantially more than the minimum due against all charge-card and car loan balances. If possible, consolidate credit-card debt onto one card and pay that down as fast as you can.
3. To accomplish this:
a) Live frugally. Economize tightly until you can get rid of the debt.
b) Develop a second income stream and devote all of it to paying off debt.
The immediate goal, of course, is to get rid of noxious debt that cuts your buying power. Every penny you pay in interest for something you bought on time reduces the value of your dollar. So, if you’re paying some bank 21 percent for the privilege of buying things on its card, every dollar you spend on the merchandise is actually worth only 79 cents. That’s how much credit-card debt shrinks your standard of living!
But the long-term goal is freedom: financial freedom. Once you’re rid of revolving debt, you can work toward buying your shelter free and clear. And when you have that, you’re more than halfway to the exit from the day job.
After you’ve succeeded in paying off credit-card debt, it’s time to shift strategies. Now you have a newfound cash flow: the chunk of cash that was going to pay creditors is coming to rest in your bank account!
Hawai’i beckons. But resist the call.
Instead of diddling away your new real income, continue to live below your means. When using credit cards, never charge more than you can pay at the end of the current month’s billing cycle. If you find you can’t control spending on cards, then pay for everything in cash. This strategy will maximize your actual income. Instead of holding your salary less what you owe to lenders, your bank account will contain…yes! Your salary. Your whole net salary.
By living below your means—a habit you’ve already developed while paying off the cards—you will accrue money to put into savings. Take all the money you were spending on servicing debt and stash it in mutual funds. Some should be in a stock fund, some in a bond fund, and some in cash (i.e., the money market, CDs, or treasuries). This creates a kind of hedge: as a general rule, when stocks are up, bonds go down; when stocks go down, bonds rise. Because you earn more in the stock market, over time, than you do in the bond market, it’s a good idea to have somewhat more than half your investments in stock funds. To avoid being ripped off by fees, choose a low-overhead mutual fund issuer such as Vanguard or Fidelity. Arrange for dividends to be reinvested, and at the same time send in a set amount to each fund every month.
Do this above and beyond any 401(k) or 403(b) plan your employer offers. If your employer matches your retirement contributions, do not neglect to participate in the job’s plan. Even if there is no match, a 401(k) or 403(b) may allow you to contribute more pre-tax dollars than you can put into a regular IRA. Check. Also find out if you can put money into a Roth IRA, and if so, how much. Roths are preferable to regular IRAs because, even though you fund them with after-tax dollars, you don’t have to pay taxes on their earnings and you can pass the money to your children without having the government take the lion’s share.
In any event, the point is to get yourself into as many savings schemes as you can. If your employer offers a savings or a pension plan, by all means enroll in it. But also save and invest on your own. Your employer’s plan should never be your only investment.
At this point, you have laid the three building blocks for financial independence:
1. Live below your means.
2. Develop more than one income stream.
3. Save and invest all funds not needed to cover living expenses.
You now have only one remaining challenge: Get a roof over your head that costs you close to nothing. Once you have that, financial freedom is within your grasp.
More, then, to come…