I define financial freedom as having the security and financial resources to no longer need your 9 to 5 job. You may choose to continue to work for a variety of reasons but you could quit your job tomorrow and have enough income to support you for the rest of your life. Isn’t that a thought? Last week I wrote about “owning a business” or buying income that separates your hours worked from cash coming in. This is the way to financial freedom. In one way or another, I think this is everyone’s goal; sip pina coladas on the beach and watch the money pour into your account each month. The good news is that this is possible, but what needs to be done to get there?
Before thinking about owning any business, there are three steps that are required to get to that point. Many people are eager to begin putting their money to work but you can’t begin to think long term until your short term is taken care of. A homeless person living on the street is not thinking about their retirement - they’re thinking about where they will sleep tonight and if they’ll be able to eat. They are ensuring short term needs are taken care of because if they aren’t, the long term needs won’t matter. The same is true for your personal finances. If you lock up every available dollar you have for the long term but have debts coming due in the near term, you will be ruined. Adequately preparing your short term finances frees you to think clearly and rationally about your long term finances.
The first step in preparing your short term is to save 1000 dollars. Keep this in cash or a separate savings account that is accessible quickly. DO NOT TOUCH THIS. This thousand dollars your emergency fund. I’m talking about emergencies like your car breaking down, unforeseen medical expenses, or losing your job. For a catastrophic event, this may not cover everything but for most short-term emergencies, a thousand dollars will get you pretty far. Do everything you can to not use this money. If you get into step two and have to dip into this emergency fund, you need to come back to this step and refill it.
The second step is to pay off your debt (except for mortgages). Just that easy right? Wrong. This is by far the most difficult and time-consuming step. For some, this may be a quick medical payment that’s been bugging you, but for others, it may be a multi year process. Tackling this step requires what people in personal finance call the debt snowball. Begin by listing all debts by size and paying minimum payments on all debts. Allocate every available dollar you have in a given month to the lowest dollar debt. Once that is paid off, take the money you were allocated to the first and apply that to the next highest dollar amount. Continue the process all the way up the debt ladder. A common objection to this is the interest payments may be larger on some than others. Starting with the smallest creates a feeling of momentum and empowerment. The feeling of paying off a credit card is a strong positive emotion and so by accruing several short-term wins, you get excited about tackling larger debts. The feeling of positive momentum is key.
Once all debt is paid off, the third step is to beef up your emergency fund. Depending on what kind of life obligations you have may dictate how large should be. Personally, I raised my thousand dollar emergency fund to six months of living expenses. What that means is that if I had no income tomorrow, I could pay all of my bills (rent, car payment, insurance, gas, groceries, etc) for six months. That money will sit in cash or a savings account in case of an emergency. The six months is arbitrary. For me, a guy that doesn’t have big medical expenses or kids to think about, I don’t need a lot. If you’re a mother or father with other people that rely on you, maybe you make it a year's worth of expenses. Depending on your risk tolerance and short term obligations, this number will vary. You need to decide what is right for your situation.
Once these three steps are complete, you are ready to begin putting your money to work long term. While this not only takes care of your potential short term needs, it provides a mental backstop for investing money in long term ideas. If you plan to retire in thirty years and you have your money in the stock market, there will be MANY pullbacks that decrease the value of your investments. When these happen, and you need that money back, the negative emotion of watching it decrease in value will inspire you to act and pull it out. It’s critical that this doesn’t happen. This is why taking care of the short term is important - you’ll pull out that money at the worst possible time because you’re scared. We want to avoid that at all costs.
When I stumbled into the idea of “debt snowball” I had close to ten thousand dollars in credit card debt and a reasonably sized car loan. Starting with the smallest and working my way up worked for me and so I can personally attest to this process. Like I had suggested early on, you need to drop back a step if you need to dip into your emergency fund. Halfway through paying off my debt, my car broke down and needed close to $600 worth of work to get me back on the road. Knowing I had set money aside for something like this gave me unbelievable mental clarity. Not only did I not need to swipe my credit card again, but I also saved myself a few gray hairs I think. I was in control and ready for it.
Like I mentioned before, money is extremely emotional. I think, in ways, this is more an exercise in building a positive relationship with money. For many people, money runs the show and makes the decisions. I lived paycheck to paycheck for so many years with the constant cloud of worry about the worst possible thing happening. Life isn’t supposed to be lived like that. These three steps put you back in the driver's seat and give you the ability to use money as a tool to achieve financial freedom.