In Part 1 of the Core Fundamentals series (What’s Your Motivation?), we addressed the importance of motivation, which serves as the catalyst needed to help us achieve our goals. Before developing a road map on how to get from Point A to the finish line, I’d like to first address the very important topic of debt. Eliminating any outstanding ‘bad’ debt is crucial if we are to have any hopes of achieving early financial independence. You can think of eliminating debt as a precursor, or warm-up lap prior to us starting our intended journey, the marathon.
Debt should be eliminated, or avoided whenever possible, but not all debt is created equal. For example, it is perfectly understandable and in many cases absolutely necessary to take on student loans to fund college. Moreover, it is generally much easier to get through college without a car, but reliable transportation is imperative once you land a job… and want to keep that job! The train or bus may simply not be reliable enough to consider as an alternative. You may decide that you need to take on a loan to payoff a new car.
So, now you have student loans, and car payments to make every month. Let’s not forget: rent, groceries, internet, utilities, cellphone, etc. You know, the day to day necessities. Once you factor that in, how much $$$ do you really have left over for fun and entertainment? If you feel the pinch for cash, you may decide that perhaps the only way to keep your head above water is to rely on credit cards to get you through the month… and worry about the 7% to 36% interest rates another day. Life sure doesn’t get less complicated after college.
So, how do we attack this problem? As an engineer, naturally, the first thing I would want to do is isolate the variables so that I am only focusing on one at a time, if possible. Basically, you can’t solve for x, y, z, alpha, beta, and gamma all at once. As a starting point, I would say:
Step 1: Assess where you currently stand
Before working out a budget, you first need to know how much money you bring in each month. After accounting for the ‘necessities’, you’ll have a good idea of how much cash you have left over to finance a car, take on student loans, or any other high-cost items.
When I first started working full-time, I was initially an engineering intern. I was making $1500 each paycheck, or $3000 a month after tax. Here is what my monthly expenses looked like:
*Cell Phone: $50
Total Monthly Expenses: $813
Take-Home Money : $3000
*Do not remember exact bill; using February 2012 Monthly Expenses as rough estimate
This left me with $2187 left over each month, not factoring in additional spending for fun and entertainment. Since I was just starting out in my career, I had many wants and needs. Particularly, for expensive items that required more careful planning. I wanted a new car. I felt like I needed to go to grad school. Now that I had an idea of how much money I had left over each month, I could concentrate on forming a realistic plan to accommodate these items.
Note: If you don’t have anything left over and are already in debt, I would suggest paying that off first before evening thinking about adding in a big-ticket item to your monthly expenses. On the flip-side, if you don’t see the need to take on such big-ticket items (ones that involve financing / monthly payments), you can skip to Step 3 or Step 5. Job well done!
Step 2: Bring in more than you spend
Once you’ve calculated your take-home pay, you have a good idea of what your ceiling is. This means you should not over-allocate and spend on items you cannot realistically afford. Using credit cards to finance expensive items at interest rates of 7% to 36% is probably a bad idea. Debt is a huge hindrance to the early financial retirement plan. Not only does it limit the amount you have available for investing, but it also consumes a lot of time to pay back. High interest debt is compound interest working in the wrong, deadly direction!
With that said, it is still possible to take on big-ticket items that require financing, and still pay it off in a timely fashion. I will demonstrate by presenting a real-life situation I faced myself at 23:
Disclaimer: Investing and early retirement were the furthest things from my mind when I first started working. But you are different, and I hope you can learn from my many mistakes!
I took out a loan of $36,000 to buy a new car and an additional loan of $16,000 to pay for graduate studies. In retrospect, this was a very poor decision I made. Looking back, I would now much have preferred to purchase a cheaper, used-car and used the monthly car payments to invest. At the time, I had my reasons for making these commitments, though you can obviously reduce costs by picking a cheaper car / school program. But by adhering to the above rule, I was still able to pay back all of my debt, and never did I have to resort to additional financing using high interest credit cards.
Car Payment (each month for 3 years; includes < 1% interest rate): $1200
Student Loans (each month for 3 years; includes 4% interest rate): $445
Monthly Expenses: $813
Total Monthly Expenses: $2458
Take-Home Money : $3000
As you can see, even with the additional payments I was making due to the car and student loans, I was still bringing in more income than I was spending. This is very important! Although my situation wasn’t ideal (I spent too much on that car!), I still made sure not to take on more bills than I could pay. As a result, I was able to pay off both loans in 3 years. In addition, I had a little bit of money left over to invest in a 401k and Roth IRA. Sadly, I did not have enough left over to fund a taxable account (live and learn).
Although, had things gotten really tight, I did have the option of re-financing both the car and student loans (at higher interest rates but spread out over the course of more years). Always keep your options open. Downgrade if necessary to reduce costs. Do anything to keep your head above water!
Step 3: Reduce Costs
Now that you have a strategy in place, and can afford to make monthly payments without needing to finance through credit cards, you are ready to look for areas to reduce costs. Here are some ideas:
-Find additional roommates, if you don’t mind.
-Temporarily move in with family. This is usually ideal right after college. You can save a fortune by not having to pay rent.
-Get a family plan and save on costs
-Forsake a data plan and get by with just basic service and text
-Buy in bulk
-Bring lunch to work
-Take advantage of any free drinks, coffee that work may offer
-Reduce driving, try walking or biking more often
Step 4: Make Liberal Repayments
I am not a fan of trying to juggle too much. Use the extra money you saved in Step 3 to pay off any remaining debt. If you are fortunate and get a pay raise, bonus, or if any other windfall comes your way, I would also suggest using this to pay off the above big-ticket expenses as soon as possible. For the most part, I would say, don’t worry about investing until your big-ticket debt goes to zero (unless you have near 0% repayment interest rates) and the only expenses you have are monthly expenses.
Step 5: Invest!
Once the debt has been cleared off and you are down to just basic monthly expenses, you should have sufficient funds to focus on investing. This is now the time to focus on developing an investment strategy to help you reach your goals of early financial independence. Congratulations, you’re ready to start the race!
Additional Disclaimer: I did not include taking on a mortgage in the big-ticket item list. A mortgage is more like a ginormous ticket item 😉 My own view is that you should probably start saving up for a down-payment in parallel to Step 5: Invest! I personally wouldn’t feel comfortable with entertaining the concept of leveraging with so much debt still lingering around.