Personal Finance Basics: Step 2

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Step #2: Improving Your Personal Finances

In Part 1 of this series, I discussed the importance of getting a grip on how much money has flowed into and out of your life. You had two choices on getting started:

• Calculate your net worth

or

• Calculating you lifetime after-tax income and compare it to your total present-day account values.

We start here to paint a very clear picture and teach you just how inaccurate your lifelong story about money truly is. You need to understand what your previous money management routine has yielded because it creates an excellent way to track where all your money has gone over your earnings lifetime.

The first step of this program was to find out how much your worth. Now what? Step two has three phases - debt elimination, emergency funds, mortgage payoff.

Phase 1 - Debt elimination

If you are in debt, and have a negative net worth, there is no such thing as good debt vs. bad debt. 

It's all bad debt if you owe more than you have saved. If you are living beyond paycheck to paycheck, stay away from borrowing any further. Slowly begin to turn the ship around on your debt. Start with all forms of debt except for your mortgage ​(that comes later).

Begin with the debt snowball or debt avalanche methods. They have been hashed out in great detail and people love Dave Ramsey's Total Money Makeover book for strategies on how to kill debt as quickly as possible. To that end, I will not repeat what others have already outlined better than I. Go read Dave's book or Google search "debt snowball" or "debt avalanche" to pay off all forms of debt except for your mortgage. 

Phase 2 - Build Emergency Fund

Age old wisdom advises 3-6 months worth of expenses in your savings account. That is your emergency fund. If you have had difficulty with savings in the past, especially if you have accumulated a history of significant debt, then aim for 12 months of expenses in an emergency account. History tends to repeat itself and the larger cushion you have the greater space you put between yourself and toxic debt. 

Above and beyond your emergency fund, maximize your effort to phase 3 (highlighted below). 

How much for an emergency fund? Anywhere from 3-12 months worth of expenses. The way to decide where you fall in the 3 to 12 month spectrum is being honest with yourself about your previous spending and saving habits. If you have never owed significant debt and are already a disciplined with your savings, 3 months works out just fine. If you previously owed more than $100,000 (excluding your mortgage), aim for closer to 12 months in an emergency fund. 

To has this out further, let's use an example. Say you previously had $25,000 in student loan debt and $30,000 in car debt, after you pay off the full $55,000 consider having 6 months worth of expenses in your emergency fund (right in the middle of our 3-12 month range). If your monthly expenses are $2,000, you would want to accumulated $12,000 in savings and/or checking accounts to fully load your emergency fund. This is not money earmarked for spending however. You are not to touch your emergency fund unless there is a major repair, accident, or true emergency that requires immediate cash-flow.

After eliminating all forms of debt (excluding your mortgage) and building 3-12 months in an emergency fund, the next step is to finish off your mortgage debt.

Phase 3 - Mortgage Payoff

Many self-proclaimed professional money managers disagree with this one. However, consider that the average person who takes the full 30 years to payoff their mortgage pays 2.5 times as much for their home as the original listing price. 

Even in a market with all-time low rates under 3%, the effect of interest can be brutal when factoring the full cost of homes. Consider that the average American has $202,284 in outstanding mortgage debt according to Experian. Even at historically low rates of 3%, that can be $6,000 per year in interest alone early in your mortgage due to the typical amortization schedule. By the same schedule, nearly all of your initial payments for the first few years of a mortgage go towards interest payments. This means you will initially live in your home without actually paying down your principal whatsoever! 

Paying off your mortgage as quickly as possible is like earning a guaranteed rate of return on your money. Early on, you will be getting a rate of return equal to the interest rate on your loan.

I do not make this recommendation likely however, have you ever met anybody who has significant financial trouble who has a fully paid off home? Neither have I. Not yet, at least.

In Closing

Part 2 of this series has three distinct phases. Phase 1, eliminate debt excluding your mortgage. Phase 2, save 3-12 months in an emergency fund. Phase 3, pay off your mortgage in full.  


In part 3 of this series, we will discuss what to do once you have established and completed Steps 1 and 2.

Part 1

Part 2

Part 3