This week, we’ll learn what to do with the surplus. “That cash is your ticket to financial freedom,” Hamm explains. “And the more you can get each month, the better off you are.” The goal is to manage the money sensibly so it continues to grow. To do so, we need to start with the following:
1. Pay off all high interest debt.
Start by making a list that shows the name of each debt, how much you owe, the minimum payment, and the current interest rate. Then call the companies to negotiate a lower rate. You could also consolidate your debt to a card with a lower rate, use a personal loan, or tap your home equity line of credit. But remember to be careful with these options and get professional advice before deciding on which is best for you.
The next step is to rank the updated list from highest rate to lowest rate. While followers of David Ramsey might prefer to rank on balance since the motivation from paying off one card will spur you on, ranking on rate is mathematically best. Flexo agrees: “You’re already motivated – and it could well be your emotions that got you into this mess of debt in the first place. Leave your emotions at the door and get out of debt the quickest, cheapest, and most efficient way possible.”
Use the money from the surplus to make extra payments into the debt at the top of your list (while you continue to pay the minimum on all others). This is the simplest way. “It’s not very exciting to tell people you decided to spend less on other things so you could pay off your debt,” Ramit Sethi admits. “But it works.” When you’ve paid off one debt, cross it off the list and celebrate (without spending money!) before channelling all this money to the next one. Once you’ve repeated the process and paid off all your high interest debt, learn how to use credit cards wisely so you don’t mess it all up. Most importantly, don’t close the account as this will affect your credit profile. Continue to charge frequent small amounts (that you automatically pay off in full) to keep them active.
2. Build an emergency fund.
“An emergency fund is an amount of money you keep in a savings account that’s intended to be used in the event of a major crisis,” Hamm explains. The suggestion is to have a month and a half of living expenses for each dependant in your household. Building this can start with a small transfer to your savings account every week. By keeping it automatic, you don’t have to worry until you need the money (for a real emergency only). “It’ll keep stress out of your life and make the crisis easy to manage without falling into debt.”
3. Max out retirement.
The amount you need to set aside depends on a number of factors so it’s best to meet with a financial planner or attend a retirement meeting at work to analyse your situation. Hamm suggests saving a bare minimum of 10% of your income and contributing at least enough to get the maximum company match. He also suggests limiting your exposure to a maximum of 5% in any one company’s stock and using a target fund that will become more conservative as you approach retirement.
4. College savings?
College tuition can be quite expensive so it’s best to start saving as soon as your child is born. Check out 529 plans if you’re in the USA or other options for your respective location. Just get started!
5. Pay off all debts.
This means getting rid of car loans, student loans, and your mortgage. You could follow a similar principle to that for high interest debt.
Last but not least, you need to invest. Hamm suggests avoiding individual stocks “unless you’re quite content to lose the money” or do research for hours on end. Yes, some individual investors and mutual fund can beat the market on a consistent basis, but commissions and fees eat into the returns making them ultimately underperform. Plus, finding these people and hoping their success continues is hard.
He opts for low-cost broad-based index funds instead. Sethi concurs: “People think that investing means buying stocks, so they throw around fancy terms like hedge funds, derivatives, and call options. Sadly, they actually think you need this level of complexity to get rich because they see people talking about this stuff on TV each day. Guess what? For individual investors like you and me, these options are completely irrelevant.”
Stick to the basics (investing for the long-term) instead of trying to get in on the next exciting thing. You don’t want to get burned all over again.
If you enjoyed this post, please remember to Like, Tweet, and Share it using the links at the top or bottom of the page. And remember to subscribe to free alerts or follow me on Twitter to be notified when the next instalment is released. For more on the subject, download free copies of Investing with the Pros and The Beauty of Debt.