Work towards rapidly moving out of living salary-to-salary and start building net worth. Every month, put some amount of money apart for later. This can be a percentage like 10% or an amount like €200. You should have estimated your financial Enough and work from there. Automate as much as the cash flow as possible so you don’t have to (re)think about it.
Your finances are water buckets. Buckets because they have a fixed size and can overflow when reaching the rim. Water because your money will flow abundantly when you follow this system. We will define financial buckets and their size, and see how they will overflow into the next. Some situations might become more complex, as a bucket might not overflow into one next bucket, but split up into multiple targets with differing contributions.
Your financial buckets are the emergency funds, employer retirement match, high interest debt, bridge funds, low interest debt, retirement contributions, large purchases funds and investments.
The emergency funds are used for unforeseen costs that should be dealt with rapidly. Your car broke down and you need to get it fixed to get to work. Your washing machine broke down. You got a fine. Around €1.000 should be sufficient, but decide what you’re comfortable with. It’s fine to cover just 1-2 emergencies, as this fund is the first to be topped up with your next monthly income anyways. You want to access this money quickly in case of need, so use a savings account for this.
The employer retirement match is a no-scam, no-risk 100% return on investment scheme. Always be careful when you hear such potentially fraudulent claims, so hear me out. Your employer might offer you a retirement match which means that for every €1 you contribute to your retirement out of your own pocket, your employer will also contribute €1 to your retirement out of its pockets. This is in addition to your existing retirement scheme. The only drawback is that there is often a limit per month or year. Pay exactly this maximum match to optimally benefit from this double-your-money-guaranteed deal.
High interest debt is debt with an interest rate of about 10% or higher. This might vary, but in general it is an interest rate higher than you would get by investing. It makes more sense to pay off the debt, than to invest your money in this case.
Paying off debt can be done via the Snowball method or the Avalanche method. With the Avalanche method, you pay off the highest interest debt first, which is the financially better option, but might also be the most demotivating option when the highest interest debt principal is large and paying it off takes a long time. With the Snowball method, you pay off the smallest principal debt first and continue with increasing size. This can soothe the mind and evoke a sense of progress, but is financially inferior. Don’t underestimate the human psyche in dealing with money, personal finance is both about the person and the finances.
The bridge funds consist of 3-6 months of total expenses. When you lose your monthly income for whatever reason, be it being fired or resigning yourself, you have some leeway to find a new monthly income source without stressing out. I think this is one of the first feelings of freedom I experienced by becoming less attached and dependent on an income source. You have to decide your level of security and take your situation into consideration. If you’re a sought after employee and can easily get a new job in this market, you can have less months of expenses saved. If you are self-employed and have highly varying income, you want more months of expenses. Store these funds in a savings account and you’re set.
Low interest debt has an interest rate of around 5%. It is less pressing than the high interest debt, as some other buckets will bring in more return on investment than this debt will cost. At some point you want to get rid of the debt. This might also make you feel psychologically better about the situation.
Retirement contributions differ in countries and continents, but are all based on some kind of tax relief or other financial attractive benefit. These are paid for by you and are different from retirement schemes and employer retirement matches which we’ve dealt with earlier. Like the employer retirement matches there is a cap. Your retirement contributions will be eligible for benefits up until a certain amount per year, and everything above will be considered regular wealth with the normal taxation. This basically makes everything above the limit a regular investment as we’ll see in the last bucket.
Large purchases funds include home renovations, college and other education investments, car purchase, etc. that you foresee in the next 3-5 years. You don’t want a loan for these purchases and the timespan is too short to safely store the money in investments in the meantime. Investments have enough time to average out and grow over 40 years, but over 4 years you could very well have entered a downturn of the market and lose a big portion of your large purchases funds. You can either store this in a savings account or a deposit, which gives a higher interest for a locked amount of time. Come up with an estimate of your costs and make this your savings goal. You don’t have to fill this bucket before continuing to the next one. You can split contributions for example 50% between large purchases and investments.
Investments are for the cool boys, but are also last on this list. It’s the hot talk in town, but the least financially attractive until you’ve filled the earlier buckets. Actually, we’ve indirectly been involved in investments with everything related to retirement as those are investments too. These investments have the benefit of being available before your retirement, so they can be used to retire early. You can also fund purchases during your lifetime. Keep in mind that the longer you let your money grow, the more money it will get you. Don’t spend too much early profit to ensure long term abundance.
Apart from genuinely making barely enough to survive, there is no excuse not to pay yourself first. Chances are your Enough is set too high and if you realistically look at your situation you would agree. You can’t see yourself living with one less car, in a smaller apartment and having to move and going out for dinner less, but you’ll manage when you try. Just admit the mistake of setting your Enough too high and now having to deal with the consequences. Also be glad that you’ve realised now and are still being able to fix the situation, instead of further spiralling downwards.