Professional pilots, surgeons, and other professionals have used checklists for years to prevent the kinds of insidious errors that can cost lives. At compounding returns, we believe the financial well being of your family is absolutely essential and so we have developed a checklist to financial freedom that seeks to prevent the very mistakes that could have long term negative consequences on your finances.
- Determine your net worth. This is the first item on the checklist for two reasons. Number one, it forces you to reconcile all of your accounts, the worth of your property, your debt load, and your savings while providing you with a starting point on your journey to financial independence. Second, it is an eye opening exercise, that will provide you with a concrete evaluation of where you stand and give you a number against which to evaluate your future success.
- Create a budget. Budgets come in many shapes and sizes. The most important thing is that you develop a budget that works for your family. It is absolutely essential that you know how much you are making, and how much you are spending. Without this knowledge, you will never be able to live below your means and begin saving aggressively for the future. Mint.com offers a great way to create a budget and track your monthly spending.
- Determine how much you owe. If you successfully completed the first item on the checklist, this should be fairly easy to do. Look at your level of indebtedness, and create a plan for paying off your debt. The Total Money Makeover: A Proven Plan for Financial Fitness
offers some very simple, lifelong strategies for getting out of debt and staying out of debt. Before you can start attacking your debt, however, you must know how much you owe, and to whom.
- Stop relying on credit, live within your means. You will notice that many of the items on this checklist build on one another. Without a detailed budget, it is very difficult to live within your means, especially if you use credit cards for daily expenses. At compounding returns, we believe that for those who are stuck on the debt treadmill, the most important first step is to stop using credit to finance a lifestyle that you cannot yet afford. If you find yourself sinking deeper in debt, the first step is to stabilize your current debt load.
- Pay off non mortgage debt and resolve to live debt free. Living debt free is an absolute must in the checklist to financial freedom. Dave Ramsey calls debt "slavery" in The Total Money Makeover: A Proven Plan for Financial Fitness
- Determine if you require additional education or training. It is no secret that additional education can significantly increase your earning potential and job stability. See Education: The key to a rich future for an analysis of how much higher education can benefit your family. (Based on BLS statistics) As we know, education is expensive. Finding ways to reduce the financial impact is extremely important. Local community colleges, state universities, and online education are all excellent ways to reduce the economic burden that traditional higher education can impose.
- Ensure your family is properly covered for emergencies. Being properly covered for emergencies includes building an emergency fund, and insuring your family and possessions. Health insurance is a must, as are renter's/homeowner's insurance, car insurance, and life insurance. The amounts of coverage that you need will vary, but these products are absolutely essential to long term financial security. An emergency fund is like a personal insurance policy. If you have followed the steps in Dave Ramsey's book The Total Money Makeover: A Proven Plan for Financial Fitness
- Start saving for individual purposes. Nobody said you cant have any fun. In fact, research has shown that an occasional splurge can help you stay on track with your financial goals. compounding returns recommends starting itemized individual accounts in a high yield online bank for just this purpose. Examples: Vacation Funds, Christmas Gift Funds, etc. Divert a monthly amount to these itemized accounts- even $10.00 a month will add up over time, and will keep you from financing your splurges with credit.
- Start investing for the future. We all look forward to the day we can hang it up and retire. But very few of us have a concrete plan to make that happen. With the current state of the economy, it is becoming more doubtful that any of us will be able to bank on Social Security providing for our needs in retirement. If you aren't already contributing at least up to the employer match in your 401K, the time is now. After contributing the employer match in your 401K, consider a Roth IRA. You can invest $5,000 after taxes per year in these tax sheltered accounts, and withdraw the earnings at age 59 1/2 without paying any tax. Got kids? 529 plans offer an excellent savings vehicle for funding their education. Helping your kids get through college while minimizing their student loans is the greatest financial boon you can give your children.
- Save for a down payment on a home. Remember those itemized saving accounts? Time to start a new one. Seek to save at least a 20 percent down payment for your first home. When seeking a first home, consider mortgage rates and cost. At compounding returns, we recommend a 15 year mortgage on a home that costs no more than 2 times your annual income.
- Work hard for promotions, raises, and bonuses. The more you make, the easier it is to save for the future, while having a little more money with which to splurge. Look at the most successful people in your field. Seek to emulate those individuals, and reap the financial rewards.
- Buy your first home. The purchase of a first home should be one of the most thoughtful decisions of your life. Recent history has proven the folly of attempting to make a quick buck from real estate capital appreciation. At compounding returns, we believe a home is a place to live, not an investment vehicle. With that said, take your time in determining the best location to buy. Look at schools, environmental quality, crime rates, accessibility to health care, and all the other little things that will make you happy in that home for many years. Remember that the purchase of a home is not a get rich scheme, but a long term strategy to reduce monthly expenses.
- Find out how much you will need to live comfortably in retirement. Some people call this your "number". Generally, this is the annual amount of your pre-retirement income that you will need to replace. This calculation will take some time, as there are many factors to consider. The number may be considerably less that your current income. Ideally your home will be paid off by retirement, so you will have no mortgage costs. Since you have no one to impress, your budget for stylish work clothing will go down. As you won't be commuting to work on a daily basis, your transportation costs will drop. Consider these and other factors unique to your situation to determine how much you will need. Most financial planners recommend withdrawing 4% from your retirement accounts per year so as not to outlive your money. If you can live on $40,000 per year and have no other sources of residual income, then you will need $1,000,000 in your retirement accounts. This number may be less if you have a traditional pension, are eligible for social security, plan to work part time, etc. We recommend using a compound interest calculator to determine the amount you must save monthly to achieve this number.
- Rebalance your investment portfolio as you near retirement. Consult with a Registered Investment Advisor or Certified Financial Planner as you get nearer to retirement to determine a strategy to reduce risk and create a plan for drawing on your nest egg. If you want to delay this meeting, target date funds are a good strategy; but be sure to keep an eye on expense ratios.
