OK, don’t freak out … today we’re going to make a financial plan! But it will be simple, and won’t take long.
You’re going to need the Power Amount you’ve been working on. If you haven’t done it yet, do it now. You can do it in 10 minutes (for now â€” add to it later).
Please note that there are two parts to this plan â€” Part I is the emergency fund, and then Part II is going to be either debt payments or investments, depending on what track you’re in. So just skip the Part II that doesn’t apply to you.
Part I: Emergency Fund
If you already have an adequate emergency savings fund, you can skip this part, but if not, please do not skip this!
How do you know if your emergency fund is adequate? Well, can you pay for an emergency trip to the hospital, or pay for your car’s engine breaking down, or an emergency repair to your house? Just from your emergency savings fund, not dipping into investments/401K or your budget for other things? Then you’re probably OK. If not, do not skip this step.
Why is this emergency fund so important? Because you can’t really be consistent about eliminating debt or growing your investments if you don’t have an adequate emergency fund, in my experience. Here’s what normally happens: you find some extra money to put each month towards debt (or investments) … but almost every month, you have to divert that money to an unexpected expense that comes up â€” your kid needs braces, you need a new battery and headlight for your car, your water heater breaks down, and so on. Things come up that we don’t expect.
Here’s the thing, though: unexpected expenses always happen. So we should expect them! And we can prepare for most of them by having at least a small emergency fund to pay for them, so we don’t have to use the debt payments or investments we have planned.
How much should your emergency fund be? Well, that’s very dependent on your finances and what kind of unexpected expenses you’re likely to see in the next few months. Here are some rough guidelines (these are my opinion only, you’ll need to figure out what works for you):
- If you’re just barely scraping by and saving $500 in a couple months seems impossible, set a goal for at least $100 for now. Then increase this slowly by $25 or $50 a month at the same time as you start to pay off your debts. Believe me, this is where I started too.
- If $500 seems like it’s possible but a bit of a stretch, aim for $400.
- If you can easily save $500, make it that.
- If you’re doing pretty well, and can imagine saving one month’s worth of essential expenses (rent, car payment, groceries, utilities), then aim for that.
- If you’re beyond that, then aim for three months of essential expenses.
Again, shoot for what seems possible to you. You can always increase that amount as we go, at the same time you’re putting most of your money towards other goals like debt and investments.
How long will it take to hit your emergency fund goal? It depends on your Power Amount â€” if you’ve found a big Power Amount, some of you might be able to hit the goal this month. Others will probably take 2-3 months. If it will take longer than that, either try to find a bigger Power Amount, work on increasing your income (more on this in a later article), or focus on something that’s possible to achieve in about 3 months.
Note that while you’re putting your Power Amount to your emergency savings fund, you want to try to make the minimum payments on all your debts if at all possible. If that’s not possible, call them to see if you can negotiate a reprieve of a couple months.
ACTION STEP: Automate the savings. OK, now you have a plan for Part I, with a goal for your emergency fund and how long you think it will take. Do you have a savings account that you can use for this emergency fund? If you have a general savings fund (no specific purpose), you can just use that. What you want to do today is set up a monthly (or biweekly) recurring transfer from your checking to this savings account, in the amount of your Power Amount. For example, if your Power Amount is $100, set up a $100 monthly transfer to savings.
Please note that you need to take whatever steps necessary to make sure this amount is available in your checking at the time the recurring transfer is going to happen. Don’t spend this savings amount! If you’re going to cut back on going to the movies to make this Power Amount possible, don’t spend it on the app store or an online music service instead!
Part II (for Debt Reduction): Apply Power Amount to Your Debts
Once you hit your emergency fund … or as much as you can hit in 3 months … you should then divert most or all of your Power Amount to debt payments. If you’ve hit your emergency fund goal, then divert all of your Power Amount towards debt … if not, put 80% towards debt while putting 20% towards trying to reach your emergency fund goal.
So here’s how we’re going to do this part of the plan:
- List your debts in order of smallest (at the top of the list) to largest, with the amounts you owe and the minimum monthly payment next to the name of each debt. If you are very disciplined, you can list in order of highest interest rate at the top. It can be ideal to pay off the highest interest rate debts first, but in my experience the great feeling of paying off small debts is a huge psychological boost that helps most people a lot.
- Apply your Power Amount to the first debt. For example: if your Power Amount is $100, and your first debt is $250 with a minimum monthly payment of $25 … the first month you’ll pay the minimum plus the Power Amount â€” so $125.
- Continue this each month until the first debt is paid off. In the above example, if you do this for two months, you’ll pay off this first debt. In some cases, you’ll be able to pay off a small debt (let’s say $50) in less than a month … in that case, use the remainder of the Power Amount to start paying extra to the next smallest debt.
- When you’ve paid off a debt, add its minimum to your Power Amount. In the above example, the Power Amount was $100 and the first debt’s minimum was $25 … once that debt is paid off, add the two numbers together to get $125. That’s your new Power Amount, because you no longer need the $25 minimum payment now that this first debt is paid off.
- Now apply your new Power Amount to the next debt. Let’s say your new Power Amount is $125 … you can now apply this to the next debt on your list … which might be $200, let’s say. If the minimum payment on this is $75, you can add this to your Power Amount and pay it all off in a month!
- Repeat until you’re debt-free. In the second example, we paid off a $200 debt in a month … we can now take the $75 minimum payment and add it to our $125 Power Amount, to get a new Power Amount of $200! This goes to the third debt on our list. And so on, repeating this each time.
This method, by the way, is called the Debt Snowball method, and was popularized years ago by Dave Ramsey. It’s what I used to get out of debt (though I never read his books) and many other people have successfully used it.
ACTION STEP: Set up a reminder to automate it. You won’t actually start this part of the plan until you put some money towards your emergency fund, in a month or two or three. So set up a reminder for a couple months from now (or whenever’s appropriate) to set up automatic payments for the first debt on your list until it’s paid off. Get your snowball rolling!
Part II (for Savings/Investing): Apply Power Amount to Investments
Once you have a reasonable emergency fund (should take 1-3 months) … or if you already have a reasonable emergency fund in place … you can now start applying your Power Amount to investments.
What should you invest in? Well, I’m not a financial advisor, and I don’t know anything about countries other than the U.S. … but here’s what I’d say based on my experience:
- If you’re already investing in a 401(k)-type plan at work, and your company has a matching plan, then take full advantage of the company’s match (it’s free money) and invest up to that amount. However, it’s usually not best to invest over this amount, as I understand it, because the funds offered by most 401(k) plans are quite expensively managed. So I would go with …
- Low-fee index funds. This is my favorite investment vehicle by far, and almost all my money is in it. It’s also not a secret, as lots of personal finance sites recommend index funds. We’ll get more into the nuts and bolts of this later.
OK, let’s assume we’ve picked a set of index funds to invest in … the rest of the plan is simple:
- Split up your Power Amount among several funds (to diversify your portfolio, more on this later).
- Set up automated transfers to those funds each month.
That’s it! Over time, I’d suggest trying to increase the Power Amount, but in general it’s super simple to set up your investments. And it’s incredibly fun to watch them grow over time.
ACTION STEP: Set up a reminder to automate your investments. As you will be working on your emergency fund for 1-3 months, you’ll want to set a reminder for your investments. Set it up today … we’ll talk about the specific steps soon.