The world of personal finance can be somewhat intimidating, especially because there are so many layers to it. You’ve got retirement accounts, credit cards, mortgages, emergency funds—where do you even start? In this article, I’ll greatly simplify the process and give you some ideas on where to start. Here’s what we’ll cover:
- Step 1: Cover the Essentials & Establish a Budget
- Step 2: Trim the Excess & Save One Month’s Worth of Expenses
- Step 3: Maximize Employer Matching & Pay Off High-Interest Debts
- Step 4: Increase Your Emergency Fund to Six Months’ Worth of Expenses
- Step 5: Maximize Retirement Accounts & Pay Off Moderate-Interest Debts
- Step 6: Save for Your Goals Based on Preferences
Step 1: Cover the Essentials & Establish a Budget
Before you even worry about investment accounts and major future planning, you need to get yourself situated in the short term to take control of your spending. To do this, start by making a monthly budget, using credit-card history, utility bills, bank statements, etc. to craft a good depiction of your general spending habits over the past several months.
The sample monthly budget template you can get from my guide linked above.
Next, make sure that your current income is enough to at least cover your absolutely-essential living expenses (rent/mortgage, utilities, groceries, and minimum payments on any outstanding debt). If you find that you’re not able to cover these, you need to quickly eliminate some non-essentials, such as restaurant spending, subscription services, etc.
Realize that the goal of this step isn’t to change the whole game, so to speak, but rather to give you an idea of where you’re starting and make sure you’re at least treading water—financially speaking.
Step 2: Trim the Excess & Save One Month’s Worth of Expenses
At this point, look at your budget to see whether there are any glaring wastes of money. For instance, are you spending $500+ on drinks at bars and eating at restaurants each month, above and beyond your grocery bills? If so, you may want to consider cutting that down a bit while you begin the first steps of your financial journey—more on this later.
Additionally, with any money left over at the end of each month (which can be further increased by reducing your unnecessary expenditures), based on your monthly budget, you should stockpile one months’ worth of expenses in a high-yield savings account to serve as the start of an emergency fund.
For reference, CBS News reported that only 40% of Americans cannot cover a $1,000 unexpected expense. For this reason, many people end up in debt to cover emergencies—often facing unfavorable lending terms—and their situation worsens. For this exact reason, your first money-saving step should be to at least be able to cover a minor emergency through this small fund.
A case where you’ll be glad you have an emergency fund…
Step 3: Maximize Employer Matching & Pay Off High-Interest Debts
Once you have a decent start to your emergency fund, and you’re able to cover your expenses while saving at least a small amount of money each month, you should start taking advantage of the matching offered by your employer’s retirement plan (e.g., 401k). This varies by industry and by employer, but, usually, employers offer to “match” your contributions to your employer-sponsored retirement plan up to a certain percentage of your salary, vested over a specified period.
In my case, my employer offers to match 50% of my contributions up to 3% of my salary, vested over 5 years. This means that on my $150,000/year base salary, if I contribute $9,000 to my 401k plan, my employer will contribute an additional $4,500 from their own reserves to my plan, 20% of which is “vested” (owned) by me each year spanning 5 years (until I own all of their contributions to my plan). This is essentially “free” money, and usually won’t require a huge sum each month from you to maximize.
Note, you’re not maximizing contributions until the individual limit ($22,500/year in 2023 for individuals under age 50), you’re just contributing until you maximize the extent to which your employer will match your contributions. After this point, you’ll want to move onto the second part of this step. Also, if your employer does not offer matching, skip directly to the second part of this step.
The next thing to do during this step is contribute any additional money you have towards your high-interest debt (e.g., greater than 8%). This means that if you have credit-card debt (often ranging from about 9% to 25% interest), personal loans (usually around 10%), or poor-term student loan debt (exceeding 8%), you’ll want to start paying these off ASAP.
In terms of which of these to start with, it’s really a matter of preference. Financially, you’ll fare best by paying off the debts with the highest interest rates first, but some people feel more motivated when they attack their debts in terms of the least balances first (so that they can cross items off of their figurative to-do list).
Step 4: Increase Your Emergency Fund to Six Months’ Worth of Expenses
By now, you’re able to handle a small emergency, you’re possibly contributing some money to retirement, and you’re attacking your debts—things are really looking up. This next step creates an even more stable environment for you. Specifically, based upon your monthly budget and historical spending, you’ll want to increase your emergency fund from the smaller amount we started with to 3-to-6-months’ worth of expenses.
This is really the last time you’ll need to substantially contribute to your emergency fund (unless your monthly expenses increase dramatically, or you end up needing to use some/all of the fund for an actual emergency). With this much saved in your emergency fund, you’re not only able to weather a small emergency (such as a minor car repair), but now you’re able to sustain yourself (or your family) for a few months in the event of job loss or severe emergency.
With your long-term intent to build wealth, having this much money in a savings account earning a measly return from interest may seem suboptimal, but this specific sum of money is not designed to create your wealth—it’s designed to protect it. I talk more about the importance and roles of emergency funds here, but just note that someday you may be very glad you have this money set aside.
Step 5: Maximize Retirement Accounts & Pay Off Moderate-Interest Debts
This is where you really start to build significant wealth. After your emergency savings are funded, and after you’ve paid off your high-interest debts, you’ll want to increase your contributions to your retirement accounts (both employer-sponsored, such as a 401k or 403b, and individual accounts—IRAs) to take full advantage of tax-efficient investing. In 2023, as an individual under age 50, you can contribute up to $22,500 to a 401k and an additional $6,500 to an IRA. If your employer offers a health savings account (HSA), you’ll want to consider maxing this out, too ($3,850 per year for individuals or $7,750 per year for family plans).
With anything left over, start paying off any moderate-interest debts (between 5% and 8%, inclusive). These will generally include any unfavorable auto loans and some student loans. Once you pay these off, you’ll only be left with low-interest debts, which you’ll be able to prioritize among other options in the final step.
If you can make it to and complete this step, you are already in an incredible position relative to most Americans, and well on your way to a comfortable retirement and significant wealth.
Step 6: Save for Your Goals Based on Preferences
At this step, you’re killing it. You have a sizable emergency fund, only low-interest debts, and you’re maxing out your retirement accounts. This is where you’re already in a great spot, so anything extra is icing on the cake. Here, you have a few options, which depend upon your preferences and goals. If you want to buy a new car or house soon, you can put aside extra savings into a dedicated account. Or, if you have no major expenditures coming up, you can invest some money into a taxable brokerage account, giving you even more growth potential. Last, you can pay off any low-interest debts, such as your mortgage.
The feeling of freedom that often accompanies this stage in your financial journey.
However, realize that if your outstanding debts’ interest rates are particularly low and you were to invest your additional money instead of use it to pay them off early, over the long haul you’d do better by putting it in the stock market. But, again, this is where preferences come in. If you feel better knowing you have no debt, then pay off your low-interest debt first! At the end of the day, personal finance isn’t just a quantitative game; it’s about making decisions that put you at ease and improve both your quantitative and qualitative financial health. Honestly, at this stage, in either case, you cannot go wrong—you’re making good moves.
In closing, although there are many (sometimes complicated) components to personal finance, it’s really a very approachable and sensible subject, especially if you follow a guided plan and prioritize your efforts. These six steps, while certainly helpful, are not necessarily rule of law; you can modify them or fit them a bit better to your situation and goals, but most guidance will put you on a largely similar path.
Wealth Explorers, where are you along your personal finance journey? For those who are further along, what did you do differently, and what worked for you? For those just starting out, what do you find to be the most difficult part? For all, good luck in your journeys!
