If you’re like me, you probably spend an excessive amount of time on Reddit. One of its notable subreddits, r/personalfinance (r/personalfinance has nearly 18m subscribers), serves as a forum for users to pose queries and provide comments on personal finance subjects. In this subreddit, you can find the ‘prime directive,’ a financial order of operations recommended by the community to guide individuals in prioritizing their financial decisions. I found the guide to be useful and have summarized it below with a few additional insights sprinkled in – Enjoy!
Step 1: Build an Emergency Fund
Start by saving a small emergency fund of $1,000 to handle unexpected expenses. Personal finance guru, Dave Ramsey, advocates for a similar approach. Starting off by building a small emergency fund helps adjust the mind into having a more proactive mindset. $1,000 dollars is not a huge sum of money, but getting that set aside can help out in the case of unexpected bills or issues. The money stashed here at the first step is a good beginning to a larger emergency fund down the line.
Contribute enough to your employer-sponsored retirement account (e.g., 401(k)) to receive the full employer match. Employers often offer a matching contribution to their employers to help them save for retirement. It’s common for employers to match contributions up to a specific threshold. For example, if an employee contributes 4% annually to a company-sponsored IRA (individual retirement account), the employer will match that 4%, resulting in an 8% total contribution for the year. Although these contribution percentages may appear modest initially, typically ranging from 2-5%, the combined value of employer and employee contributions can have a significant impact over the long term as noted in our article on compound interest.
When it comes to employer match, it’s crucial to recognize the value of this opportunity as essentially free money. If your employer offers a plan featuring a 5% match, you have the chance to claim that additional 5% contribution by simply contributing up to that same percentage. Seize this opportunity to maximize your earnings, it’s basically free money!
Step 3: Pay Off High-Interest Debt
Focus on paying off high-interest debt, such as credit cards and personal loans. Prioritizing the payoff of high-interest debt, particularly credit card debt, is a crucial and time-sensitive personal finance step. A simple Google search reveals that the average interest rate on credit cards surpasses 20%. This starkly contrasts with the average stock market return of 7-10%. By promptly addressing high-interest debt, you effectively secure a guaranteed return on your money of 20% or higher.
Consider strategies like the debt snowball or debt avalanche to accelerate debt repayment. The debt snowball method is outlined below:
- List Your Debts: begin rolling the snowball by compiling a comprehensive list of your debts, encompassing outstanding balances and minimum monthly payments for each.
- Order by Balance: Organize your debts in ascending order based on the outstanding balance, disregarding interest rates in this stage.
- Minimum Payments: Ensure prompt payment of the minimum monthly amount for each debt, sidestepping late fees and penalties.
- Focus on Smallest Debt: Channel any surplus funds or additional payments towards the debt with the smallest balance, while consistently meeting minimum payments on the remaining debts.
- Build Momentum: By focusing on the smallest debt first, you can pay it off relatively quickly. This initial success provides a psychological boost and motivation to continue the debt repayment process.
- Snowball Effect: Once the smallest debt is paid off, take the amount you were paying towards that debt (including the minimum payment) and apply it to the next smallest debt on your list. This creates a “snowball effect” as the amount available for debt repayment increases with each debt paid off.
- Repeat and Progress: Continue this process, rolling over the payments from paid-off debts into the next one on your list.
Step 4: Build a Fully Funded Emergency Fund
Increase your emergency fund to cover 3 to 6 months (or more) of living expenses. Ensure the funds are easily accessible in a high yield savings account or a money market fund. To ensure its usefulness and full availability of funds, an emergency fund must be easily accessible when the need arises. Typically, it is securely held in a liquid and low-risk account, such as a savings account or a money market account. Unlike regular savings or long-term investments, an emergency fund is specifically set aside for unexpected expenses, not planned spending or future goals. It’s there to handle life’s curveballs when they come your way.
Step 5: Save for Short-Term Goals
Start saving for short-term goals like vacations, house down payments, or car purchases. Taking charge of expenses like these brings big rewards in the long run. Saving up for vacations helps avoid credit card reliance and promotes better financial habits. Building larger down payments for homes or cars not only gets you better interest rates and financing options but also opens doors for higher loan amounts and potentially lower monthly payments. Consider using a high-yield savings account to gain additional interest on these savings, we’ve listed some good HYSAs here.
Maximize contributions to your retirement accounts, such as 401(k), IRA, or Roth IRA. Aim to save 15% or more of your gross income for retirement. Adding a Roth IRA to your employer’s retirement plan boosts investment diversity. With a Roth IRA, you contribute after-tax dollars, meaning the money is already taxed. Traditional IRA contributions are usually pre-tax, potentially lowering your taxable income for the year. But remember, withdrawals from a traditional IRA in retirement are taxed. Balancing both approaches based on your income and situation can be a savvy move.
Step 7: Save for Other Goals
Once you get to this point, things can really start to go on autopilot. By this point in your journey, your retirement has had steady contributions, bad debt is no longer a problem and there’s nothing holding you back. You could allocate funds towards other goals like education for your kids, or starting a business. Consider investment options based on the timeframe and risk tolerance associated with these goals.
Step 8: Pay Off Low-Interest Debt
Focus on paying off low-interest debt, such as student loans or mortgages. These are what personal finance gurus generally refer to as “good debt.” Prioritize paying off debts with higher interest rates first if they still exist.
Step 9: Maximize Tax-Advantaged Accounts
Explore additional tax-advantaged accounts like Health Savings Accounts (HSAs) or 529 plans. HSAs are tax-advantaged savings accounts designed to help individuals set aside money specifically for medical expenses. Contributions to HSAs are made with pre-tax dollars, meaning they are not subject to federal income tax at the time of deposit and the earnings on the HSA investments grow tax-free. 529 plans, also known as “qualified tuition plans,” are tax-advantaged savings accounts designed to help families save and invest for future education expenses. ontributions to 529 plans are made with after-tax dollars, meaning they are not deductible from federal income tax. However, the earnings in a 529 plan grow tax-free, and withdrawals used for qualified education expenses are also tax-free.
Step 10: Build Wealth and Give Back
Continue investing in taxable brokerage accounts and other investment vehicles. These contributions will just help you get further and further ahead. You can also begin setting aside greater amounts of money to donate to charitable giving or supporting causes you care about. At this point in your personal finance journey, things will be on autopilot and you’ll be reaping the benefits of compounding interest.
Remember that this financial order of operations is a general guideline, and personal circumstances may vary. It’s essential to adapt and modify these steps based on your specific financial situation and goals.