In our last article, we walked you through some specific steps to identify where you currently stand financially. Now, it’s time to figure out where you want to go. So grab your notebook and let’s help you clarify your goals. In step 2 we had asked you to list all your debts. Your current level of debt will determine to a large extent how soon you can achieve your financial goals. The steps below should help you identify your current options. Make sure to record your answers in your notebook as you will need this information in the future.
Step 1: Write down your top two or three financial goals. For example, do you want to pay off your debts? Save for retirement? Save money for a specific purchase, such as a home or a car? Once you’re done, put a number next to each goal to identify your priorities. For example, if saving for retirement is your number one goal, put a “1” next to it. Are you on track for retirement? If you are not sure, steps 2 and 3 below will help you find out. Are your debts out of control or are you living debt free? At what age do you want to be financially independent?
Step 2: Now let’s see what is possible in your given situation. Look at step 4 from January where you had written down a list of your recurring monthly expenses. Add up all of your expenses and multiply that number by 12. This will give you the approximate amount you need in order to pay for one year’s worth of expenses. Let’s say you’re currently spending $4,000 / month. If you multiply that number by 12, you’ll get $48,000. Now take your annual spending and multiply that number by 25. If our example, $48,000 x 25 would give us a total of $1,200,000. That number represents the approximate amount you would need in order to become financially independent*. Let’s call it your “magic number”. (Note: if you want to ensure a more secure retirement, you may want to multiply your annual spending by 30 or 35.)
Step 3: Now let’s use a savings calculator to figure out how much you need to save each month in order to reach your “magic number”. Bankrate provides a simple calculator for this task but there are plenty of other calculators you can use. Most people will want to use an interest rate between 5% and 8% in their calculations (we assume a 7% rate of return in most of our investment calculations). Play around with different numbers until you find an amount you can reliably save each month. If the amount is higher than what you can afford to save, you will either need to add more working years or figure out a way to decrease your monthly expenses. Try to eliminate as many non-essential expenses as possible.
Step 4: We believe that saving for retirement should be a top priority in most cases, but if you are in so much debt that it is making it impossible for you to save for retirement, you might have to focus on paying off your debts first. Most experts recommend to pay off debts in order from high-interest to lower-interest debt. For example, if you have two credit cards, one charging you 15% while the other is only charging 9%, pay off the 15% card as quickly as possible, while making minimum payments on the 9% card. Once you are done paying off the first card, pay off the second one as quickly as possible. If you are unable to handle your debt situation, you might need to get some extra help. One option would be to contact the National Foundation for Credit Counseling.
If you are making more than minimum payments on your debt and you are still able to comfortably save/invest the amount you identified in step 3 above, then you may want to put money towards both debt reduction and retirement savings at the same time. However, if you have significant amounts of debt, you’ll have to do some math. For example, many people expect to make an average return of 7 or 8% annually in the stock market. If your credit card is charging you 15%, then you should pay off your credit card first. However, if you expect to make 8% in the stock market but are only paying 4% on your mortgage, then you will likely be better off investing as much as possible for retirement rather than prepaying your mortgage. Every person’s situation will be different, but these are some useful guidelines.
Step 5: Now look back at your goals from step 1 above. How would you grade your financial health? Are you on track to meet your goals? If the answer is “no”, try adjusting some of your numbers. For example, if you are heavily indebted (especially with high-interest debt), would it make sense for you to dedicate a large percentage of your income on debt reduction for the next few years? Saving for retirement is of paramount importance but if your debt is preventing you from being able to invest, then it needs to be handled first.
If, on the other hand, you have very little debt and are on track for retirement, would it make sense for you to increase your retirement savings to reach financial independence at a younger age? (Always be kind to your future self!) If you have little to no debt and are well on track with your retirement savings, then you can focus on saving towards a specific goal. Ultimately, only you can answer these questions. But you should now have a better idea of where you’re going and how you’re going to get there.
*Using the 4% rule, a $1,200,000 portfolio would generate approximately $48,000 in annual income. Note that this is not an exact science and some people might want to save more in order to feel more secure in their retirement years but it gives you a number to aim for (which puts you in a better position that most people). It should also be noted that the 4% rule does not guarantee that your money will last for at least 30 years, which is why some people will want to multiply their annual expenses by 30, 35, or even higher. The higher the number, the more of a financial cushion you are creating for yourself in case the market doesn’t perform as expected.
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