Imagine you are fortunate and have $500 left at the end of your month. Your bills are paid, groceries are purchased, your cars are filled up with gas, and you enjoyed the extra-curricular activities such as dinner out and kid’s activities. How do you decide what to do with the $500?
First, know that there are three things you can typically do with money:
- Spend it (duh!)
- Save it
- Prepay debt with it
So here is a very simple, but powerful four-step framework I have been empowering homeowners and soon-to-be homeowners with for over a decade.
Step 1: Establish or fill up your Cash Reserves
- This is the foundation of financial security and is typically money in your savings accounts at your bank. I don’t care what rate of return it is getting you. It is for emergencies or the unexpected and is all about being safe and readily available when you need it. Set a goal that will help you sleep well at night knowing you are safe and put your extra money here first until your goal is reached.
Step 2: Pay off consumer debt or “bad” debt
- This means pretty much any debt outside of your mortgages. Put another way, think of any debt that is not leveraging an asset that goes up in value over time, as “bad” debt. Once your Cash Reserves goal is met, hammer away at those credit cards, auto loans, student loans and any other debt that is taking up your hard-earned paycheck each month.
Step 3: Build liquidity
- Now it gets fun, but unfortunately too few American’s are at this stage. With your Cash Reserves in place, and consumer debt paid off, it is time to fill up your nest egg. I explain this as the money in between your Cash Reserves and your retirement accounts. A goal I like to set for people that get them excited is one year of their salary. Imagine having one year of your income saved somewhere, earning you interest. Imagine the confidence you would have and the opportunities you could take advantage of when they come your way.
Step 4: Pay off your mortgage(s)
- Yes, I believe people should pay off their mortgages…someday. The problem is, people make the mistake of attacking their mortgage before the first three steps are in place. This is typically done out of emotion. Often it is because homeowners are falsely equating financial safety and security with no mortgage. This could not be further from the truth.
Yes, I’ve watched people for years pay extra on their mortgage, year after year, only to then decide to sell that house and buy another. This is done blindly without seeing the bigger impact it plays on their long-term financial plan and goals. Someday you WILL be in the house you want to retire in and have no mortgage on. That is the house to pay off the mortgage and enjoy the freedom that comes along with it. But until then, build liquidity and safety and keep your money somewhere you can control, with YOUR financial advisor, rather than giving extra money to the bank each month that is servicing your loan. They don’t need it, and they definitely won’t give it back to you when you most need it.