How to become Financially Free

“I found the road to wealth when I decided that a part of all I earned was mine to keep. And so will you.” — George S. Clason

A catchy quote I hope you might find inspiring, originally from the book “The Richest Man in Babylon.” Before we begin I’d like to point out that this is not an article that will make you wealthy tomorrow, next week, next month, nor in the next year. This is just a collection of principles that, if followed, will ensure financial success given enough patience from you. Therefore, you need to ask yourself: “Am I ready to give up a portion of my today, for a better tomorrow?” If not, this article will serve no purpose for you whatsoever.

Save a portion of your income

First of all, let’s review the initial quote a bit more closely. “I found the road to wealth when I decided that a part of all I earned was mine to keep.” This is the single most important principle when discussing wealth, thus also the first one to be laid out.

What happens when your paycheck hits your bank account today? Usually we have a mortgage, utility bills, car payments, credit card interest etc. to pay. The chunk of cash that is left usually sits in the bank account throughout the month, ready to pay for groceries, Starbucks coffee, parking and other everyday expenses. At the end of the month, nothing is left. Rinse and repeat, and we have now displayed the typical paycheck-to-paycheck way to live.

What you need to do is take at least 10% of your income, and if needed, literally move it to a different bank account to avoid being spent on your day to day expenses. “But that’s impossible” is the most common objection. I agree, it might seem impossible, but the least you can do is try. You wouldn’t be here, reading this article, if you were not ready for some change. Most people who try this will realize that it’s actually possible to live on 90% of their income. If you can’t, embrace the situation with humility and realize that you probably live in a too large apartment/house, have a too expensive car, eat too expensive food etc.

Pay off your debt

Given that we now have a steady stream of 10% of your net income, we are going to start paying off debt. Have you ever heard the “If you invested $10,000 in the S&P500 50 years ago you would be a millionaire today?” Probably. Then you also know what the compound effect can do to grow a pile of cash, given enough time. However, this works both ways. All your loans collect interest, and if we don’t start paying them off the interest payments will never disappear.

Now, the most logical thing to do is to pay off the loan with the largest percentage of interest, since this will reduce your monthly payment the most. However, humans are not always rational creatures. Therefore, the most reasonable thing to do might be to pay off the debt with the smallest amount lent, called “debt snowballing”, notwithstanding the fact that this might imply paying off a loan with lower interest first. This technique is rationalized by feelings of accomplishment as a consequence of “removing” a loan from your life. I say, whatever floats your boat.

Time

I can’t stress time enough. Whilst this is just a paragraph later in this article, we will probably be talking about years to pay off this debt. You don’t have to read any further just for the sake of it, there will be no magic formula described later. If this article can help you to just pay off your debt, I feel it has already provided enough value.

However, if you don’t have any debt, or even better have already paid it all off, we will continue discussing what we should do with our 10% we just free’d up.

Build up Emergency Fund

The first thing we should do with our 10% per month is to build up an emergency fund. This is a reserve saved in cash (on a bank account) to be used when something unexpected turns up. This includes insurance claims, water heater breaking down, living expenses if fired from your job etc. Therefore, this does not include travel, sightseeing, a new iPhone, or any other consumables you can think of. See this money as “I will only touch if I really need to.”

The size of this emergency depends on the size of your monthly expenses. A solid guideline is 6–12 months of expenses, therefore providing safety in case of sudden loss of income. If you have a family, or other obligations towards other people, this emergency fund should be larger than if you are a student living by yourself.

Start investing

Having paid off all debt, built up an emergency account and still putting away 10% (or more, hopefully) we can start building real wealth. The place to start is simply investing in index funds. Google online brokers, open an account, transfer the funds each months, and ideally set up so it automatically moves into the index funds of your choice.

Why index funds? Because they are “cheap.” On average, the stock market returns 7–8% annually, and placing your money in index funds you will get these returns at a low annual fee of between 0–0.3%. Avoid hedge funds and other complex instruments your bank might try to sell you. To keep things easy, investigate the product’s annual fee, and if it exceeds 0.3%, don’t bother investigating further.

Because this article is focused on making you financially free, with the biggest battle being getting out of and avoiding debt, I will not continue delving deeper into the subject of investing. When you reach this point in your life, I encourage you to read more about investing in stocks, bonds, real estate and other income generating assets, since it will definitely make the wealth building aspect more interesting, and most importantly, your net worth will probably increase faster.

Please, jump into the comments. Criticize, discuss, call me an idiot. I’d love to discuss this on a more personal basis, anchored instead in your personal living situation.