The 19th Century Englishman Charles Dickens was world renowned as a novelist and social critic. But he didn’t stop there; he also has some truly outstanding advice for how you can achieve financial independence, which is every bit as applicable today as it was back in his time. If there were an award for the single quote which best sums up the essence of personal finance in the fewest words, this gem from Dickens in the novel David Copperfield would get my vote:
"Annual income 20 pounds, annual expenditure 19 pounds, result happiness.
Annual income, 20 pounds, annual expenditure 21 pounds, result misery.”*
There’s a lot of wisdom in that short quote! First, it highlights that sometimes the difference between personal finance success and failure can be the tiniest of margins. Lowering expenses from just above the income level, to just below it, doesn’t have to mean a drastic lifestyle makeover. It probably means continuing to enjoy the same types of expenses as you always have, just a little less often. That small change triggers a chain reaction, eventually resulting in a complete financial turnaround.
But this powerhouse quote does something else even more profound: it focuses your attention on the difference between income and spending, and just how vitally important that difference is.
At I Am Net Worthy, we call this difference your “gap,” and it’s crucial to understand how important it is.
If you’re spending less than your income, your gap is positive, your financial ship is afloat, and you have the opportunity to chart a course towards financial independence. But if you’re spending more than your income, your gap is negative, your financial ship is sinking – and you’re not going anywhere but down, until you tackle your gap.
Okay, let’s take a short pause to translate the quote from Dickens’ time to ours. He lived in a world without income taxes, but we don’t. So we’re going to specify that the income we’re talking about to define your gap is your take home pay, not your gross income. And in today’s financial world, it’s customary for most ongoing expenses to be billed monthly, so let’s focus on your monthly gap instead your annual one.
Finally, your take home pay might not be spread evenly across the year. You could have seasonal ups and downs, or you might be working in a commission type of pay structure, where some months can bring much more reward than others. To account for that, we’ll smooth things out and take a monthly average over the past 6 to 12 months. So the Net Worthy version for your household turns out to be:
Monthly Gap = Average Monthly Take Home Pay – Average Monthly Expenses
Enough about how to define your gap, back to what to do about it and why it’s so important! Let’s say you’ve arrived at a place in your financial life where you have achieved a positive monthly gap. It might have taken you a long time, or it might have been easy and natural.
Either way, the important thing is this: that positive financial gap you’ve now achieved is absolutely precious.
Your financial future, in a very real sense, depends on how big your financial gap is, and exactly what you choose to do with it.
It might be hard at first to appreciate just how precious your gap is. Compared to the other numbers in your financial picture, your monthly gap might seem too small to make much of a difference. Don’t be fooled! Just remember, that’s the amount that you’ll set aside for your financial future, every single month – and as the months go by, it’s going to really start to add up.
As it does, time will begin to feel like your financial ally – because every month that goes by, you’ll be getting closer to, not further from, financial independence.
Remember learning about expense streams, and how sneaky-dangerous they are? This is the exact opposite. That’s right, a positive gap may seem small, but it’s sneaky-wonderful! When was the last time you looked at your overall financial position, and said “Hey, wow! Every time I look at this, I’m surprised by how much better it looks than I thought it was going to be.” That’s just the kind of thing you’ll say if you put yourself in a positive-gap position, and stick with it.
So that brings us to the central question for this article: once you achieve a positive financial gap, what do you do with it?
At this point, you’re not a financial newbie anymore. In order for you to have gotten to positive gap status, you’ve already developed the skills to tell good ideas from bad ones. So I’ll skip the obvious advice to not waste the gap you’ve worked so hard for.
No, this is a different kind of dilemma. You’ve got options, and they’re all good, sound alternative ways for you to potentially use your gap. But you can’t do them all, at least not all at once, so you’ll have to choose. Should you pay off your student loans as fast as you can? Build an emergency fund? Invest in your employer’s 401(k) plan? Pay off those credit cards once and for all? None of these are bad ideas. So, does it even matter which one you tackle first?
Yes, it matters!
You’ve worked hard to achieve that positive gap, so you want to use it as wisely as you possibly can. It’s like following a recipe. Ask anyone who knows how to bake a perfect apple pie whether it matters if the steps in the recipe are followed in the right order. Well, it’s just the same with your financial pie. Either way, follow the steps in the right sequence if you want the best result for your dough. (Ahh, sorry!)
So what is the right sequence of events for your all-important gap? It’s called the Net Worthy Road to Financial Independence, and here it is:
A full description of exactly what’s involved in each step is what Chapter 9 in I Am Net Worthy (or, Volume 9 in the I Am Net Worthy ebook series) is all about. I recommend that you take the time to familiarize yourself with the long version of each step while you’re working it. But for now, here’s a quick, simplified version of each step on the Road to Financial Independence:
When you owe money, there’s almost always a minimum amount that you owe each month. Your monthly car payment, the minimum payment on each credit card, your monthly student loan payments (once they’ve begun), and so forth. Miss any of these, you’ll hear about it fast, and negative consequences aren’t far behind unless you promptly pay. We call this Priority 0, because these payments are so crucial to your financial health, you pay them even before you calculate your gap (i.e. if you can’t afford to pay every one of these, you haven’t yet achieved a positive gap.)
Life without an emergency fund is super stressful even if you don’t experience a financial emergency, and painfully disruptive if you do. You definitely need a bare bones emergency fund, equal to one month’s average expenses, and you need it before you tackle any other financial priority. So why do so many people skip this? Because nobody bills you, nobody threatens to repossess anything, there are no (immediate) credit score implications – in short, nobody will make you create an emergency fund. The only way you’ll build an emergency fund is if you make yourself do it! So buckle down, grind it out until you can put a big old check mark on priority #1. The reward will be a vital, giant step towards true financial stability.
Be advised – this doesn’t apply to everybody. If you work for an employer who not only provides a tax advantaged retirement savings program, but who matches your contributions up to a certain point – and if you’ve worked for that employer long enough to be eligible for that match – then you’ve got an investment opportunity that’s simply so good that you can’t afford not to participate. Some employers match 50% of what you contribute, some match 100% or even more, but some choose not to match at all. If you’re not sure, ask your employer’s HR or payroll department. Super important: we’re only talking about investing the amount that gets matched by your employer, and not a penny more at this point. If this applies to you, definitely use your gap to take full advantage. If it doesn’t, skip this and go on to priority 3.
You knew this was coming, and here it is – time to tackle those credit card balances! Americans have a really hard time managing credit. The most recent statistics show that 38% of US households carry a balance from month to month, and that balance averages almost $5,500 per borrowing cardholder. But that doesn’t have to be you! The big APR’s that credit cards charge mean that the power of compound interest is working against you big time, so this is exactly where your gap needs to come to the rescue. To make even faster progress, consider a balance transfer strategy, outlined in detail in Chapter 9 of I Am Net Worthy. Even with that, it will likely take you longer to pay this debt off than it did to rack it up in the first place. Don’t let that discourage you! Once you’ve paid these all the way down to zero, you’ll have learned your lesson, and you never have to fall into credit card quicksand again.
Congratulations on getting this far! Now get ready, because your mighty gap is going to go after two opponents at once. If this kind of two-against-one seems unfair, remember a key fact: if you had some double-digit debt that you’ve now eliminated in priority 3, your gap is getting bigger – and that’s going to allow you pick up momentum as you march towards financial independence. Now it’s time to attack the last two obstacles keeping you in the red phase: you’ll fill your emergency fund all the way up to your risk adjusted ideal level, and you’ll pay off all single digit APR debts, which could be anything from student loans, to auto loans, or anything remaining from the BoFF (Bank of Friends and Family). There’s an interesting debate to be had about whether these are really, truly equal priorities – but leave the debate for nth decimal spreadsheet geeks like me. Just throw your gap at them in whatever proportion you like, keep at it until both goals are met.
Boom! By meeting both of the priority 4 goals, you’ve just broken the barrier from the red phase into the yellow phase. Take a minute to realize… most Americans never make it into the yellow phase, but you have, and at an early age. You’re making incredible progress, don’t slow down now! The yellow phase mantra is earn, save, invest, repeat – so you’re going to start out by investing in the tax advantaged account that offers you the most flexibility, and the lowest fees – which is an IRA (Individual Retirement Account). You’ll find a very low fee Target Date Fund, you’ll make a decision between Roth or pretax tax treatment, and then you’ll keep on investing in shares of that fund until you hit the IRS maximum amount ($6,000 is the annual limit for 2019). As soon as you hit that limit, move onto priority 6; if the year finishes before you hit the limit, start over again each following year until you do. (Lots more details on all this in I Am Net Worthy.)
Now that you’ve maxed out your IRA, it’s time to do exactly the same kind of investing you have been, but in a different tax-advantaged investment account – the one provided for you by your employer. Once you reach priority 6, you will fall into one of these three categories:
1. You’ve already invested in your employer’s plan back in priority 2. So now, you’ll come back and invest still further in this account, but this time you’ll be doing it without the employer match. No worries – you’re still taking huge advantage of compound interest, you’re still saving on taxes, so keep on investing here until you reach the IRS maximum ($19,000 for 2019).
2. Your employer doesn’t match, so you’re investing in this account for the first time. It’s not quite as sweet as an IRA – because your selection of target date funds is more limited, and fees are generally higher. But it’s the next sweetest thing you can do, so have at it, all the way up to the $19,000 per year limit!
3. You don’t work for an employer with a tax advantaged retirement savings plan. That means you missed out in priority 2, and sadly, you’ll miss out again here. That doesn’t necessarily mean you should quit what you’re doing and go to work for a 401(k)-type employer, especially if you feel that you’re earning much more as a solo/freelancer than you think you could as a W-2 employee. But it does mean you should consult a tax professional and learn what kind of tax advantaged retirement savings account you may be able to set up for yourself.
Oh wow, you’re crushing this Road to Financial Independence, aren’t you? Nice! It does mean, however, that you’ve already burned through the relatively easy strategies, so now you’re going to have to dig a little deeper into the playbook to keep moving ahead. Chapter 9 of I Am Net Worthy can point you in some of the right directions, and you may need to dive into some focused research, call in a qualified financial professional – or both.
Wait a minute, did we skip buying a house? Shouldn’t that have already appeared on the priority list earlier? We call this priority X, because it’s a wild card on your priority list. Buying a house isn’t only a financial decision, it’s a major life decision. So if and when it might make sense for you can’t be neatly placed on a list of financial priorities – it’s not that simple. (Example: some adorable bouncing baby dependents might show up in your life without first checking on your financial status!) There is one hard and fast rule though: it’s not financially smart to buy at least until you’ve gotten past priority 3. But once you have, anytime it makes sense for you to buy, do it! Just insert priority X wherever you are on the Road to Financial Independence, buy the house and get settled, then resume your journey down the road. Remember, don’t feel like you have to buy – if it just doesn’t feel like it’s a wise time in your life to commit to staying in one place for the next 3-5 years, then just keep on renting.
That’s it! That’s the Road to Financial Independence, in one blog post. You probably already had a pretty good idea of what the right things to do were, now you also know what order to do them in.
Remember, it all comes down to your monthly gap – the bigger it is, the faster you can go. Safe travels, and I’ll see you in the green phase!
*Special note to Charles Dickens fans: yes, I know, I simplified the quote to make it more memorable and dramatic, so no need to write in and correct me. The actual quote is: “Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.” But unless you’re a regular user of the now-obsolete pounds and shillings, and are an “ought-means-zero” fan as well, the original quote loses its punch once you’ve taken the time to decode it.