Financial Security In 4 Steps

INTRODUCTION • SMALL CASH BUFFER • HIGH INTEREST DEBT • FULL CASH BUFFER • INVESTING • FREE MONEY • FAQ • SUMMARY

Introduction

If you're tired of living pay check to pay check and want to stop worrying how you'll pay your bills, this is the article you're looking for. Financial freedom could seem out of reach for many people but here I'll show 4 easy steps that you can follow to improve your financial position.

Step 1 - Small Cash Buffer

If you're always waiting for the next pay check and hoping that an unexpected expense doesn't pop up, or worse, lose your job, this step is easy and it does a world of good for your mental health too.

Start building a safety buffer. For this step, it only needs to be 1 month's of living costs. Having this will give you the mental capacity to take a breather and know that you don't have to make any quick decisions or sell a kidney! This can be either in your bank account or a high interest account, I would recommend the high interest account option and keep it separate to your main account so you're not tempted to spend it.

Step 2 - High Interest Debt

If you have any high interest debt this is the time to tackle it. Car payments, for example can have interest rates as high as 20%. You should pay these off as fast as possible. If you're struggling to see the benefit think of it as a guaranteed return of your interest rate. If you know of an investment that guarantees 20% every year, sign me up! Any other loans you have over around 8% should be paid off before moving onto the next step.

There are 2 options for this often referred to as the debt avalanche (mathematically optimal) which is to pay off the one with the largest interest first. The second is the debt snowball (psychologically motivating) which s to pay off the smallest first so there is 1 less loan to pay sooner. Once you start paying off these loans, the avalanche effect starts to occur as you have more funds to pay off your other debts, and you'll have more funds to work with in step 3 and 4.

Step 3 - Full Cash Buffer

Now you've got rid of your expensive loans, your "cashed out" money that was going to your loans can be redirected to a proper emergency fund. For most people 3 - 6 months of living costs should be enough for this step. If you are self employed, you may want to aim for 6 - 9 months since small businesses tend to have more of a variable income.
I previously said, in Step 1, that it wouldn't make a lot of difference whether this buffer is in a bank account or a high interest account. Now the amount is a bit more substantial, it should go into a high interest a savings account. For example, if you have monthly expenses of £2,000, and an interest rate of 4%, that could be £12,000 earning £480 a year. If you manage to get a higher interest rate or have more saved up, you might benefit from utilizing Premium Bonds which are tax free, see the FAQ below for more information about this.

Once you have this you are fully prepared for any shocks life may throw at you so read on to see the most accessible wealth building tool.

Step 4 - Investing

Investing is a lot more accessible than it used to be, forget the days of having to pay an "expert" fund manager to manage your money and needing thousands of pounds just to get started. There are many trading platforms that provide commission free investing where you can get started from as little as a £1. (There may also be foreign exchange currency fees depending on what you invest in). "What about shares that cost over a pound?" I hear you saying, don't worry about that, most providers allow the purchase of fractional shares. I would suggest pound cost averaging (see the FAQ if you're unsure what this is) into an index fund, either the US S&P 500 or the an all world tracker. Over the last 10 years (at the time of writing), these have provided an annual return of 13.15% and 10.5% respectively. This would turn £1,000 into £3,547 and £2,714, not bad for just leaving it to sit there. Please be aware that stock markets can be volatile and these figures are averages if you hold on to your investments through the tough times when it drops in value considerably.

Please note that past returns are not an indicator of future returns and there is a chance you could get back less than you invest.

Bonus step - Free Money

As a bonus step which you can fit in wherever you like, most employers offer a pension match or if you contribute more, they will do that too. This is literally free money and this will be left to compound till you reach pension age. It's more of a long term financial future plan but certainly worth considering.

FAQ

Should I buy Premium Bonds?
Premium bonds are backed by the government and any gains are tax free. Depending on how much you have to put there and what your salary is determines how well they can perform. If you are a basic rate tax payer, your personal savings allowance is £1,000, as a higher rate taxpayer, you only get a personal savings allowance of £500 and additional rate tax payers don't get any personal savings allowance at all. With that in mind, if you're likely to exceed your allowance, this could be a good option.

What is pound cost averaging?
Pound cost averaging is where you invest the same amount each month so when the price is high, you only buy a few shares and when it is low, you buy more. This means that your average cost per share decreases.

Should I temporarily stop my pension contributions?
This is probably not a good idea. If you were to stop your pension contributions you would have to ensure that the money is well used and be aware that you would be taxed on it. Also, If you become accustomed to having a higher salary in your pocket, you may find it hard to reduce it back to what it was when you restart your contributions.

What is an index tracker?
An index is a collection of companies, for example the 100 largest companies in the UK makes up the FTSE 100 index. An index tracker is a portfolio/fund that mirrors an index and since it is fairly simple to copy (all the company information is publicly available) the ongoing charges for these are often less than 0.5%. They are not just in the UK, they are all over the world in many different markets.

Summary

By following the steps we've discussed financial freedom isn't that far away, it just takes time and persistence. You may have to make some sacrifices now but it will be well worth it in the future. If you struggle to see the benefit of any of the steps, imagine how you would feel being at the next step.

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Disclaimer

The usual disclaimer: I'm just a guy on the internet sharing what I've learned. This isn't financial advice so do your own research and speak to a qualified adviser about your specific situation.