My neighbor reached out to me the other day and asked, "What is the best way to pay debt fast?" I gave him my advice and realized that I was in his shoes not long ago. Until a few years ago, I had a ton of consumer debt and was alien to the concept of budgeting. Here is what I learned over the last few years.
There are several strategies that can help you pay down debt faster. Here are a few suggestions-:
Create a budget- start by tracking your income and expenses and live below your means.
Snowball effect- focus on paying the smallest debt first while making minimum payments on other debts.
Increase income- your expenses can only be decreased to $0 (hypothetically) but your income can be increased infinitely. Find ways to increase your income, spend less than you make, and use the difference to pay debt and/or to invest.
Stay the course- celebrate small wins and be disciplined and consistent.
50/30/20 Rule
The 50/30/20 rule is a popular rule of thumb for budgeting. It basically means allocating your after-tax income into 3 major categories-:
50% for Needs
30% for Wants
20% for Savings
Please note that this is not a one-size-fits-all rule. It is a general rule of thumb and you might have to adjust it depending upon your specific situation and financial goals. Additionally, you must consider your after-tax income and not pre-tax income. After-tax income means net pay that you receive each month after deducting all the taxes, insurance, 401k, etc., and any other monthly deductions from your paycheck. Let’s look at each one of them in detail.
1. 50% for Needs
The first category is ‘Needs’. This means that you need to allocate 50% of your after-tax income to cover essential expenses and needs. These are fixed expenses that are necessary for your basic living.
Rent or mortgage payments
Utilities
Groceries and essential items
Insurance
Transportation
These expenses can be negotiated in the long-term by negotiating a lower rent or refinancing your mortgage, spending reasonably on groceries by shopping in bulk or at discount grocery stores, negotiating your insurance, using public transportation, etc. However, they are necessary for living and you cannot remove them completely.
2. 30% for Wants
The second category is ‘Wants’. You need to dedicate 30% of your after-tax income to discretionary spending on wants and lifestyle choices. These expenses are non-essential and provide you with enjoyment or personal satisfaction. Some people confuse it with ‘Needs’ and justify it by saying to themselves that they deserve this.
“I work hard so I deserve to buy those expensive shoes”.
“I work hard so I deserve to go to expensive restaurants”.
“I work hard so I deserve to travel in business class”.
Let me disappoint you. You don’t need to buy expensive branded shoes because nobody cares.
You don’t need to buy new clothes just because they are in the sale.
You don’t need to order food or eat out every day or every weekend.
These expenses are not essential to living and thus are considered ‘Wants’.
Examples include:
Dining out and entertainment
Travel
Hobbies
Streaming services
Shopping
3. 20% for Savings
The third category is ‘Savings’. In my opinion, this is the most important category because most people think this category is optional or non-existent. Whatever your income is, whether it is $50,000 or $500,000 annually, you must allocate 20% of your after-tax income to savings and financial goals. Do not make the mistake of thinking that you will save more and make up the difference when you earn more. If you don’t save now, you are unlikely you'll able to save more when you earn more for 2 reasons-:
a. Firstly, saving and investing are about mindset. It is a habit. It is a lifestyle. If you do not have the habit of saving $10, you won’t be able to save $1000 suddenly just because you have it. If your mind tells you to spend $10, then your mind will tell you to do the same thing with $1000.
b. Secondly, the cost of saving/investing later vs now is much greater than most people realize. Most people fail to realize that starting early gives you an excellent head start if you reinvest your gains through a phenomenon called compound interest. According to Vanguard, at the age of 20, you’d need to save $4500 per year to retire at 65 with a million dollars. However, if you start at age 30, you’d have to save $9000 per year to reach your goal at age 65. Shockingly, if you wait until age 40, you’d need to come up with $18000 per year to reach that goal. Do you see the pattern here?
Think about this. Who do you think is more likely to reach their goal? A 20-year-old who starts early and saves $4500 per year with relatively fewer expenses or a 40-year-old who must come up with $18000 per year with possibly much more expenses such as a mortgage, kids’ tuition, family expenses, etc. It’s not impossible to reach your goal if you start at age 40, however, it is certainly harder.
This category focuses on building your financial security, reducing debt, and planning for the future. Consider these savings priorities.
Emergency fund
Retirement savings (401k, Roth)
Paying debt beyond minimum payments
Long-term investments
How to make a budget
· Track down every cent that’s coming in and going out such as your income, expenses, and savings to help you to make informed decisions and achieve your financial goals. You can use the traditional pen and paper method to note down everything or you can download free templates from Google Sheets that help you create a monthly budget and allows you to categorize and sub-categorize your income and expenses. You can add fixed expenses where your mortgage, insurance, utilities, etc., and any other fixed expenses go. Then you can add variable expenses such as eating out, shopping, personal, gas, maintenance, etc. For income, you categorize it as a paycheck, rental, investment, bonus, etc. The Google template will automatically summarize the transactions for your review so that you know how much you are earning and how much are you saving. I’d highly recommend downloading a FREE budget app from the play store that lets you connect all your bank accounts in one place. This way, you can track your net worth, monthly spending, cash available, investments, loans, and credit card balance. There are a ton of FREE apps out there, but I like to use the FREE version of the MINT app by Intuit. There are other popular apps such as the Personal Capital and the You Need a Budget app.
Build an emergency fund
Start small by saving at least $1000. You would like to keep these funds easily available in emergencies. So, it is highly recommended to keep this money readily available in liquid cash rather than in a bank account so that it can be easily deployed in case there is an unforeseen circumstance. Your goal would be to build up an emergency fund of up to 3-6 months of living expenses to handle any unexpected financial challenges. Aside from the initial $1000, the remaining 3-6 months of emergency funds can be saved in high-yield savings or checking account so that it is easily accessible, and you earn interest on your savings from the bank.
Review your budget
· Periodically, monitor your actual spending against your budgeted amounts to identify areas where you may be overspending or underspending. Be flexible and make necessary changes to align with your financial priorities.
Stay the course
· Remember that budgeting is an ongoing process as opposed to a one-time exercise. You need to periodically review and adjust according to changes in your income, expenses, and financial goals.
Budgeting is boring but effective. Make no mistake, everyone needs to budget. You need to stay the course and be disciplined about it. It needs to be reviewed periodically and altered as per changes to your income, expenses, and goals. Let me know in the comments below what strategies you follow for budgeting. Save and share this article if you found it valuable.
Comments