Financial freedom should be a goal for everyone. We all need money to survive, and wisely dealing with that money is vital for long-term financial health.
But where do you start? Should you start with investing, paying off debts, contributing to your 401(k), building an emergency fund, or something else?
There seem to be a million different priorities pulling you in all different directions, and so it’s hard to know where to begin. After all, your income can only go to so many places at once.
There are certainly many opinions out there, but there’s one place I believe everyone needs to start.
You don’t need to focus on this exclusively, but it should definitely be one of your major priorities. Doing this step properly will break the paycheck-to-paycheck cycle, and ensure that you have plenty of forewarning before financial issues really start impacting you.
How Much Money Is in Your Checking Account?
Presumably you have a primary account where your expenses are paid.
What’s your average balance in this account? Do you only have a small amount left before getting paid again? Would you be in trouble if you got paid a bit later than expected, or if some small emergency came up?
If you find yourself in this situation, you’re far from alone. In fact, 40% of Americans would be unable to cover a $400 emergency with cash or savings, according to a 2018 survey by the Federal Reserve.
To me, this is the obvious place to start. If you’re so close to the edge that $400 would be more than you could cover in an emergency, then something’s wrong. This is far more important than any debt, and if you’re in this situation, then you probably don’t have the extra money to invest (or haven’t actually gone through with trying).
But how much extra should you be keeping around? You’ve almost certainly heard the recommendation to have a 3-6 month emergency fund, but that’s a rather daunting goal if you’re just starting out.
But there’s a far more manageable goal that I think every person needs to establish immediately if they haven’t already.
Living on Last Month’s Income
About 12 years ago or so, I came across a budgeting program called, simply, You Need A Budget (YNAB). It was a novel approach to budgeting, and to this day I have never found a budgeting program to beat YNAB. I’ll be writing a post in the future that discusses their methodology at greater length.
But one of the “4 rules” of YNAB was this: live on last month’s income. They’ve since restated that rule, but I still love the simplicity of the original. It was called colloquially “Rule 4”.
Basically it means this: whatever you get paid this month, you don’t actually spend until next month. That means that this month, you are spending your income from last month.
Essentially it’s a cushion of sorts: a 30-day buffer to protect you against any minor financial mishaps, plus just smooth out the day-to-day operation of your finances.
Imagine you get paid today, but instead of going out and immediately spending that on bills, you put it away somewhere to pull back out later. After all, this month is already covered, by the income you received last month. Then when next month rolls by, you have that income you set aside from this month.
This would solve a whole bunch of problems all at once:
- No longer would you be unable to afford a $400 emergency. in fact, you could absorb an emergency up to one month’s income (the size of your buffer).
- No longer would you have to worry about when to pay your bills, paying certain bills after certain paychecks according to what you could afford.
- No longer would you be worried about being low on grocery money (or gas money, or anything else) coming up to your next paycheck. The whole month is covered up front, so you’re never running low.
- No longer would you be worried about overdrafting your account from an unexpected charge, adding on more fees which you couldn’t cover. Now you will constantly have at least one month’s income in your checking account at all times.
Sounds pretty awesome, right? Now you can hopefully see why I believe this should be your very first goal on your road to financial freedom. Without this, your foundation is weak and can be breached by the smallest unexpected emergency.
But, how do you do it? Living on last month’s income might seem to be a far off dream only for those with lots of extra money.
How to Build Your Buffer
There’s no easy way around this, unless you’re able to cut back on some massive expense and can save up the majority of your income. But I doubt this is the case.
Unfortunately my suggestion to save 10% of your income is insufficient for this task. I mean it could work, but it’d take you 10 months to build your buffer, and quite honestly this should be a task you get through within 2 or 3 months, and move onto the next step. This is just laying your foundation for financial freedom, so you really don’t want to spend 10 months on this.
So you’re going to have to create some kind of drastic change just for the 2-3 months it takes to build your buffer.
There are two ways of having more money to save: spending less, or earning more.
So on the spending less side of the equation, you could temporarily cut back on discretionary expenses. Cut out a streaming service or two, cut back on eating out (or cut it out entirely if you have to), try to save on groceries, see if you can save on gas somehow. Do what you have to do to pull back on your expenses just for a couple months.
On the income side, see if you can bring in some extra money somehow. See if you have anything to sell that’s just been lying around. Sell things on Ebay. If you have the skills, offer freelance services on a site like Upwork. If you have an hourly job, see if you can put in some overtime.
You’ll want to increase your savings to about 33% of your usual income in order to build the buffer in 3 months, or 50% if you want to build it in 2. That may seem like a lot, but between cutting back on spending and adding a bit of extra income on the side, you should be able to pull it off.
And by the way, if you do happen to have an emergency fund in savings somewhere, then redeploying part of that for your buffer would definitely be appropriate in my opinion.
Where Should Your Buffer Go?
You might think that your buffer should go into your savings account, but actually this is incorrect.
Your buffer is meant to act as a cushion for your account, to absorb any extra costs throughout the month, and protect you against overdraft. It can’t do this very effectively from a savings account.
Sure, perhaps you’re missing out on a bit of interest that your money could earn in a savings account, but it’s far more important to get the other benefits of the buffer, which you can only do by keeping it in your primary checking account.
Any savings above and beyond the buffer should absolutely be kept somewhere where it gains interest over time. But those first 30 days of savings should go right into your checking account.
Control Your Spending
Some people might be worried, “If I see an extra few thousand sitting around in my checking account, I’ll be tempted to spend it.”
My answer? You’ll have to curb that habit. Your propensity to spend whatever’s in your checking account is not a good reason to give up the benefits of having a buffer.
There are ways around this, like keeping a good budget, which I’ll cover in the future. But, the bottom line is that if this is a problem for you, you’ll have to discipline yourself to not do that.
I think that once your buffer is established, you’ll find the freedom so addicting that you wouldn’t think of spending that buffer needlessly.
If you want to create financial freedom for yourself, you have to build a strong foundation that can withstand anything life can throw at you. A 30-day buffer is your best tool to break the paycheck-to-paycheck cycle and finally stop worrying about money.
It’s certainly not the whole story. There are lots of other steps to take to reach financial freedom, but this is a huge step in the right direction.
Do you sometimes feel overwhelmed with your budget, or like there is never enough money? I’m now offering a service called “Budget Makeover”, where I’ll work with you to look through your financial situation and find a way to get your budget to work with your goals.