STEP 1: Understanding Your Financial Picture
Disclosure: This article may contain affiliate links for services and sites we trust or use. To learn more, please read our full disclaimer.
You've take the first step to bettering your financial future. So now what?
Financial freedom is something many desire for themselves, yet so few know what’s necessary to achieve this status.
The thing is — it’s not that hard. It only becomes difficult when you try to do everything at once, in no strategic order. And most importantly, it’s difficult because you probably haven’t defined what financial freedom is to you.
That’s right! The very first thing you need to consider before moving forward is what financial freedom means to you. This means different things to many people, but for the majority, financial freedom means being able to cover your expenses (which includes all the things you need and want) without working again.
Sounds nice, doesn’t it? Well, if that sounds good to you, define what financial freedom means to you and keep reading as we embark on a 7-step process that will help you get on the coveted path to financial freedom.
This 7-step process includes the following:
1-Understanding your financial picture
5-Saving for retirement
Understanding Your Current Financial Picture
In this Step, we're going to talk about how to get a better understanding of your current financial picture.
Understanding where you currently stand can help you identify things that may be keeping you from your desired goal of being financially free.
This is also where you will create new financial goals that are in alignment with where you want to be.
To get a better understanding of your finances as they currently stand, take a look at these three things:
1) your net worth,
2) your current financial habits, and
3) your current financial goals.
For example: Mike &Cindy have a goal to retire in 10 years at the age of fifty-five. They currently have $65,000 saved and contribute $100 per month to their retirement fund. To fill the picture in, add the fact that they have $150,000 remaining on their mortgage and a $25,000 car loan.
If you sit down and do the math and compare it to their modest income of $50,000, this situation might not exactly spell financial freedom within ten years. Of course, this is just an example.
Use this scenario as a guide to help you paint your own picture. You need to determine your own current financial status and whether or not your spending and savings goals are helping you get closer your ultimate goal.
Your net worth will be the best number in helping you figure out how close you are to your goal of financial freedom. If the number is negative, this means you have more debt than you do assets.
If your net worth is positive, that’s a start, but it still doesn’t mean you’re closer to your goal of early retirement if your savings goals aren’t aggressive enough.
So, figure out your net worth first. Once you know this number, you can then evaluate your current spending habits to see where you need to make adjustments. Studies show that many Americans are spending 103% of their income.
That's 3% more than they generally earn. For most, 45% of income goes toward debt, 25% goes toward taxes, and 33% goes toward other spending. That leaves nothing for saving and giving.
If these numbers describe you, adjustments to your current spending patterns are inevitable. This could make a world of a difference when it comes to meeting the financial goals you’ll be creating to obtain financial freedom. Overall, you want to be able to answer the following questions:
How much am I saving?
How much am I giving?
How much of my spending benefits me long-term?
Where is most my money going?
Do I have any money left at the end of the month?
Where can I reduce spending?
Once you’ve asked yourself these questions and understand your net worth, you will know where you stand. At this point, you’ll be able to create more focused financial goals moving forward.
Creating Financial Goals
Now that you know your numbers, where do you stand? Do you have debt? If so, your new financial goals MUST include debt repayment. Lack of savings? You will need to include these types of goals as well.
Basically, wherever you currently stand financially, you need to determine whether it’s good enough to get you to financial freedom. If not, your new goals need to be goals that will move you in that direction.
Your goals may be quite simple once you've evaluated your financial state. You might want to pay off all of your debt or save $15,000 for an emergency fund.
Whatever your goals are, you need to write them down, and you need to make sure they're specific.
Wanting to pay off all your debt isn’t enough. You need to know how much debt you will need to pay each month and give yourself a deadline.
After all, you want to achieve financial freedom sooner than later, right? So, make sure all of your goals have a specific amount, action, and date. — let’s create a goal!
The very first goal should be to bring the net worth into the positive. To do so, let’s assume you’re focusing on paying off your debt.
A good goal would be to pay off the $25,000 car note in 18 months. Therefore, your goal should be to pay a little over $1,300 per month to knock out this debt.
Obtaining Debt Freedom
Once you've defined financial freedom and made the assessment of your current financial situation, you're ready to move forward.
Let's briefly discuss the other important elements in this 7-step process.
In Step #2 you will focus on your budget. Your budget will help you realize why your net worth may be in the negative and the reasons why you may not be on the fast track to financial freedom.
Your budget is also where you’ll include smaller financial goals for expenses that occur periodically over the year (holidays, vacations, insurance premiums, etc.). You’ll discover the best way to prepare for periodic expenses is to save for them throughout the year.
Once your budget is complete, you will have a plan in place to help you build your emergency fund (Step 3).
These funds are crucial because they provide you with financial security. Don’t confuse this with financial independence.
Financial security means you have enough money in liquid assets to endure a job loss, medical emergency, or some other financially debilitating event.
After you’ve determined a comfortable amount for your emergency fund, debt management (Step 4) will be the next area of focus.
Depending on the amount of debt you have, your strategy will be the most important part of your debt management plan.
Two popular strategies to consider are the debt snowball and debt avalanche methods.
With a debt management plan in place, next, you will focus on (Step 5) creating a retirement savings strategy that will help you reach your desired destination.
If you want to be financially independent by age 45, your retirement savings plan will need to consist of aggressive savings goals.
Last, you will want to consider how giving back plays a role in your plan to financial freedom. With a budget telling you where your money is going, financial security, and a plan for eliminating debt and saving for retirement — you may discover you have the financial capacity to give to others (Step 6).
As you progress through these steps, your goals may change (Step 7). Based on how important some goals are to you, you may decide to re-prioritize some goals or add more to your list.
Plan to revisit the financial analysis phase often throughout your journey. It will help ensure you’re always on track to reach your final destination.