Financial Order of Operations

You may remember the term 'order of operations' from algebra class.  In a mathematical expression such as:

the algebraic order of operations defines the correct sequence in which you must evaluate the components of the expression in order to arrive at the correct answer.

In personal finance too, there is a proper order of operations.  While it's obvious that you shouldn't be researching investment properties while you're deep in credit card debt, the details of the correct order in which to go about improving your financial situation aren't necessarily trivial.  When the way forward isn't obvious, a common reaction is inaction.  This article seeks to summarize a lot of what's out there into a straightforward roadmap toward solvency, stability, and ultimately, financial independence.

Step One — Figure Out Where You Are

Before you can begin making changes, you need to have a very good sense of your current financial standing.  This means knowing the amount and interest rates of all of your debts, how and where you spend your money, and your credit rating.

0) Gather information on all of your loans.  You need to know the identity of the loanholder, the remaining principal, and the interest rate.  Make sure you have access on the loanholder's website.

1) Sign up for Mint.com.  Add your banks, loans, and credit accounts, and this free service automatically aggregates and analyzes information on all of the flows of money in, between, and out of your accounts.  You may be surprised to see where your money is going!

2) Sign up for CreditSesame.  This free service provides you with your actual FICO credit score from Experian, which is what banks use when evaluating your credit and loan applications and deciding your interest rates.  This score is updated every month, so you can see how your actions impact the numerical value.

3) Pull your free credit reports at AnnualCreditReport.com.  This is what the banks can see and this information is used to calculate your numerical credit score.  One-third to one-half of credit reports are estimated to contain errors, so make sure that yours aren't among them.

Check out the Credit Hub for more information on how (and why) to maximize your credit score.

Step Two — Get In The Right Mindset

All of the following steps require that you have money available to carry them out.  If you currently spend 100%—or more—of what you make, you need to make a change.  If you already spend less than you make, great!  With a little conscious thought, you may find that you can save even more.

(accumulation rate) = (income rate) - (spending rate)

If you want to improve the accumulation rate, changes to either term on the right are equally helpful; for the vast majority, it's much easier—and much better-aligned with a sustainable, satisfying existence—to reduce expenditures than it is to increase income.  For this reason, it's expense reduction that I'll focus on.

If you find yourself totally unmotivated—or even offended by the suggestion—to cancel your cable subscription, cut back on the Amazon orders, and brew your own damn coffee, what you need first is an Attitude Adjustment.

There has been a lot written on the subject of living a sane, purposeful, sustainable, meaningful existence, and much of it is even free on the internet.  To get started, read Mr. Money Mustache and Raptitude.  If you want to go old-school, add some Thoreau.  This is Industrial Strength Attitude Adjustment Serum.

Check out some Profiles of Financially Independent People (work in progress!) for additional inspiration.

Step Three — Decrease Your Expense:Earnings Ratio

You can buy your freedom and retire early.  You can write that book.  You can learn to play guitar.  You can raise your own kids, for real.  You can devote the many remaining years of your life to exploring opportunities and solving problems that no one would ever pay you for.  The things that give your life meaning can be your full-time job.

Is this possible while living the default full-time 9-to-5 buy-what-I-want-because-I-can-afford-it lifestyle?  Maybe, for some tiny percentage of the population.  Saving 30%, 40%, 70% of your take-home pay and retiring in just a few years?  Make the numbers work, and this works for anyone.

Would you cook your own lunches and dinners for that?  Would you ride a bike to work instead of driving?  Share an apartment?  Give up the smartphone?  Buy used or borrow?  Learn how to fix things yourself?

This graph shows that you can't get something for nothing, and the less you save, the more years you commit to being required to work for pay:
The level of sacrifice required will scale according to your income and what you want 'early retirement' to mean.  An $80k income will finance a cushy existence even at a 60% savings rate, while saving half at $35k is going to be challenging.

Check out the Lifestyle Hub for ideas; Mr. Money Mustache also has quite the archive.

Once your savings rate is at least positive, proceed!

Step Four — Build an Emergency Fund

Before you start investing or engage in accelerated debt pay-down, set aside enough money to cover a few months' expenses to insure against the unexpected.

Step Five — Take the Free Money

Some may tell you that you should not make any financial investments until you are debt-free.  This is incorrect.  When you have debts, you should only make financial investments that have a greater rate of return than the interest rate on your highest-interest debt.

If your employer offers matching for your retirement plan contributions and you are in a position to take advantage of them, do it!  A full match is a free, instantaneous 100% return on investment.  Contribute the amount necessary to maximize the match, and direct the money into whatever Total Stock Market or S&P500 investment your employer offers (definitely not company stock!).

(Do watch out for vesting requirements, though — you may be required to forfeit the match if you leave the company before working there a stated minimum number of years)

Step Six — Attack Your High-Interest Debt

Debt with an interest rate above 5% is an emergency, and should be dealt with as such. High-interest debt can explode if not carefully managed.  After you've paid the minimum on all of your debts and you have an emergency fund, but all available money toward paying off your highest-interest debt.  Rinse and repeat, and do not buy depreciating luxuries on credit to avoid getting into this situation again in the future.

Step Seven — Fully Fund a Roth IRA

If you've taken care of the preceding steps, congratulations!  You are now ready to begin investing toward your future financial freedom in earnest.

After taking advantage of company retirement plan matching in Step Six, opening and fully funding a Roth IRA (Individual Retirement Account) is the next order of business.  In addition to the Getting Started page, I have a whole series of articles on the specifics.  This will take care of the first $5,500 a year that you'd like to invest.

Check out the Index Investing Series and the Investment Hub for more information on how best to utilize the accounts available to you and what to look for in an investment.

Step Eight — Max Your Employer-Sponsored Retirement Plan

Everyone's heard of the 401(k) plan, and the 403(b) and 457(b) plans offered by other industries are pretty much the same thing.  These plans give you a big tax break to encourage you to save toward retirement.  What, precisely, you should invest in depends on the options made available by your employer.  This will take care of the next $17,500 a year that you'd like to invest.

Step Nine — Fund a Taxable Brokerage Account

A regular brokerage account lacks the tax incentives of the IRA and the employer-sponsored retirement plan, but you're free to invest in whatever you'd like and there are no annual contribution or withdrawal restrictions.

Step Ten — Consider Nontraditional Investments

Real estate, peer-to-peer lending, crowdfunded investments—technology is opening up all sorts of nontraditional opportunities to the casual investor.  These opportunities may require more capital and expertise than the stock and bond markets, and are very likely less diversified and afflicted by hidden, systemic risks.  They can, however, be quite fun!  Some of these new ideas will certainly spawn opportunities that will be here to stay... it's just too early to tell which ones will succeed and which will crash and burn.

So, there you have it.  That's all you have to do!

This should keep us both busy for a while.

(The answer is 25, by the way)