If I had to choose only two principles to teach anyone new to personal finance it would be your savings rate and automating your financial life. Your savings rate matters more than just about anything else if you want to become financially independent. This is because your savings rate incorporates other important ideas like spending less than you earn. The second, and equally important principle, is to pay yourself first by automating your financial life.
The purpose behind paying your future self first is to prevent yourself from the most common American financial mistake – spending everything you earn. If the money is swept out of your bank account to your real priorities first, then you cannot spend it. Why? Because you’ll never see it in your checking account. It turns out that “out of sight, out of mind” is quite true in personal finance.
Here are 6 ways that you can make your financial lives more efficient through automation. By doing so, you’ll find it easier and easier to reach your financial goals. For a primer, here is a visual representation of what I discuss below:
1. Emergency Fund
If you haven’t created an emergency fund yet, this is the first place that your money should go (after receiving any matching money from your employer towards your 401K/403B). Most recommend saving 3-6 months of living expenses in your emergency fund. This should be an entirely separate account from your checking account.
There are many reasons that an emergency fund is important. To list a few, emergency funds allow us to live a life with less financial stress, encourage us to be aggressive with our investing, and allow us to avoid digging ourselves further into consumer and credit card debt.
If your funds get depleted due to an emergency expense this should be repleted first before anything else is done. For example, when our air conditioning unit went out, we paid this with some monthly cash flow (since we always spend less than we take home) and the additional money came from our emergency fund. Because it was there, the $5500 AC unit did not add any additional stress to our lives.
How much is 3 to 6 months worth of spending for you or your family? It depends.
For my family, we spend about $10,000 per month. So, we have between $30,000 to $60,000 in liquid assets (i.e. cash in a high-yield savings account) available to us at all times. To figure out how much you spend each month, see number 6 below.
2. Retirement Accounts
The next place to route your paycheck is towards your retirement accounts. If you have student loans, you may consider breaking this up into two separate steps (getting your match from you 401K/403B and then directing money towards your student loans prior to putting additional money into other accounts). If you don’t have student loans, then you should be filling up this space according to your monthly savings goals.
For example, say that you have determined that you need to save $100,000 per year to be financially independent by age 50. This means you need to save $8334 per month.
According to the Investing Waterfall, it might look like the following:
- $592 to your Health Savings Account
- $1625 per month to your 401K
- [Employer match towards 401K of $1000 per month]
- $1625 per month to your governmental 457 plan
- $1,000 per month towards your annual Backdoor Roth IRA
- $2,492 to a taxable brokerage account
The above would result in an annual savings goal of right at $100,000. If you are paying yourself first, all of this money would be swept out of your paycheck BEFORE you see it and have the chance to spend what is left.
Further Reading:If you aren’t sure how much you should be saving each year, read this annual savings goal post.
3. Student Loan Payment
For the 80% of readers graduating with student loan debt, you obviously need to automate these payments as well. If your Debt to Income Ratio (DIR) is < 1, then I recomend you refinance your student loans through The Physicician Philosopher to get a cashback deal. If your DIR >1 (and particularly 1.5) then you should consider PSLF as a potential option.
Regardless, your anticipated student loan payment to have your loans taken care of in 3 to 5 years should be swept out of your bank account automatically. It’s another example of paying your debt-free future self first!
For my family, this meant a scheduled $5,500 monthly payment with plans to use 90% of any bonus/unexpected pay towards our student loans according to The 10% Rule. This allowed us to pay off $200,000 in 19 months. You can likely do the same, if you automate your financial tasks and pay yourself first.
