When you spend less and earn more, your personal profit will grow. As it grows, you’ll create what I call a “wealth snowball”. Your wealth snowball is the mass of money that comes when your invested profits grow through the power of compounding.
Compounding is the magic that occurs when your money earns interest – or investment returns – over a long period of time. You earn returns not only on the amount you’ve contributed, but also on your previous earnings.
- So, if you invest $100 at 10% interest, you’ll have $110 after one year.
- But, in the second year, you earn 10% on your original $100 contribution and on the $10 interest you earned the first year. In year two, you earn $11 in interest. Now you have $121.
- Then, in year three you earn 10% on that $121, and your original investment grows to $133. And so on.
That’s basic compounding. But compounding becomes even more powerful when you continue to add to your investment. In this way, you earn interest not only on your initial investment (and subsequent interest earnings) but also on the new money you add.
That’s the wealth snowball in action. The effects of compounding start small but over time, they become enormous.
The Debt Snowball
While many folks who have purchased this course probably have a strong financial base already, I know that won’t be true for everyone. So, before we jump ahead to building wealth, let’s take a few moments to address what you should do if you’re currently struggling with money.
For these people, I’m a big fan of the advice offered by Dave Ramsey. Yes, I’m aware that Ramsey frequently gets himself into hot water for his political and religious views. I don’t care about that. I care about whether or not he helps people master their money. And he does.
Ramsey’s philosophy (which you can find in his book, The Total Money Makeover) is built around a series of “baby steps” designed to help people develop financial confidence. These steps work. I used them myself to get out of debt nearly twenty years ago and I recommend them to others. What follows is my version of Ramsey’s advice.
Once you’ve begun to produce a personal profit (once you’re earning more than you spend), follow these steps. Do them before you begin to invest.
- First, get current on existing bills and obligations. Use your personal profit to catch up on rent, electricity, your cell phone, and so on.
- Next, set aside an emergency fund. This money is only for emergencies. It’s like your own personal insurance fund. I recommend starting with one month of expenses in a savings account. If you spend $2500 each month, your initial emergency fund should be $2500.
- Finally, repay your debt using the debt snowball method.
I explain the debt snowball in the course, obviously, so I won’t re-hash that info here. Here’s one video as a refresher.
Here’s a collection of debt snowball spreadsheets. And here’s the official debt snowball calculator from Dave Ramsey’s website. (Note that Dave Ramsey didn’t invent the debt snowball. However, he did popularize this version of it.)
When you tackle debt using the debt snowball method, things start slowly but they gradually pick up speed. It’s like a snowball rolling downhill gaining size and momentum. By the time you reach your final debt, you’re making huge progress.
The Wealth Snowball
After you’ve completed your debt snowball – or if you never had debt to begin with – it’s time to turn your attention to building a wealth snowball.
Before you begin investing for the future, it’s best to increase your buffer against bad fortune. Once you’ve eliminated your high-interest debt, bolster your emergency fund. No two experts agree on how much you should set aside for rainy days, but I think this is a good guideline:
- If your personal situation is stable and the economy seems sound, you should set aside at least three months of expenses in your emergency fund. So, if you spend about $2500 each month, increase your emergency savings to $7500.
- If the national economy is struggling and/or your own personal economy is unstable, save more. Set aside at least six months’ worth of expenses – or a year, if possible. With $2500 of monthly spending, that would mean saving between $15,000 and $30,000.
I finished writing this course the week COVID-19 hit the United States. I recorded it two months later with no idea of what its long-term effects would be. In retrospect, it’s clear that many Americans would have benefited by having increased savings. Use the coronavirus pandemic (and your experience with it) as a guide to determine how much you should save for emergencies.
Stick this money into a high-yield savings account.
After you’ve increased your emergency savings, it’s time to start the fun part of the financial independence journey. You’ve paid off your past and provided for your present. Now you’re ready to fund your future.
This is the order I recommend you prioritize your retirement investing. (We’ll cover how to invest in the next lesson.)
- If you have access to a retirement program through your employer – whether that’s a 401(k), a 403(b), the Thrift Savings Plan, or something else – contribute at least enough to earn the employer match. Doing this is almost like being given “free” money. If your employer doesn’t match contributions, start with step two.
- If you qualify – if your income isn’t too high – contribute as much as possible to a Roth IRA, up to the legal maximum. If you earn too much for a Roth, max out a traditional IRA instead.
- After you’ve taken full advantage of your IRAs, go back and max out your employer-sponsored retirement plan.
If you’re in the fortunate position where you’re able to fully fund tax-advantaged retirement accounts and still have money left over, the next step is to turn your attention to personal priorities.
You might continue investing for retirement through the use of regular, taxable accounts. You might choose to repay low-interest debt that wasn’t included in your debt snowball. You might pay off your mortgage. The choice is up to you.
The Road to Financial Freedom
Too many people view financial independence as only one thing, as a destination. To them, financial independence is when you’ve saved enough that you can live off your investments for the rest of your life.
I don’t think of financial independence as a destination. I think of it as a journey. Nowadays, I talk about the path to financial freedom as comprising seven stages, each step building on the ones before it.
Several years ago, I created this graphic to explain those stages:
![[The Stages of Financial Freedom]](https://www.getrichslowly.org/wp-content/uploads/23440575834_c247120755_b.jpg "It took me far longer to create this graphic than you might expect. I am not a graphic artist.")
Obviously, these seven stages are largely arbitrary divisions. They’re meant to illustrate an idea: Financial independence isn’t any one thing. It’s not a fixed destination but a series of steps that lead to ever-greater options.
The more money you have, the more freedom you have — and the more risks you can take. As your financial independence increases, you chip away at the wall of worry. When it’s time to make a decision, you no longer have to ask yourself, “Can I afford this?” Instead, you begin to ask, “Which choice will make me happiest?”
Additional Resources
Finally, here’s a list of additional resources if you’d like to learn more about the concepts in this lecture. First up, here are some books on this topic:
- The Total Money Makeover by Dave Ramsey
- How to Get Out of Debt, Stay Out of Debt, and Live Prosperously by Jerrold Mundis
- The Snowball: Warren Buffett and the Business of Life by Alice Schroeder
If you’d rather read material on the web, here are some related articles:
- The Extraordinary Power of Compounding at Get Rich Slowly
- How and Why You Should Start an Emergency Fund at Get Rich Slowly
And don’t forget: If you’d like some general resources for financial independence and early retirement, I’ve created a page here at Money Toolbox that links to useful FIRE apps and tools.