Do you remember the mnemonic, Please Excuse My Dear Aunt Sally?
As a refresher, this saying is a way to remember the mathematical order of operations which is the sequence of steps you need to take to get the correct answer and solve a math problem.
The same thing is true in personal finance. Everyone has a unique financial order of operations. It too establishes a procedure that helps you optimize your extra money and achieve financial freedom, faster!
Your financial order of operations acts as a guide for your money. It tells you how to use your cash in the most efficient way possible which in turn allows you to reach your goals faster and retire earlier!
There are two main ways to become debt free; the debt snowball and avalanche. The snowball has you pay the smallest balance first. Whereas the avalanche starts with your highest-rate debt.
The main difference between these two is the amount of time and money it takes to pay your bills off. Since the avalanche focuses on your highest rate debt, it stops the loans that are working hardest against you, first. This reduces the power of compounding faster, allowing you to pay your bills off sooner!
Compounding has two sides, a negative and a positive. The negative aspect works against you and is known as debt. Whereas assets work for you and your benefit.
But, what if you have the option of either paying off debt or investing? How do you choose which one is better?
Debts and assets make your money move in one direction or the other. The rate at which this change occurs is an interest rate. The larger it is, the faster compounding is taking place!
For example, imagine you have an extra $500 after paying your monthly expenses. You have the option of putting the money towards a loan with a 15% interest rate or investing it in your 401k. Which should you choose?
Paying down the loan gives you a 15% return. Whereas investing it in your 401K yields around 7%. Fifteen is greater than 7, meaning that compounding is working harder on the debt which makes it the better option.
But, what if your employer matched your $500 monthly contribution? You’d double your money before earning any rate of return, making the 401K more profitable than the loan.
If you’re like most people, you work hard. You dream of creating wealth and having a happy retirement. And to achieve these things, you’ll need to build a strong financial foundation.
Your financial order of operations starts with having some basic money skills. Doing things like setting goals, budgeting, and controlling your expenses. All which allow you to begin saving and building an emergency fund.
Once your budget and emergency fund are in place, you’re ready to start. Begin by reviewing your personal financial statement and writing down all your assets and liabilities. Next to each one, note the account balance and interest rate that you pay or earn.
Then, consider your employee benefits. Determine the percentage and dollar amount that your employer matches on contributions made to 401Ks and HSAs.
For example, imagine you make $50k per year. Your employer matches 50% of your contributions up to 5% of your salary. On your financial order of operations worksheet, you would write down an interest rate of 50% and a dollar amount of $2,500.
Also, consider your investment options. Most people like stocks and according to The Simple Dollar the average return on the stock market is 7% over the long term. A figure that doesn’t account for inflation or total expense ratios. But is still one choice to include on your worksheet.
Once you have a list of all your financials, sort them by interest rate from highest to lowest. Then, direct your extra money to the top item first. Once it’s fully funded, you’ll move down to the next. A process that will continue until you’ve allocated all your cash surplus.
Also, consider how you can make the money you have already work harder. Think about moving some funds from items lower on the list to ones higher up. This change will increase the power of compounding and the interest rate you earn!
Listed below are the top areas most people should put their money. These are the items that will yield the biggest bang for your buck!
Most employees get free money when they contribute to a 401k. Max this benefit out by putting in enough money to receive your employer’s full match.
Consider the other benefits that your company offers, too. Some may match deposits made to Health Savings Accounts (HSAs) or offer an Employee Stock Purchase Plan (ESPP). Find out everything your employer offers and then add it to your financial order of operations worksheet.
According to Nerd Wallet, the average US household has over $7,000 in revolving credit card debt. And a report on The Balance found that the average interest rate on them is over 20%!
Credit card debt and personal loans work against you at an alarming rate. Their high-interest rates rob you of your time and money. Also, they handcuff you to your job and limit the options available in your life!
But, there’s a silver lining for those that have high-interest rate debt. Paying these accounts off allows you to become debt-free while earning an enormous risk-free rate of return at the same time!
If you have any debt over 10%, pay it off. Get your spending under control and make sure it doesn’t come back!
NOTE: The financial order of operations assumes you continue making minimum payments on all debts.
Your money mindset and financial goals determine the next steps you should take. If you’re against debt, then you’ll continue getting rid of it. Whereas if building passive income is your dream, you’ll look to invest.
As an investor, you’ll need to figure out your investment criteria and plan. The assets you should buy, the tax implications of each, and how they’ll help you reach your goals.
Also, explore the different ways you can grow your nest egg. This one step can save you thousands in taxes, alone!
Your financial order of operations is unique to you. It gives you a game plan for your money. One that allows your capital to get used in the most productive and efficient way possible. As a result, you’ll either have tens of thousands of dollars more by the time you’re ready to retire or you can retire even sooner!
Review your financial order of operations every time you receive a windfall, bonus, or pay raise. It will show you the money’s best use and get you the fastest results!
According to your financial order of operations, what’s the best use of your money? Comment below.
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