A Case Study

Jason and Amy make $96,000 per year. Their monthly income is about $8,000 per month. They have $5,000 on their credit card, $2,000 in their checking account, $3,000 in their savings account, and $15,000 in their 401(k). Table 3.1 shows where they are and compares it to a balanced path. They could use the glide path to guide their decisions.

The table suggests Jason and Amy reprioritize, and they consider:

1. Reducing their oppressive debt; it is $5,000 too high.
2. Building up cash in their checking account by $6,000.
3. Deemphasizing/pausing from adding to their retirement plan. To be clear, they should NOT take funds from their retirement plan. Table 3.1 simply suggests this bucket might be overwatered. The best way to get it in balance will be to grow everything else around it.
4. Building up cash in their savings account by an additional $13,000.

This is a pretty common situation in which people have a strong early start to retirement savings but also have credit card debt and limited cash savings. If this is you, I'm thrilled you've started saving for retirement early, but I'm concerned you do not have enough liquidity to handle the curve balls life sends.

Here's how I suggest Jason and Amy change things. Let's assume they are saving 12 percent, all in their 401(k). Their employer matches 3 percent of the first 3 percent of their contribution. They could consider the following action steps:

1. Reduce their 401(k) savings to 3 percent. This lets them take advantage of the match (free money!), but gives them more take-home pay to even out their balance sheet.
2. Direct all other savings to eliminating oppressive debt.
3. Build up cash reserves in checking first, then in savings.
4. Continue this process until each bucket reaches its goal.

They should try to accomplish these goals over a three- to five-year period. If they try to do it in less than three years, the change would be too radical and nudge them off course. I would further advise that they target building toward an 18 percent savings rate. They could do this by increasing their savings by 1 percent per year for the next three years. They would be saving 15 percent plus their employer match of 3 percent, for a total of 18 percent.²

If you aren't saving at 15 percent, you should build to that rate over time. Here is a good trick to get there: Take 15 percent less your current savings rate/5. For example, if you are saving at 5 percent, then 15 percent less 5 percent = 10 percent. 10 percent/5 = 2 percent. You could consider increasing your savings by 2 percent per year for the next five years, gradually working toward 15 percent.

Application

1. Write down your gross pretax annual household income = _______
2. Divide the number by 12 = ____________

For example, if your household makes $60,000 per year, you would write down $5,000. If your household makes $120,000, you would write down $10,000.

Using your monthly income as a base figure, we can start to build a customized plan and a glide path. Together, we will create a table with a suggestion for what a balanced path can look like. Then we can fill in where you are at this point in your life. The final step will be to look at the gap between the balanced path and where you are right now. If you are higher in a certain area, then I suggest you de-emphasize adding to that bucket. If you are lower in a certain area, then you will want to focus on building to the target zone.

It is important that you look at each step sequentially, like a video game: You have to clear level one in order to get to level two. This is true for the phases and the steps within a phase. Once a step is full, check it off and move on to the next step or phase.

We all learn at different paces and in different ways. Being familiar with how to use these tables will be key to moving forward in the other phases so Table 3.2 includes more commentary on how the process works. If it is still confusing, I recommend you read through the material one time, focusing on the examples, and then come back and try it with your personal life.

Table 3.3 is for you to use so we can determine a specific action plan. I recommend you begin with the column that says Balanced Path first. This will give you the glide path for what each goal should look like. As you fill in where you are, start at the top and work down. For example, the goal is zero oppressive debt. If you have $10,000 on your credit card then you would write zero in the balanced path, $10,000 where you are and $0 – $10,000 in the gap column = (–$10,000). This gap of $10,000 means that you are $10,000 too high, you have $10,000 too much oppressive debt. If this is the case, I suggest you deemphasize other goals and focus on paying down credit card debt.

As you fill out the table, try not to get discouraged about any existing gaps you have. Remember, it is not helpful to look at the past. Know that much of America is right where you are, and many are likely worse off than you. Focus on the future and you can have a successful Launch.

There is one complicating trick to this phase: I am separating your checking and savings accounts. I want you to have a three-month total reserve so you break the paycheck-to-paycheck cycle. I think it is important to separate the money and use your checking account for expenses and a savings account for emergencies. I find it helpful to separate the two, but if you disagree you can look at those two steps as interconnected goals and focus on the total in the two accounts.

The bigger point is that too many people over emphasize retirement savings early and risk having too little in cash while they also have oppressive debt. This is the cycle that I want you to break.

When your household income is more than $50,000 and you have no oppressive debt, a retirement plan with a balance of at least one month's income, and three months' cash reserve, congratulations are in order. You are ahead of approximately 40 percent of Americans.³ You're much less likely to live paycheck to paycheck again. You can consider buying a home or making those major purchases. And, if you can accomplish this and establish an excellent credit score, your financial future is bright.

Frequently Asked Questions

My goal is to make the advice throughout this book specific and actionable. With that in mind, let's address some of the more common questions that come up during this phase that warrant more discussion:

• What about student debt?
• Should I rent or buy my house?
• What if I already own a house?
• What if I do not have a match from my employer?

Scenario 1: You Do Not Own a House

Continuing to expand on the same framework we used in the Launch phase we get the following steps:

1. Step 0: Zero oppressive debt. While it may seem a bit repetitive, it is worth repeating. No oppressive debt. Not now. Not ever.
2. Step 1: Build a three-month cash reserve in your checking account. Three months' reserve in a checking account is a good level of “oil in the engine” to cover surprise expenses. With the three-month reserve in your savings account, you'll have six months of cash reserve, which gives you greater ability to ride out many storms.
3. Step 2: Build your retirement savings. Work towards saving six times your monthly income.
4. Step 3: Establish a big life changes fund. Many people want to own a home. Others want to get married and have a big wedding. Still others want to go to graduate school or change careers. I suggest building a nine-month cash reserve in your savings account for these kinds of purchases.

Meet Steve and Kevin. They rent and plan to continue renting for a while. They make $90,000 a year and save $15,000 each year. They have $15,000 in checking, $5,000 in savings, $75,000 in retirement, and $25,000 in some mutual funds. They recently went on a trip and are carrying $5,000 on their credit card but want to pay it off from savings over the next couple of months. Table 3.7 provides a sketch of where they are and of what a balanced path could look like with these goals. With their annual income of $90,000, their monthly income to use for the table is $7,500.

I would suggest that Steve and Kevin need to eliminate that credit card debt quickly. They are ahead on retirement and behind in building up their cash reserves and big life changes bucket. Therefore, I would encourage them to first eliminate the credit card debt, deemphasize retirement savings (but always be sure they are taking full advantage of their employer's match), build up checking, build up savings, and then build up their big life changes bucket.

Table 3.8 provides a tool to sketch out what a balanced path could look like with these goals. Feel free to combine checking and savings into one bucket.

Scenario 2: You Would Like to Purchase a House

Brandon and Teresa are in the Independence phase and want to buy a house. They make $60,000, or $5,000 per month. They have:

• $0 oppressive debt
• $15,000 in their checking account
• $15,000 cash reserve in their savings account
• $30,000 in retirement savings
• $45,000 in their big life changes fund

That equals $105,000 net worth.

Let's assume they want to buy a $240,000 house. In this example, their income is approximately equal to the median income and their home purchase is approximately equal to the average (median) home purchase price.⁵ If Brandon and Teresa use their down payment savings of $45,000, they need a mortgage for $195,000.

Table 3.9 shows what Brandon and Teresa's financial life could look like.

Note the $195,000 mortgage divided by the $240,000 purchase price equals 81 percent loan-to-value. We will get into more detail on mortgages later, but many loans require a 20 percent down payment. If Brandon and Teresa have to dip into their savings to get the mortgage to 80 percent, that's fine. It is okay to dip into your savings from time to time; that's what it's there for. At the same time, if you use that reserve, it is essential you immediately build it back up to get back in balance.

Recall our notes on calculating your net worth. Table 3.10 shows how buying the house changes both sides of Brandon and Teresa's balance sheet.

Notice the debt ratio is $195,000/$300,000 or 65 percent. This level of debt is too high long term and needs to be reduced. Long term, I would like to see their debt ratio closer to 35 percent and falling. There are two ways for Brandon and Teresa to reduce their debt ratio: Grow assets or pay down debt. At this point in their life, the best thing for Brandon and Teresa is to focus on growing their assets, not on paying down this low-cost, working debt.

A Case Study of Dual Income, No Kids

Bryan and Kate are married with dual incomes, have no kids, and live in Chicago. They are in their late 30s and have been renting since college. They make $180,000, or $15,000 per month, and would like to move into a house and start a family. Table 3.11 shows what their financial picture looks like.

Bryan and Kate are following a balanced path, so how much home might they consider? For now, I want to focus on the balance between assets and liabilities and income, independent of interest rates. If Bryan and Kate purchase a house worth $750,000, their assets would be $950,000 and their liabilities would be $600,000, as shown in Table 3.12.

Application

As we did in Phase 1, use Table 3.13 to compare where you are to what a balanced path might look like with these goals. As a reminder, start by filling in the answers to the suggested balanced path. Then fill in where you are, starting at the top and working down. The gap is the difference between where you are and what a balanced path represents. This can give you a framework to consider, discuss, and apply to your personal situation.

Scenario 3: You Already Own a House

If you already own a house, the same concept applies. Fill out Table 3.13 and look at where you are relative to the recommended areas.

If your mortgage is under your monthly income × 39, that is OK, but I suggest you deemphasize paying down any more against your mortgage. Instead, money should go to building up the other areas such as cash, retirement savings, and the big life changes account. At this point, you still have many more changes to come and nothing helps more than having money at the ready.

If your mortgage is higher than your monthly income × 39, then we need to check in with the other categories. If any other area is low, meaning it is under the suggested balanced path, then I suggest you build up those areas before you work toward paying down your mortgage. This is controversial. The “debt is bad” camp will tell you to reduce your debt by paying it down. My point is to reduce your debt ratio by building assets. In this phase of L.I.F.E., independent of your age, you need more assets, not less working debt.

Always remember, you can change your net worth by paying down debt or by building up assets. To be clear, I would rather that you direct future savings to the other categories until they are close to full/accomplishing their goals. I also would consider the list to be a prioritized list. I suggest you first build up your checking and savings and then your retirement. By the time you hit a net worth of 21 × your monthly income, you are ready to start to look at moving into the next phase.

If any other number is significantly out of line from the target, you want to deemphasize adding to that bucket and build up everything else around it so you're closer to balance.

I want to hammer home a few important points as we are still building our long-term foundation. Table 3.14 highlights a few of the differences between what so many people do and my specific recommendation.

Congratulations—if you are under 50 and you clear the Independence phase, saving at a rate of at least 15 percent, then it is likely that your net worth is not only near the top 40 percent of all Americans, but you are also likely to be on track for retirement.⁶