Last night, I was pondering the subject of cash flow (essentially how money flow through our hands) and about financial well being. I played around with various visualizations that consist of income, expenses, debt, and assets. What I came up with was the 5 stages of financial health below.
I believe that all of us go through these stages at one point in time, although some may never fall into “the debt spiral” or achieve “financial freedom”. Below are the description of each stage and some suggestions on how to improve your finances if you fall into that particular category.
Stage 1 – The Debt Spiral
You are earning less than you spend, forcing you to rely on payday loans and credit cards to make ends meet. To make it worse, these debts are causing to pay fees and interest expenses that add to your already overwhelming expenses.
What Can You Do
This is a dangerous stage to be in, and there are basically two things you can do:
- Fight it by reducing your expenses to the bare bone and increasing your income. You’ll have to reevaluate your priorities and look at every single expense. If it doesn’t play a role in your survival, you have to cut it out. The best kind of expenses to look at first is the recurring ones that you pay monthly — i.e., subscriptions, utility, housing, food, entertainment, transportation, etc.
- Give up by declaring bankruptcy and starting over. If you are going down this route, be sure you are ready for the consequences of filing for bankruptcy. More importantly, will you be able to adjust your habits so that you don’t fall into yet another debt spiral?
Personally, I hope that you’ll pursue option #1 and work yourself toward Stage 2.
Stage 2 – Living Paycheck to Paycheck
You are spending everything you earn, and you are not saving a dime. Occasionally, you’ll go hungry for a few days before your next paycheck. On the bright side, you are able to keep your debt in check…for the most part.
What Can You Do
Certainly, this is not a great place to be in, but the good thing is that you have options. There are several things you can do at this stage:
- Like the first stage, you want to keep your expenses in check and reduce it as much as possible. One way to do this is by creating a habit of frugal living. And understanding the difference between a “need” and a “want” will go a long way.
- Again, continue to explore alternative income ideas. Since you are essentially breaking even, every bit of extra income helps.
- Attack your debt with a passion. You can follow this basic debt reduction program, or learn more about Dave Ramsey’s Debt Snowball and Gazelle Intensity. Another good resource for attacking debt is a concept called Snowflaking.
If you could do these three things, you’ll soon be moving to Stage 3.
Stage 3 – Spending Less Than You Earn and Building Wealth
This is your basic middle of the road stage. Your income is greater than your expenses, you have some debt such as mortgage, car loan(s), and student loan(s) that you pay monthly, and you have a little left to save and invest. Your savings and investment may even add a little bit to your income by ways of interest payment, dividend, distribution, or even rental income.
What Can You Do
This is not a bad place to be in. At the very least, you have a positive cash flow and are accumulating wealth. However, there are certainly things that you could do to improve your finances further:
- Have clearly defined financial goals.
- Make savings and investing automatic.
- Learn to invest wisely.
- Protect your finances and family with various types of insurance.
- Maintain your frugal lifestyle.
- Continue to look for ways to build your primary income, investment income, and alternative income streams. Perhaps expanding into areas like real estate investing and starting your own business.
Now on to Stage 4.
Stage 4 – Power Wealth Building
This is a build on Stage 3. You are continuing to keep your debt and expenses under control, while growing your alternative income and building up your assets by savings and investing.
What Can You Do
You are doing well financially — however you should continue to tweak and improve various aspects of your finances wherever you can. Complacency is the enemy here…never stop looking. Key things that you could do at this point:
- Keep growing your investment income.
- Start shifting your primary and alternative income toward passive income sources.
- If you haven’t done so in the past, it’s time to take care of your health. As you age, health care expenses will be the most significant expense category.
At this point, financial freedom is within reach. All you have to do to reach Stage 5 is stop trading your time for money — that is shift your income from active to passive sources.
Stage 5 – Financial Freedom
You no longer have to work for money, or at least in a sense that you no longer have to work regularly for it. You don’t have to work for someone else…you work for you. At this point income from your investments and alternative sources could pay for all of your expenses and debt (if you still have any left by that time).
What Can You Do
You worked hard to get to this point…enjoy it! However, please do consider these things:
- Since you’re no longer working for your income, you have to make sure you do not outlive your assets. There are several things you could do:
- Adjust your investment risk through asset allocation with bias toward fixed income investments.
- Know your safe withdrawal rate.
- Consider an annuity to guarantee a life-time income stream (please consider this very carefully).
- Protect your assets with long-term care insurance (again, may not be right for everyone).
- Learn how you can retire with less.
- Make sure you stay on top of your health.
- Regularly evaluate your estate plan (or legacy planning).
I hope you enjoy these diagrams and the accompanying descriptions. Which financial stage best describe your finances? Do you agree or disagree with the suggestions?
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.