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®.
Your illustrations really help the points stand out. I think the stages you’ve defined and the steps you listed are dead on.
I’ve only just passed Stage 2 a couple of years ago and now I’m investigating ways to move beyond Stage 3. My business didn’t take off (I didn’t really give it a chance to succeed), but I’m hoping my writing work will start giving me the breathing room I need to save and invest more.
Thanks for including my article in your illustration.
Great diagrams! I’m working at Stage right now. I used to be at Stage 1 a few years ago.
Pinyo-Great post. I love how it clearly shows the stages. It makes it easy to see where you stand, especially stages one and two.
Stages one, two, and three are well defined. I think four and five need to be fleshed out. At this point expense control takes a backseat (it’s still important) to income generation and investing. That needs more coverage.
Again, great job putting this together. I hope you don’t mind me referring to it!
Oh, I forgot to say what stage I’m at. I’m currently at stage 4 where my day job is still my primary source of income. I’m working to grow my side income to replace it. It’s part of the reason my blog focuses on entrepreneurship as I believe it is the best path to financial freedom. The key is to not build yourself another job!
Great disagrams and illistrations. I live the description and ‘what can you do’ of each stage. I am currently in stage 4 and working hard to get to stage 5. Stage 1 is the worst place to be. I’ve been there and it sucks. It’s very hard to get any traction. I think stage 1 is where most people need help. Once they get past stage 2, their own motivation will push them through the other stages.
@B Smith — Great input. I will add something about retirement funding sources, safe withdrawal rate, possibly annuity, and something about maintaining a healthy lifestyle to Stage 5. Thank you.
Great post. Good illustrations and TONS of good advice. Along the same lines of retirement would be legacy planning. One of the biggest reasons we are all doing this is to leave a legacy and that oftentimes comes with tons of cash and assets for loved ones.
I believe one needs to really start this, no matter which stage you are in, but definitely by Stage 2…
Excellent post! The debt spiral reminds me of the “hamster wheel” of debt people tend to get on while in debt. The more money they spend on debt reduction, the less cash they have, so the more they charge on credit cards. It’s a vicious cycle to be in – I know because I’ve been there. Thankfully, I’ve moved on, but I’m still paying off past financials sins.
Great post! My one complaint is that you show the majority of cash flows going to expenses even on the later stages. It seems to me the best path would have expenses be a smaller component while the majority of income goes back into savings and investments.
Hey Pinyo – saw your post on Reddit’s frontpage. Nice one! I upmodded you. Good luck!
Woohoo, I’m at step 3! It actually feels really good to be able to say that. This time lasy year I was very much a step 1 kinda gal.
Awesome post, and the images in particular really work to illustrate the different stages.
When my husband and I got to Stage 3, we referred to it as the “Just Don’t Screw It Up” phase. 🙂
At the moment I’m between stage 2 and 3.
I’m hoping that making money from blogging is a beginning to wealth building. The diagrams are great.
Pictures do say thousands of words. You have send us all a very clear and important message. I am at the early stages of Stage 3.
Thank you everyone!
@Adam — Not drawn to scale 🙂 But I would argue that you’ll have a lot of expenses at later stages too — i.e., lifestyle inflation, health care, etc.
Hi – like the diagram and how they clearly illustrate the stages. I definately see my self in many of those stages at one time or another in my life. I am focused on Stage 4 now, although I have to struggle sometimes to keep stages 1 and 2 at bay.
sounds like Rich Dad, poor dad
I’m a Stage 4, I’m still working and have a side income
How do you make such great charts and graphs? I would love to be able to have the great graphics you have.
While I can see Stages 4 and 5 as freestanding, the first 3 Stages in my experience are more fluid. For example, our income over the past few months has been somewhat lower than usual so we’ve been running up credit card debt after having been totally debt free at one point (Stage 1) but we continue to add money to our retirement plans and for our minor child’s post-secondary education (Stage 3). We still own our future retirement home outright (Stage 3 or maybe 4), but our expenses continue to rise (gas prices!) (Stage 1) and I’m currently planning… Read more »
@Moneymonk — Must be because I am talking about money…seriously.
@Jason — Believe it or not, it’s PowerPoint. 🙂
@Shevy — I agree that things are more fluid in real-life. And I didn’t say that everyone in Stage 1 resort to Payday Loan (and I hope not).
The problem I see is that the diagrams for stages 3, 4, and 5 do not show relative wealth accumulation and stage 1 should show a death spiral for debt. I think these diagrams could be more instructive if viewed on the side (or angled side), adding a relative third dimension where you are spiraling up, down, or staying flat.
Also, I’m wondering if stage 5 should have any debt shown. You should be able, at that stage, to not carry any debt, and any debt you carry should be significantly less than your assets IMHO. Just a thought.
Wow these illustrations hit home with me. I really think that you could have had this post with just the illustrations and no narrative whatsoever! That is an amazing feat if you ask me! This is going in one of my posts of the week PINYO. You provide us with amazing content that adds value to us all!
I liked this post a lot – the illustrations really helped some things click for me. I am teetering between stages 1 and 2 – trying to move firmly into 2 so I can work on getting to 3.
@getagrip — Thank you for your ideas. The reason I still have debt in the last stage is because I think most people will have some form of debt no matter how small. This could be a few hundred dollars you pay to your credit card companies.
@Doctor S — Thank you. 🙂
@Dawn — And this is a good time to move into stage 3 (investing and saving) also. Hopefully, you’ll be able to retire some of your debts soon so that you can move forward.
Wow. Great post. Staying healthy physically is also insurance for your wallet. Your tips are awesome and following them will definitely lead to a more financial security.