Financial foundations
A definition for the English word “sonder” was coined by John Koenig as part of his best-selling book, The Dictionary of Obscure Sorrows, published in 2021:
“the realization that each random passerby is the main character in their own story, in which you are just an extra in the background.”
At Sonder Consulting, it is a reminder that personal finance is deeply personal; everyone’s story is unique, and our approach to coaching is rooted in that belief.
With that being said, there are some things that we consider foundational - that is, they apply to almost everyone, and should be in place before anything more complex is considered. These foundational concepts provide a framework answer to the question: “what should I focus on first?” In the vast majority of cases, following these steps will set you up with a great financial base to work from. There is still nuance to these foundational concepts, so we do encourage you to reach out for coaching if you are unsure how these apply to your unique situation.
We approach Financial Foundations like a classic Hierarchy of needs. In general, we encourage clients to start at the bottom and work up to the top, though of course there can be exceptions to this. In this post we will explain each step and provide context as to why we have them in this particular order, and where you may be able to perform steps concurrently, or consider changing the order.
STEP ONE: build an emergency fund
You may have heard of an Emergency Fund before, sometimes called a Rainy Day Fund, or just Savings. We like to separate an Emergency Fund (EF) from other types of savings, which is why we will continue to use that terminology.
We consider an EF crucial because it provides the security needed to move on to the other steps. Setting money aside to cover unexpected expenses like an emergency vet bill or a fender bender will give you freedom. Freedom to continue to pursue other goals without going into debt or being forced to make difficult decisions. An EF is peace of mind, insurance, a safety net so that you can keep crushing your other goals.
The two considerations for an EF are how big it needs to be and where it should be kept. The answers to both of these questions are nuanced and we help clients determine what is right for them based on their unique situations. As a general guideline, an EF should be able to cover 3-6 months worth of essential expenses and should be liquid (cash) and easily accessible (e.g., in a high interest savings account).
One important note: it is crucial that you continue to pay all minimum required payments on any debt while saving your EF. We strongly suggest that building your EF is your first focus, but you should not ignore all other obligations to prioritize it.
step two: pay off high interest debt
What counts as high interest debt? We consider anything over 10% to be high interest. This will include almost any credit card, some lines of credit, and may include some other loans (car, student, etc.). Why 10%? Because, as we will discuss later, we assume 8-10% returns on long term investments; therefore, you are losing money if you have debt with an interest rate higher than 10% and it is important to prioritize paying off this debt before focusing on investing or saving for other purchases.
The two most common strategies to tackle debt are the Snowball Method and the Avalanche Method.
The Snowball method involves listing your debt in order of increasing balance and starting with the lowest balance (while still making minimum payments on all balances). Once the lowest balance is paid off, move on to the next one and add the monthly payment from your first debt to the second one (so the payment is larger), and continue like that.
The Avalanche method considers interest rates. List your debts in order of decreasing interest rate, and then start with the highest interest rate. Again, continue to make minimum payments on all debts but focus extra money on the highest interest rate debt. Once it is paid off, add the extra money to the second-highest interest rate, and so on.
Mathematically, the Avalanche method is superior and you will ultimately save money. However, as we know, money is deeply psychological and the way we feel about debt is often not at all logical. If it is motivating to you to see an entire credit card or loan paid off, then start with the lowest balance and use your successes as motivation.
A third, less talked about, option that we like to consider for clients is a “feelings” based payoff strategy. Maybe you have a credit card that is maxed out and has a fairly low interest rate but you feel anxious about carrying the balance and want to get rid of it. Maybe you have a loan that you took out while you were a student, but you really value your degree and you are glad you made that decision. Your feelings about these two different types of debt are entirely different, and it may be best to pay off the debt you feel “bad” about over the ones you feel “ok” about, regardless of balance or interest rates.
The important thing here is to pick a strategy and stick to it.
step three: low interest debt and investing
Now that your high interest debt is taken care of and you have an EF, you can focus on a combination of chipping away at low interest debt and starting to invest for retirement or “financial independence”.
We recommend that any money you are saving for retirement/financial independence is invested.
“Compound interest is the eighth wonder of the world. (S)He who understands it, earns it … (s)he who doesn’t … pays it.”
This where we start to get your money working for you!
Investing is definitely a topic too big for this post, but it is very easy now to get set up on a virtual, low-fees investing platform (like Questrade or Wealthsimple), open an account, and set up a roboadvisor. For most new investors we recommend using a roboadvisor so that your portfolio will be balanced according to your risk tolerance. If you want to dive into this topic further, please reach out to work with us!
Your priorities may shift between paying off low interest debt and funding your investment accounts. Shifts may be due to changes in your life (starting a family, buying a home, a sudden influx of cash) or you may strategically shift to keep yourself motivated. For example, some of our clients like to focus on maxing out their registered accounts from January to June and then switching to increasing their low interest debt payments between July and December. We would love to help set up a plan that works for you!
step four: saving for other purchases
Step four will start to happen concurrently with step 3, but we always recommend focusing most of your attention on getting a good base of investments set up before looking to other large purchases or significant savings goals (think home ownership, big vacations, a splurge car, etc.).
We also recommend saving for things like vacations, gifts, weddings, etc. in advance, normally using something called a “sinking fund”, which is a separate account that money is deliberately set aside in for future purchases. This ensures you will not get into debt when the holiday season rolls around or you get invited to a bachelorette party in the Carribbean.
This is considered step four mostly because it is the highest level of sophistication in a financial plan, not because it has to happen absolutely last. For the vast majority of our clients, their “status quo” is always circling somewhere in steps three and four, and we help them strategize what to focus on when. Once you have a fully funded Emergency Fund, your high interest debt is paid off, and you are regularly contributing to your investment accounts, you get to choose how to allocate the rest of your money - and we would love to help you figure out what that looks like for your specific situation, values, and goals.
We hope it goes without saying that there is a LOT of nuance and caveats to all of these steps, but it is a good general framework and starting point. We always recommend reaching out for personalized coaching so that we can help you navigate these steps - you don’t have to make financial decisions alone!
Are you ready to get your financial sh*t together? We can’t wait to meet you.
