Pagliarini has a quick quiz to determine if you're in the financial danger zone (red zone) or in the safe (green) zone.
If you work in the housing industry, finance, auto or retail, you're in the red zone because more layoffs are expected in those fields. The green zone jobs are everything else.
Contrary to conventional wisdom, if both spouses work Pagliarini considers that the red zone. If two people are struggling to stay above water and pay their bills, and one loses a job there's no one there to help. If only one spouse is working, then the other can jump in and lend a hand by getting a job or pitching in financially some other way.
You're in the green zone if you hit financial trouble and have a strong network of friends and family who can help, whether it's babysitting the kids, giving you a ride to a job interview or lending you money.
You're in the danger zone if you have less than six months of your household expenses saved..
Having monthly fixed expenses puts you in the danger zone. If your monthly expenses are more variable, you can cut back if you need to.
If you have a lot of debt at a variable interest rate, you're in the danger zone. If you have fairly low debt at a fixed rate interest, you're in good shape.
Pagliarini says if you've got more reds than greens, you need to take action. Use fear to motivate you, not to paralyze you. Boost your savings by cutting expenses. Shift from variable interest rate debt to fixed rate and pay it down quickly by getting a part-time job.
Read an excerpt from "The Six-Day Financial Makeover":
What Is a Financial Makeover?
Maybe you're not sure what to expect from a financial makeover. That's fair. It's good to be a little skeptical. If you're familiar with fashion makeover, you know the successful ones don't stop with a facial or a new wardrobe. Successful makeovers require a total transformation—from head to toe and inside and out. Likewise, your financial makeover won't stop with just a budget or an investment plan. Your financial transformation will include all of the critical areas of your financial life—creating a spending and savings plan, protecting assets, investing wisely, risk management, insurance, estate planning, and much, much more.
Over the next six days, your financial makeover will strip away every thing that is not working—maybe you're spending too much, sabotaging your own success, taking too much risk, not investing wisely, or leaving yourself and your loved ones financially exposed—and replace it with a solid foundation from which you can immediately start to see success and feel a sense of confidence. Your financial makeover will also maximize what you're already doing well. If you have powerful and inspiring goals, are saving diligently, and investing well, your Six-Day Financial Makeover will help you maximize and optimize your strengths.
I will walk with you, step by step, throughout the six-day transformation. Together we will turn the complexities of budgeting, investing, insurance, and estate planning into something understandable and practical. We're going to take the "pie-in-the-sky" theories and turn them into bite-sized pieces that you can implement in your life immediately.
The Importance of Financial Independence
Financial independence is a phrase that gets tossed around too often and usually without any understanding of what it really means—often by salespeople on late-night infomercials hocking "get rich quick" real estate schemes, home-based businesses, or investment trading programs. My goal is to take the mystery out of financial independence and to show you exactly what it is and what it provides and to explain what financial independence is not. Financial independence should be your primary financial goal, and here's why.
At the root of financial independence is the freedom to choose. The ability to choose between several options puts you in control of your finances and your life. It allows you to shape your life rather than being at the mercy of someone else's vision of your future. It takes you out of life's passenger seat and puts you behind the wheel. Suddenly you can choose the kind of work that stimulates and inspires you without worrying about how much money you will earn. It also allows you to pursue your hobbies without regard to their cost or time commitment. For many, financial independence allows them to volunteer their time and money to worthy causes.
Financial independence also provides security. How would you feel if you could live the lifestyle of your dreams without worrying about being downsized, having to work two jobs, or sacrificing time with your family? When you become financially independent, your sense of security comes from having control over your life and your future. Without financial independence, your life is dictated by someone else—usually your employer.
Your security is in the hands and at the whim of an organization or an individual with their own best interests at heart—not yours.
What Is Financial Independence?
Financial independence means different things to different people. To some, it means being able to pay the bills. For others, it means being able to eat out every night. Yet for some, it means being able to have three vacation homes and a yacht. I define financial independence as being able to support the lifestyle you desire without having to work.
There are two important pieces to this definition. First, you need to differentiate the lifestyle you desire from your current lifestyle. This is a signficant distinction. Too often, we reduce our lifestyle to fit within our means.1 Financial independence is not about limiting or reducing your lifestyle, but about living the life you want and having the means to support it.
Second, financial independence means you don't need to work to support your lifestyle. This just means that the income generated by your assets can fully support your expenses.
Income from labor is earned income. It requires your participation, effort, and energy. If you decide to take a year off, your earned income ceases. Earned income is how most of us receive money. Our alarm clock wakes us in the morning, wre have our cup of coffee, we take a shower and get dressed, and we drive to work. We put in our day and drive home. Every couple of weeks, we get a paycheck. This is the earned income cycle.
Earned income is an exchange of time for money. Through education and experience, we can increase the value of our time and be compensated accordingly. Even high-powered attorneys or surgeons who make hundreds or thousands of dollars an hour still exchange their time for a paycheck. The minute they stop this exchange, they stop earning income.
Financial independence breaks this cycle. It replaces earned income
with passive income. Passive income includes the following sources of income:
Investment income (e.g., dividends, interest, capital gains)
Rental real estate income
Partnership and business income (if you don't have to work or manage anything to receive it)
Social security and pension income
Passive income is the Holy Grail of personal finance. Why? You don't have to trade your time for it. Passive income gives you the freedom to do what you want. Earned income is a chain that restricts what you can do and when you can do it. Passive income liberates us from nine-to-five jobs and two-week vacation limitations.
Contrary to its name, accumulating passive income is not a passive endeavor! Accumulating the assets to generate passive income requires skill, education, and diligence. You can't expect to sit back and have massive amounts of passive income deposited into your bank account every month. Generating passive income from dividends and interest requires you to select and to monitor the appropriate investments. Rental income requires purchasing and maintaining commercial or residential real estate. Royalties and licenses require the development and sale of a product. Partnership and business passive income, like investments, requires the careful selection of investments and monitoring them diligently.
There are two important advantages to passive income. First, passive income doesn't take as much effort to maintain. To earn a salary, you typically have to put in forty or more hours of work a week. Maintaining the same amount of passive income takes a fraction of the time.
Second, you can outsource what little time it takes to maintain passive income to somebody else. You can hire a financial advisor to select and monitor your investments, an accountant to monitor your royalty and license fees, and a property management company to collect rent and fill vacancies. This is an advantage that just doesn't exist with earned income.
Can you imagine hiring a temp to take your place at work? Financial independence does not mean that you can't work; it simply gives you the option of working. Most of us want to continue working—our contribution to the world provides a sense of accomplishment and esteem.
What Financial Independence Doesn't Guarantee
We've all heard the saying, "Money doesn't buy happiness." Well, it's true— money doesn't buy happiness, and financial independence doesn't guarantee happiness, either. Personal income in the United States has almost tripled since 1956, but the number of Americans who claim to be "very happy" hasn't increased—it has remained at about 30 percent year after year.
Income is up, yet the level of happiness is flat. Why? While there are thousands of factors that contribute to happiness or unhappiness, it appears that simply earning more money isn't enough to ensure happiness. Academic research suggests that our current actions are based on predictions of future emotional consequences. Our decision to order a double bacon cheeseburger, compete in a marathon, work late nights and weekends, or purchase a larger house, is based on how we think we will feel once we've accomplished these things.
If we were good predictors of our emotional reactions to these events, this wouldn't be a problem. According to Harvard psychology professor Daniel Gilbert, we do a poor job of determining how we will feel as a result of something—we tend to overestimate the future positive effect of an action and how long we are going to feel good. We think the brand-new car will make us feel much happier and for a longer period than it actually will. In other words, we overestimate those things that we think will make us happy Gilbert's research tells us that whatever we think will make us happy won't make us as happy as much as we estimate or for as long as we estimate.
Does this make financial independence an unworthy goal? Absolutely not. It means that financial independence is a means to an end, a tool. Financial independence alone will not make you happy. It's what you do once you become financially independent that determines your level of happiness.
Most people know what they should want to make them happy. Our brain is powerful beyond comprehension, but it is constantly trying to make things easier for us. As a result, we simplify and streamline what we think will make us happier. We are susceptible to ads that promise excitement and satisfaction without thinking critically about whether the product really will or not. If we did, I would venture to say jeans ads with scantily dressed models (nor even wearing the jeans being advertised!)—just oozing sex appeal—would not be as effective.
As a result of this overly simple approach to happiness, it is no wonder that we are poor predictors of our happiness. If we stop and honestly evaluate what will make our lives richer and more fulfilling, we might experience happiness. The next chapter will help you determine what will make you happy—in effect, it will make you think, maybe for the first time, about what drives you.
Because of the billions of dollars spent on advertisements and marketing campaigns, we incorrectly assume that our happiness is linked directly to material possessions. Too often, we set goals about what we want to own. While these things can add to our level of satisfaction, happiness will ultimately come from accomplishing goals and growing as people. Advertisements trick us into thinking that a product will satisfy our needs. A Hummer will make us a rebel. A Rolex will make us sophisticated. Chapter2—Design the Life of Your Dreams—will strip away the ads and products and will help you determine what you truly want to accomplish and who you want to be.
Armed with the knowledge of what it will take to enrich our lives and add excitement, we can use financial independence as a tool to help us achieve our other goals. What's the worst-case scenario? We become financially independent, get the things we want, accomplish what we want, and become who we want to be—and are no happier than when we started. Whoever said, "If I had a choice, I'd rather be rich and unhappy than poor and unhappy," was on the right track! In our pursuit of financial success, though, it is important not to neglect the other areas of our lives.
From The Six-Day Financial Makeover by Robert Pagliarini. Copyright © 2006 by Robert Pagliarini. Reprinted by permission of St. Martin's Griffin.