Like millions of Americans, you may be having trouble keeping up with a barrage of bills. And who can blame you? Electricity prices are up 4.1% in the past year, gasoline prices have climbed from $2.70 per gallon in the fall of 2009 to over $3.35 per gallon in September, and the cost to put a roof over our heads is up nearly 3% in the past year. The examples go on and on.
While that revelation may be depressing -- especially if you're coming up short every month -- there's a simple way to get back on track.
It's the little things
In Alice in Wonderland, Lewis Carroll wrote, "If you don't know where you are going, any road will get you there."
That's great advice, but knowing where you're going becomes even more useful when you know where you are today.
Every day, spending on daily this-and-thats are eating into your monthly paycheck. For instance, a $4 daily latte may not seem like a major expense, but over the course of a month, spending on that latte totals $120. Over a year it totals $1,440. Multiply that over a typical 40 year working career, and it totals a mind-numbing $57,600.
I'm not suggesting that you eliminate caffeine from your routine, but I am suggesting that understanding how you spend your money is critical to understanding where you are today, so you can get to where you want to go.
Which brings me to ...
A six letter word
Creating a budget may have a bad reputation as the fastest way to kill a good night, but just because no one looks forward to cozying up with an excel spreadsheet and a stack of receipts after work doesn't mean it isn't one of the most important things you can do if you're serious about financial freedom.
Consider Mary, a fictional friend of mine who is an elementary school teacher and makes the national average salary for her position, or roughly $56,000 a year.
Assuming Mary spends the national average of $905 per month on rent, another $800 per month on food, and sets aside 15% per month for taxes, and also assuming her expenses include electricity, cable, gasoline, health insurance, student loans, and a car loan, Mary spends about $3,755 of her $4,667 in monthly wages, leaving her with about $926 left-over at the end of the month. Sounds pretty good, right?
But there's a problem. Mary is living paycheck-to-paycheck, which means that at the end of the month that $900 has disappeared and Mary has no idea where it went. Why? Because Mary doesn't keep a budget.
Now let's assume that Mary creates a budget and discovers, sure enough, that $926 has gone missing on little things that have really added up.
Instead of continuing to spend her money that way, she makes a decision. She sets aside $600 every month that she can spend on impulse items, leaving her with $326 per month that she can invest, or about 7% of her salary, which is a bit better than the national average personal savings rate of 5.4%.
If Mary's investments average 6% annually, that $326 a month would become $147,000 just by budgeting her spending and investing what was left over.
Ditching credit card debt
Creating and sticking to a budget is a great first step, but spending on the little things isn't the only thing that's eating up your paycheck.
Another big culprit is credit card debt. Credit cards are incredibly common and undeniably convenient, but they're also the absolute worst when it comes to breaking free of paycheck-to-paycheck living.
That's because at their core, credit cards are designed to do one thing: transfer your wealth to someone else.
The average American with a credit card owes more than $5,000 on their credit cards and pays an average 13.02% per year in interest (for variable rate cards the average annual interest rate is over 15%!). That means that the average person is spending $660 per year in interest alone.
Let's assume that the $5,000 the average person owes on their credit cards was invested instead and that -- like Mary -- that investment earns 6% a year. Let's also assume that the $55 per month spent on credit card interest every month is also invested using dollar-cost averaging, a program in which a set amount is invested at a specific interval (say monthly) to help smooth out the average cost of your investment and reduce your risk. That investment would grow to nearly $42,000 over twenty years.
Sounds good, but ...
Paying down credit card debt can seem daunting, but it's far less daunting if you take my first bit of advice and create a budget. If you do, then you'll be better able to see how quickly you can eliminate that credit card payment and start investing that money instead.
For example, if you owe $5,000 on your credit card and pay a 13% interest rate, your monthly payment would be roughly $104 per month (interest + 1% of your balance) and it would take 261 months to pay off your balance. If you increased your payment to $200 per month, your balance would be paid off in just 30 months.
Budgeting spending and paying down debt aren't the only financially smart decisions you can make to get your finances in shape, but they're great first steps. If you follow this advice, you may someday look back on today and wonder why you hadn't started sooner. Or as Lewis Carroll also wrote, "I can't go back to yesterday -- because I was a different person then."
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.