In Step 1 we looked at the different zones of financial health status and how to accurately evaluate which zone we are in, financially. In this article, we'll look at ways to progress out of the red zone towards true financial independence.

Goals

As mentioned above, our goal in this step is to leave the red zone, or, in other words, reach a point where our income is greater than our expenses. Needless to say, this may not happen immediately and takes patience and perhaps some sacrifice. But, being determined to achieve financial independence and reach a state where we are masters of our financial fate, we know that we are ready to take on this challenge.

Actions

The red zone doesn't give us many levers to play with, but we do have a few. The most important ones are:

• Getting insight into our spending habits.
• Using the insight to reduce our expenses and debts.
• Increase our savings.
• Finding higher sources of income.

Even though these actions will take time to pay off, it is important to start on these small incremental changes as soon as possible.

In this article, we'll look at the first three steps. The article Financial Independence - Step 3: Increasing Income examines the last step in detail.

Create a Budget

Our first order of business is to create a budget for a few months. The only purpose of our budget is to tell us where our money is going. We might think we already know this, but it is good to verify with real numbers. We'll create what is known as an 'envelope budget' — it simply tracks how much we spend in different categories (such as food, clothes, health care, etc.).

This budget is only for a short time. We don't have to maintain the budget for the rest our lives. (Phew! That's a relief!) Once we have an idea of where our money is going and in which areas we can save money, we're done with the budget. (Of course, if maintaining a budget and always knowing where your money goes gives you a good feeling, feel free to continue the budget.)

The structure of the budget is described in the article Benefits of Budgeting, so we won't repeat all the details in this article. Briefly, the budget allows us to:

• Create spending categories.
• Identify each category as a short-term, medium-term or long-term expense.
• Keep track of daily expenses in each category.
• View a report of average/annual spending patterns and short-, medium- and long-term expense types.

Here, then, are our tasks:

• Daily: enter expenses into budget sheet.
• Every month: check budget envelope vs actual.

Spending Insights

What do we learn from our budget? We learn a) how our money is being spent vis a vis how much we think we're spending; b) how much of our money is spent on each of short-, medium-, long-term items; c) our expenses towards "needs" versus "wants". (Wants are fine as long as we understand that they are wants and don't confuse them with needs.)

Reduce Expenses and Debts

Once we have an insight into our spending patterns, it is time for the next step — identify areas to reduce expenses. It is true that when we're already struggling to make ends meet, reducing expenses is definitely not easy. But, if we can reduce our expenses by even a little bit, that'll help make a huge difference in terms of our mindset towards finance. We'll understand about unavoidable expenses (those that are forced on us) versus areas where we have at least some control. When coupled with other techniques that we'll learn later, this will advance us towards financial independence.

We can take small steps by doing the following:

• Reduce our expenses in the short-term items category.
• Revisit our wants and comparing them with our needs.
• Reduce our debt.

We understand that today's happiness is as important as happiness in the future. Sacrificing our enjoyment in the present for the sake of future happiness is always tough and is also very personal. Spending on short-term items and on wants varies from person to person, family to family. Keeping all this in mind, all we do is compare our expenses in these areas with our financial independence goals and decide whether some of the expenses could be postponed (for a short time) getting us quicker towards our financial independence.

Another big part of reducing expenses is debt reduction. If we currently have debts with monthly or annual payments, reducing these debts may be one of the most effective actions we could take in reducing our overall expenses. Here's why: unpaid debt payments keep increasing over time. Also, if we continue to incur more debt (e.g., if we're continuing to use a credit card with an already significant debt on it), we're adding to our burden. If it is not easy to reduce the debts now, it'll only become more difficult the longer we postpone paying off the debts.

Among the different ways to reduce our debts, we need to pick the ones that make most sense for us:

• Pay off one debt at a time.
• Pay off a little bit of all debts concurrently.
• Consolidate the debts: the idea is that we take a low-interest loan use to help us pay off some (or all) of the other (high-interest) loans. As a result, we end up with just one or two low-interest loans in place of the several that we had before. Once the higher-interest loans are paid off, we start paying off the consolidated loan as well.

All of these require careful thinking — a good financial advisor can provide us with a debt reduction plan. The Debt Reduction Calculator can be used to get a quick idea of how long it might take to reduce our debts.

Save

Here's the third step. Once we've identified which areas we could reduce expenses in and by how much, the money we save goes into a savings account. We try to target saving five to ten percent of our income. (We understand that, at this stage, this is easier said than done. Getting to this target will probably take a few years. But, we also know that we can make progress only if we start.)

Where to save? If we already have a savings account, we could simply add to that. Otherwise, consider creating a savings account. Keeping the savings outside our home makes it (slightly) easier to avoid temptations of spending that money.

If creating a new savings account, here are some tips:

• if you have access to a tax-deferred retirement account (401K, IRA, etc.), consider such an account. This has the added advantage that our savings will reduce our income tax (by a bit) for that year. But beware: retirement accounts make it difficult to withdraw from them before the age of 65, e.g., if we want to invest the savings later. If we anticipate needing the money sooner, then a retirement account is not a good choice.
• Save in a regular bank. We'll later see how to increase the savings and invest it to get higher returns.

Summary

Even if we can save only a little bit, that's a major achievement and deserves a pat on the back. Along with reducing expenses and saving money, we're also training ourselves to take our financial future in our own hands.

The steps that we looked at to get us started on this are:

• Understand our spending patterns.
• Reduce expenses and debts.
• Increase savings.

Our main objective at this stage is to get to a point where we are saving five to ten percent of our income for 3 months continuously.