Below are some of my personal rules for putting oneself on the path to becoming wealthy. Let me lay ’em down for you.
A definition of ‘Wealth’
And just so we’re clear, let me give my definition of wealth. To me, wealth does not necessarily mean owning a huge home, a yacht, or a professional sports franchise. It simply means the ability to be financially independent. That is, to have monetary means that allow you to live your life how you want without relying on financial support from anyone else (including an employer, family, friends, the government, etc.) Now, the way you want to live your life may mean that you need more annual income than I do, but that’s for you to figure out.
Rules for Achieving Financial Independence
Rule #1 – Spend less than you earn
1) The single most important rule to becoming wealthy is this: Spend less than you earn. It’s really that simple. The only way to build wealth is to keep some of it for yourself, and to increase those accumulated savings over time. The greater the difference between the amount you make and the amount you spend, the greater your savings, and likely the greater your wealth over time.
While this rule is simple, it is not necessarily easy. There are two ways to increase your savings: increase your income and/or decrease your spending. For most people, it is easier to decrease your spending by a significant amount than to increase your income, so let’s discuss that:
The trick is not to deny yourself the things you really enjoy in life, but to simply take a step back and try to prioritize your spending. Track your expenditures for a month, and then look at the numbers. What did you spend most on? Where can you cut back? Are there some lower cost substitutes that allow you to enjoy similar things but at a cheaper price? (I.e: checking your DVDs out from the local library for free instead of renting them from Blockbuster or *gasp* buying them. Or you could cook at home more often instead of eating out.)
Now that you’ve managed to consistently set aside some savings from your paycheck, let’s can move on to rule number two. (And hopefully these savings will increase over time, both through income increases, like a raise at your job, and expense reductions: Sell the damn boat! Take your next vacation locally! You get the idea…)
Rule #2 – Insure yourself, family and assets
There’s another important aspect of personal finance that you should have nailed down before investing: Insurance! All that money you’re going to sock away can evaporate in what might feel like an instant if you don’t protect yourself from disaster. And yes, you can lose your house and other assets too if you’re not properly insured!
Liability car insurance is mandatory by law, but you need to make sure you have the right levels of coverage (I think $300 – $100 – $100 is standard, but your level of coverage should depend on how much in assets you have that could be at risk if someone were to sue you.) Also, if your car isn’t cheap like mine is (and therefore fairly easy to replace), you probably want some collision insurance as well, in case you run into a pole or someone without insurance hits you.
A key insurance area that some people overlook, especially younger people, is medical insurance. One stay at a hospital could wipe you out financially. Therefore, you MUST have health insurance. If you’re healthy and young and don’t have any dependents (like kids or a stay-at-home spouse), high-deductible “catastrophic” health insurance may be the right choice for you. Check out http://www.ehealthinsurance.com to search for and compare policies.
If you have dependents (basically anyone who relies on your income) who would be in trouble if you died, get life insurance. Many jobs offer it as a free benefit, but if the payout upon your death is not enough to look after your family, you could purchase additional life insurance as well. If you need it, I recommend term life insurance.
[Side note: I also believe that while life insurance may be necessary, at least until your kids are through college and can support themselves, the best way to protect your family in emergencies is to build up wealth through steady investment over time (we’ll get to that later.)]
If you have property, home owner’s insurance is a must as well. If you’re renting, consider renter’s insurance. Personally, I’ve never used it, but I live in a pretty secure building in a decent neighborhood, and I always lock my doors! Also, there’s nothing in my apartment that I couldn’t replace (from a monetary standpoint) should it be stolen (although it might take me a while if the thieves took everything…)
A general rule about insurance is, if you can’t afford to lose it or replace it, insure it! (Hint: an easy way to make something replaceable is… don’t pay too much for it! If you drive an inexpensive car, rent or own a moderately priced house, and stay away from $1000 suits or expensive watches and jewelry, then you’re exposing yourself to less risk should something happen to those possessions! Also, for the items that you DO have to insure, like a house, your insurance payments will be less for an asset that’s less expensive. That’s not even mentioning the obvious, large, up-front savings of making reasonably priced purchases.)
With all this being said about the importance of certain types of insurance, don’t go overboard. Insurance companies wouldn’t insure you if they didn’t think they were getting the better end of the deal. In some cases, you may be better served by concentrating on investing the extra money you would’ve spent on, say, renter’s insurance into an account for emergencies (like theft.) Always shop around to get the best price and policy for your situation. Keep in mind not only the monthly premiums, but the deductibles and levels of coverage for ANY type of insurance that you’re considering.
Rule #3 – Pay off high-interest debt ASAP!
Wanna know the best (and maybe only) way to earn a whopping, instant and totally guaranteed return on investment? Hint: It’s not a hedge fund, a penny stock or a lottery ticket, it’s paying off your high-interest debt (with an annual interest rate greater than 9-10%.)
Many credit cards have Annual Percentage Rates (APRs) anywhere from 11 to 20-something percent. By reducing and eventually eliminating your high-interest debt, you’re giving yourself an instant and guaranteed return on your money. Carrying around a $4000 balance at 20% means you’re paying $800 per year just for the privilege of carrying that piece of plastic around. (And that $800 doesn’t even include any extra fees associated with that credit card debt, like late fees, etc.)
My advice? Pick the lowest rate card you have, plan to use it only for emergencies (starting now!), and hide the rest of your cards. Then, start with the account with the highest annual rate, and pay that down aggressively until it reaches zero (then cancel that card, you really only need one or two at the most.) Next, take the account with the next highest interest rate and repeat. When you’re done with the credit cards (whew), aggressively pay down any other high interest date as well. Car loans are kind of on the border (since the rates are usually lower than 10%), but I recommend paying that off quickly as well.
Student loans with a low interest rate (preferably a locked-in rate that’s less than 7-8%) and housing mortgages (again, fixed-rate please) are generally OK debt: the less the better, but okay to just pay down in regular payments (as you should be doing already.)
[The reason this debt is ‘ok’ is that the interest rate is typically under 8% and you can get a tax break on the interest (which effectively cuts down the ‘real’ interest rate.*)]
Once you’ve paid off all your high interest debt, brief a sigh of relief and treat yourself! (Just don’t put it on plastic.) You’ve worked hard to become debt free, so stay that way! Always pay that credit card balance off at the end of the month, and if you don’t have the money for something, don’t buy it!
Now that you’ve exhausted the best available “investment” by eliminating your high-interest debt, you can move on to rule #4.
Rule #4 – Put your savings into appreciating assets (like stocks and bonds!)
Before we go any further, STOP! Have you paid off all your high-interest debt? If not, go right back to step #2 (do not pass go, do not collect $200.)
An “appreciating asset” is just a fancy term for something you own that increases in value over time. Some everyday examples would be stocks (my personal favorite), bonds, real estate, gold, CDs (Certificates of Deposit), and that Willie Mays rookie card from your Grandfather.
Now that we know what one is, the question is to what appreciating assets do you entrust your hard-earned dollars? One sensible answer would be to try to get the maximum percentage increase (known as a ‘rate of return’) possible from a particular asset. The asset ‘class’ (i.e.: category) that has historically given savers the highest rate of return is stocks (about 10.5% annually over the last several decades. This means that if you invested $10,000 at that historical rate, you’d be looking at $200,000 in 30 years, all without adding a cent to that original ten grand yourself! That’s the magic of compound interest.)
Another approach might be to pick an asset whose value not only increases, but remains fairly stable over time (like a US Treasury Bond, where the ‘principal’, or initial amount that you invest, remains constant over time. This is unlike a stock, whose entire value can fluctuate, up or down, over any given period of time.)
In order to answer “what should I invest in?” I like to break the question into two parts:
A) Where should I put my money for the short-term (less than 1-5 years)? and
B) Where should I put my money for the long-term (more than 3-5 years)?
For A, I believe the best answer is a stable investment (one where your principle will be largely preserved, regardless of what happens to the greater economy), that is sufficiently liquid, that still generates a decent return. Hopefully, this return is greater than the average annual rate of inflation, which is about 3%.
An example of this type of investment is a money market fund or a bond fund, which might return 4-6% annually. You want your investment to be liquid (easily accessible for you to use) as well, in case you need that money for emergencies in your 1-5 year time frame, or for whatever major expenses you have identified that will need to be paid for in that period. Vanguard’s Total Bond Market Fund (VBMFX) is an excellent example of a short-term investment vehicle that is highly liquid, fairly stable and has a high rate of return compared to other short-term investments.
For B, instead of looking for short-term principle preservation, we’re looking for high long-term growth in value. We want our money to increase as much as possible, so we want the highest return rate on our money. Since we are planning on socking that money away for at least 3-5 years (and preferably longer), we don’t care if the value goes up and down over a period of months, or even over a year or two. We can take more risk (a prudent amount) to earn more reward.
I believe this long-term time frame calls for full investment in stocks. The easiest, safest way to achieve this is by purchasing a broad, low-cost index fund. Vanguard’s S&P 500 index fund (VFINX) is an excellent (really) low-cost, broad index that seeks to match the return of the stock market as a whole (as represented by the S&P 500, a collection of 500 stocks of businesses that are representative of America’s entire economy.)
Another way to juice your returns is to take advantage of tax-sheltered retirement accounts. Your employers 401k (or 403b) (or a IRA or Roth IRA) provide you with ways to keep part of your precious income entirely out of Uncle Sam’s hands (legally.) If you’re in the 25% tax bracket and you invest $4000 in a 401k this year, you’ll have just saved a thousand bucks! ($4000 taxed at 25% = $1000 in taxes and only $3000 that you get to keep and invest.) Also, since you can’t dip into the money until you’re 59 1/2 without paying a huge penalty, it’s a good way to force yourself to invest for the long term.
So there you have it, 4 simple rules for becoming wealthy (aka financially independent.) Spend less than you make, protect yourself with the right amount of insurance (not too much, not too little), eliminate all high-interest debt (and avoid taking any on in the future), and then invest your savings in appreciating assets appropriate for both the short and long-term (taking advantage of tax-free retirement accounts.)
If you follow this recipe for wealth (it won’t always be easy, but you can do it!), I guarantee that with a reasonable return on your investments (read: historical average), enough time (which is the most important factor for big investment gains) and a sufficient savings rate (at least 10% of your paycheck, hopefully increasing with time), anyone can become a millionaire by the time they’re ready to retire.
* If you pay interest of 8% on your mortgage, and you’re in the 25% tax bracket, you get back (from the IRS) 25% of the money you pay in mortgage interest each year. This means that your interest rate of 8% is effectively only 6% (8*(1 – 0.25) = 6).