Do I Really Need a 20% Down Payment?
My last post discussed the wonders of using the 20% rule as a guiding principal for determining a purchase price of a house. Now it's time to investigate the flipside of this argument.
Practically speaking, the 20% down payment rule on a house is mostly meant to serve as an affordability indicator. There will be many times however when a full 20% down payment is unnecessary and borderline dangerous.
Exceptions to the 20% Rule:
1. If you have significant repairs to make.
If you believe you will have significant costs associated with renovations or refurbishment of existing structures, consider that having additional cash on hand might be better off. When mortgage rates are low, it makes more sense to avoid paying more interest for a construction loan. Keep in mind that construction loans seem to run around 1% higher than the prevailing mortgage rates over a given time.
2. If you anticipate needing cash for a large event.
Paying for your own wedding? Perhaps putting 20% down is not such a great idea after all. You will want to have additional cash on hand for flowers, décor, and whatever else comes your way.
3. If you are living a F.I. lifestyle
In this case, eliminating a significant amount of your capital might hurt your overall rate of return. If you are expecting an 8-10% yield from the stock market, then why take this money out of the market and put it into a house that typically only increases by 1% in value per year after inflation? If mortgage rates are high, this might make sense. But if mortgage rates are low (3% as of this writing), then you are likely better off leaving your money invested long-term in index funds.
4. When your mortgage payment is still less than 25% of your take-home pay with less than 20% down
If you made a sensible purchase, and after only 5 or 10% down you still have a mortgage payment less than one-quarter of your after-tax household monthly pay, then I admit you have some wiggle room. You should never, and I mean never, use this formula to purchase more house than you can afford. In other words, don't put less than 20% down just to purchase a home that is more expensive.
5. If you value having months or years worth of expenses saved in cash over equity in your home
This one is self explanatory. Would you lock all your hard earned savings into a home in the form of a down payment or have several years worth of expenses saved in a cash account. Put differently, would you rather have $60,000 in home equity via a down payment or 2 years worth of living expenses saved up in cash (assuming $3,000 a month in expenses)? The choice is yours.
How to decide how much to put down
I still suggest saving at least 20% down of your expected purchase price in cash. After that, you can decide if you want to put more or less down based on the criteria above.
Utilizing the 20% rule allows you to keep your purchase price realistic when shopping for a new place to live. It also demonstrates that you have the ability to save money consistently and diligently. It is a valuable rule to live by, yet can be flexible once you have attained it.
Leave a comment below if you believe you have another valid different reason to save less than 20% down.
Why a minimum down payment of 20 percent is necessary
Many loan products in today's marketplace offer as low as 0% down when purchasing a home. For conventional loans, typically the buyer is required to put at least 5% down. Regardless, using anything below 20% as a down payment when shopping for homes is a big mistake.
The 20% Rule
Generally speaking, a 20% down payment should be the norm when purchasing your home. Here are some reasons to put as much as possible down on a home:
These are some of the most noteworthy reasons to put 20% down on a home. Mortgage interest write offs are a thing of the past and should not be a reason to borrow more money. Remember, large interest payments are the enemy of debt elimination. Having significant amounts of interest is indicative of high principal balance that is ultimately still owed. This is never a good thing for those on the path to financial independence.
However, there is still an even bigger reason to put 20% down on a home.
The single biggest reason to put 20% down payment
The most significant reason to put 20% down on a home is to keep you honest with your home search. If you stay within a price of homes that still permits a comfortable 20% down payment, it will prevent you from living above your means. Using 20% down is a an excellent way to figure out how much house you can truly afford.
As a general rule of thumb, I still like to have 6 months worth of savings in an emergency fund along with at least $2,500 in my checking account after making a down payment and closing costs. Working backwards to figure out how much you need saved would look something like this:
For example, say you have $3,000 a month in expenses and you are seeking to purchase a home below $275,000. Using the equation above, we can find out the minimum amount necessary to fund the purchase of a $275,000 home.
I would suggest that you never expect to use your emergency fund for anything related to a home purchase and closing costs. Do not earmark this money for anything except a true emergency. The extra $2,500 I recommend is to cover some minor expenses and repairs that you come across when moving into a home for the first time.
One look at the necessary minimum for purchasing a $275,000 home may leave you feeling like this is unattainable. If this is the case, you have two options. Option A is to lower your desired purchase price. Option B is to save up for longer because you are not ready to purchase this much home.
The safeguards of 20% down
Using the 20% rule as a metric for determining how much house you can afford would prevent the most common financial mistake of homebuyers, purchasing too much home. Further, by saving the necessary minimum amount highlighted in the equation above, you prove to yourself that you are financially prepared to make the largest purchasing decision of your life.
Be careful about listening to the advisement of those urging you to put no money down or using bizarre mortgage products such as interest only loans. Saving and preparing financially for a home purchase can be simple and straightforward, whereas using a more advanced strategy like an interest only loan or a 0% down payment can be costly and complex long-term. Nothing is more devastating in personal finance than debt and a mortgage will likely be the largest loan you will ever incur. Do not be afraid to purchase a home, but first make sure you are truly financially prepared by using the tips found above.
How one decision can set off a chain reaction
In modern Western society we are driven heavily by consumption which is largely driven by ideology. The West was purported to be a land of discovery, vastly unexplored. Yet, over time, America became known as the "land of possibility". By the early 1900's, a major shift began to occur when American society became aware of the limitless possibilities of a free-market society. By the 1920's, Ford had introduced the assembly line and by the 40's General Motors began spearheading innovation of big business and production standards.
The argument could be made that automobile production was the spark that ignited our modern consumerist culture. With innovations in production and rapid technological development over the following decades, Americans became increasingly expectant in the ability to participate in the free-market. Fast forward another 80 years and the average American presumes that everything should be instant access. Two day shipping is the new norm and instant downloads have overtaken our previous dial-up connections. Our ability to purchase and consume has reached a point the world has never seen. So where do we go from here?
Don't get me wrong, the ability to have access to a free-market is a great gift given to us in the West. Our access to fresh food, clothes, and other necessities is a luxury that many other societies may never know. However, this superpower is to be used with caution. Greed is not a word familiar to the people in resource-constrained societies such as Uganda or Haiti. Same day delivery and online shopping are completely foreign concepts to many in underdeveloped nations. Yet, in America, greed drives every socioeconomic class from the poorest of the poor to the richest of the rich. Greed is defined as an "excessive or rapacious desire, especially for wealth or possessions" (source). We all are subject to feelings of greed throughout our lives by wanting and desiring more than is absolutely necessary and required.
Introducing the Diderot Effect
The Diderot effect is named after French philosopher Denis Diderot and highlights a profound pattern of consumption that emerges across individuals related to the purchase of consumer goods. The term Diderot effect was first coined by anthropologist Grant McCracken in 1988 but actually originally referenced by Diderot himself a personal essay titled Regrets on Parting with My Old Dressing Gown.
Diderot was in financial need which became known to the Russian Empress Catherine the Great. Upon learning about Diderot's need for money, she agreed to purchase his library for a large sum of money and appoint him lifetime caretaker. What he did shortly after that windfall is what led to the realization of the "Diderot effect".
Diderot highlights how the purchase of a beautiful red dressing gown led to a spiral of consumption that ultimately landed him back in debt. Upon the initial purchase of his new red gown (and hence the parting ways with his old dressing gown), Diderot began to examine all of his other possessions in comparison to his bright new red robe. He quickly realized how lousy they were in comparison. His solution at the time was to begin purchasing new items that were more in line with the luxury of the beautiful red gown, all leading back to the same level of financial constraint that he was originally plagued with.
We are no different than Denis Diderot
The purchase of a new phone is accompanied by a fancy new case, a protection plan, insurance, and a higher monthly bill to boot. Refinishing your deck or patio area comes with the purchase of a new gas grill, patio furniture, outdoor plants, and some trendy decorative lighting. A new outfit needs new shoes and jewelry to match. We are eternally damned by these types of purchases.
The goal is not to stop this urge from happening, but rather change the way you respond to it. Replacing a worn out or broken couch does not have to lead to new lamps, end tables, coffee tables, and an impressive new area rug. You can replace or fix the couch but be cautious of the temptation to enter a proceeding spiral of consumption. Consider painting the tables or simply changing the lamp shades as an alternative to complete replacements- a substitution of undesired behavior.
Instead of substituting the undesired behavior, you could also aim for complete elimination of Diderot-like behavior. This might involve saving up an exact amount for the purchase of a new item- a couch in our example above. Any purchases made within the next 90 days would then need to be examined against whether the original purchase influenced that behavior. If you can hold off beyond 90 days, then the item you were considering purchasing is likely a desire, not a necessity.
What to do about it
I will admit, it is definitely nice to have nice things. Although frugality is an important trait that I hope to share with everyone, frugality does not have to be synonymous with deprivation. By recognizing that we are all subject to the same pressures as Denis Diderot, we can recognize that a spiral of consumption is never more than one purchase away. In particular, if you are already in financial trouble, one single spiral can derail a significant amount of positive progress.
Be mindful of your purchases. Truly consider how much you will value your purchase in the long-term. Certainly do not agonize over every single purchase, but rather try to emphasize mindfulness and frugality more consistently over time. With enough practice, you will easily be able to identify what purchases are in line with your values, and which ones aren't. Overconsumption is not an impressive or attractive quality. Take the time to analyze whether something, or someone, is influencing you to engage in spending behaviors that are not consistent with your ideals.
How to start investing in low cost index funds
Previously we outlined how to begin investing with 5 actionable steps. Begin with this article if you do not currently have an investing account. After reading that article and setting up an account, then you may proceed to the information below.
After choosing the type of account that you would like to transfer your savings into, you have some options once the money arrives for what you would like to invest in. You could try to pick individual stocks and become the next Warren Buffet, but I strongly encourage you to avoid this temptation. Rather, I like to keep 90% of my money exposed to a broad array of stocks which typically earn 8-10% per year over the last 200 plus years. How do I do this? Low cost index fund investing.
The choice is yours. Consult a financial advisor immediately if you are not willing to embark on this journey alone and accept the full responsibility of managing your own money. For those so inclined, managing your own money has the ability to yield superior results, if you are willing to become an expert in personal finance along the way (yet another reason to start reading).
My favorite companies to open investing accounts with are Vanguard and Fidelity. They offer some of the lowest cost index funds that give you the opportunity to participate in years and years of compound interest, without all the added fees that active mutual funds typically carry.
Be advised, not all companies will offer top notch low cost index funds. Often times, especially in 401(k) and 403(b) plans, your options will be very limited. I believe that you can still find good low cost options that expose you to a broad array of stock ownership by following some simple tips outlined below.
How To Find Good Index Funds Regardless of What Company Your Investment Account Is With
When considering index fund investing, here is primarily what you are looking for:
The Average Millennial's Financial Situation
Let's face it, most of the discussion around personal finance and net worth involves the Baby Boomer generation. Perhaps this is due to their overall proximity to the traditional retirement age of 60-65 years old.
Generally speaking, the Boomer's have a sad financial state of affairs given their age (more on that later). This lack of financial net worth is significant because of how many Boomers there are in this country. According to a 2019 survey, there are just over 69 million Boomers in the United States. However, most are unaware that there are actually more Millennials in the US to the tune of 72 million.
The fact that Millennials actually outnumber the Baby Boomers is lost on most people. Most of the news and media reports are focused on the Boomers proximity to receiving Medicare and requiring long-term care. It seems unwise to focus so intently on one group, especially if they are not the largest percentage of our overall population. That said, we need to put the present state of financial affairs of the average Millennial into focus.
Millennials vs. Boomers
Most Millennials (generally considered those born between 1981-1996) entered the workforce around The Great Recession between 2007-2009. That said, with rising costs of education and living in general combined with decreased earnings, the unfortunate average financial net worth of a Millennial is below $8,000 per household according to a 2019 study by the Deloitte accounting firm.
Typically parents want their children to do better than they did. Consider how low that bar might actually be set given that the average Baby Boomer household retirement savings is $144,000, per a recent Transamerica survey. Boomer's are widely considered those born between 1946-1964. That leaves some Boomers older than 75 years old with the youngest Millennials in their early 20's (as of 2020). Some Millennials may be up to 50 years young than some of the oldest Baby Boomers.
According to recent U.S. Census data, 60% of married Millennials and 80% of unmarried Millennials earn less than $40,000 per year. The folks over at SmartAsset report that the average salary of a Millennial today is an estimated 20% lower, in inflation-adjusted dollars, than the average salary that a Baby Boomer had at the same age. Although generally Millennials are off to a rough start, there may just be hope for the future.
First, let's assess the biggest areas where Millennials are failing. Then we can take a look at what might give Millennials hope fore the future.
The Balance Sheet Of An Everyday Millennial
The vicious cycle of spending and consumption that follows societal expectations is leaving Millennials in a difficult situation financially. It is unattractive to live with your parents, drive an old car, and wear old shoes and clothes, so we don't. Instead Millennials have an ever-present pull towards consumption because most of their friends and family mistakenly judges success by your possessions. According to modern society you must be broke and failing if you do not own nice things. This is one of the most pervasive fallacies of the West in the 21st century.
Displaying a high social status is not a measure of success. I would argue that conforming to societal expectations of increasing possessions by giving into unnecessary spending behavior to impress others is borderline pathological.
So how has this absurd idealism and pathological societal expectations impact the average Millennial?
Where Do Millennials Shine?
Perhaps Millennials demonstrate the most resilience out of any prior generation. Recall that nearly every young person in the Millennials generation entered the workforce during The Great Recession, or otherwise one of the greatest economic downturns of any of our lifetime's.
To make matters worse, when Millennials were supposed to be experiencing stability typical of approaching or entering your 30's, a had a pandemic hit. During COVID-19, the unemployment rates have spiked sharply. Another economic downturn was bestowed upon this generation making their increased debt and financial obligations even more difficult to combat.
Millennials also tend to attain higher education, specifically college education. The downside to this is the ever-increasing student loan debt but there at least demonstrates the continued resilience to endure a 4 year liberal arts education and at least give themselves a crack at becoming more enlightened (although this doesn't always happen).
Another positive attribute is the entrance of women into the workforce. According to the Pew study, In 1966, when Silent Generation (born 1928 to 1945) women were between the ages of 22 and 37, only 40% of the women were employed. Compare that to today where 72% of Millennial women are employed. With increased participation in the workforce, families are at least given the chance to earn more money than prior generations, although this has not yet proven to be true largely due to two significant economic downturns during the earliest earning years of a Millennials life.
Despite the woes of the Millennial generation they do demonstrate some additional positive attributes:
In Summary: The Potential For Millennials
I believe overall the potential for Millennials in the future is great despite previous history treating them unkindly. Millennials demonstrate their resilience in the face of increased student loans, higher costs of living, The Great Recession, and now a pandemic. We must encourage the entire Millennial generation to continue to increase their financial wit through reading, researching, and asking prudent questions. They have demonstrated that they are willing to ask for help, but this is when the rubber meets the road.
There is hope in the future yet as long as we continue to grow stronger and wiser with our finances and realize that their still may be many challenges yet to come.
The ability to resist temptation is the key to financial strength
Today, we outline a common theme in the financial independence community, delayed gratification. In financial terms, saving and investing is the equivalent of delayed gratification.
The ability to save is heavily dependent on spending behavior. But why do we spend so much as a society? What is it about spending that taps into our internal reward system? Enter the concept of self-gratification.
self-gratification - the act of pleasing or satisfying oneself, especially the gratifying of one's own impulses, needs, or desires. Source
Delayed gratification is actually a form of self-gratification. It is the ability to restrain oneself from immediate indulgence in exchange for a later reward. Delayed gratification also happens to be a highly useful tool for increasing your net worth.
The concept of delayed gratification is simple: instead of immediately indulging yourself for a reward (instant gratification), the temptation is resisted in an effort to attain a future reward.
The negative connotations around immediate reward is ever-present in contemporary society. Instant gratification is centered around consumerism and reward-seeking behavior which happens to be the crux of modern day America. Financially speaking, instant gratification is also known as keeping up with the Joneses.
We are driven by a culture of consumerism and spending in the United States. Some estimates indicate that we see up to 10,000 ads per day, and that is only from digital sources. That number doesn't even include how many billboards, newspaper ads, magazine ads, and physical advertisements we are exposed to on a daily basis. Being driven by consumerism is not friendly when it comes to personal finances. Instant gratification- keeping up with the Joneses- is inherently self-defeating when it comes to finances. The downward spiral begins when you realize that the first purchase often does not lead to the amount of reward that you originally anticipated. This can often lead to more purchases on the tail-end of a recent purchase, also known as the Diderot effect.
The Diderot effect is named after French philosopher Denis Diderot who sudden came into money after the sale of his library. What he did with his windfall was purchase a beautiful red dressing gown, which is exactly where his troubles began. Suddenly, this red gown was the nicest thing Diderot owned and it made all of his other possessions look lousy. He realized there was only one way to fix this- purchasing new items to "live up" to the beautiful red gown. He began replacing straw chairs and old tables until all of his possessions were suddenly beautiful, all at a great expense to Diderot.
We have this happen all the time as well. Buying a new phone comes with purchase of a new case, a protection and insurance plan, premium app purchases, and a higher monthly bill to boot. Redoing your deck leads to new furniture, a brand new gas grill, plants, and the trending decorative lighting. This is the Diderot effect in full force. Your goal is to interject before the spiral of consumption begins.
The story of the kids and the marshmallows
In 1972, a study was published from a group of researchers out of Stanford. The design of the study involved giving children the choice of immediate gratification or delayed gratification. The children were placed in a room with an investigator and given a marshmallow. They were told that if they waited and did not eat the first marshmallow, they would be given a second marshmallow. Then the investigators left the room for a short period to let the children decide for themselves- eat the first marshmallow immediately or wait and have two to eat in the future. In other words, instant gratification versus delayed gratification.
Now understand that these children were preschoolers, the most likely crowd to give in to the temptations of instant reward and gratification. The remarkable fact is, some didn't give in. Some waited. So what happened to the children who were able to wait? They followed up years later with the original cohort of preschoolers and cross-referenced the data of those who waited versus those who didn't. You can see the studies for yourself here, here, and here. So what did they find when they followed up with the original students?
On average, the students who avoided eating the first marshmallow in exchange for two marshmallows later (i.e. those that demonstrated delayed gratification):
Not bad for the pain of waiting a few extra minutes for two marshmallows. So what does this have to do with finances?
How delayed gratification affects finances
The children who chose delayed gratification in the Stanford research experiment overall scored better in nearly every objective measure when assessed years later than the children who chose instant gratification. With better ratings of academic competence, social competence, rationality, attentiveness, planfulness, and improved ability to cope with stress, who better suited to resist keeping up with the Joneses than those who displayed delayed gratification!
Perhaps the traits the preschool children showed early in life can help inform us of how delayed vs. instant gratification can effect our finances.
For example- someone who is more inclined to value delayed gratification might avoid the temptations of a quick purchase in exchange for long-term growth of your net worth. If you can resist temptation to purchase new things and you value savings, you are likely in a better situation to invest. By investing over a long period, you are likely to participate in the profound powers of compound interest. All of this begins with the simple ability to resist instant gratification in exchange for the future rewards of compounded growth. A better life is often the fruits of displaying delayed gratification. Working out once is not going to give you the body of your dreams. Skipping a small purchase at a gas station is not instantly going to make you wealthy. Eating one salad will not ameliorate the risks of eating poorly at every other meal. Rather, it is the cumulative effect of these choices to delay your gratification and reward system in exchange for a better future self.
Make the difficult sacrifices now to provide better financial means in the future. Purchasing everything now, in the moment, destroys your ability to participate in one of the greatest mathematical phenomena known to man- compound interest.
Being smart with money is about increasing financial awareness
We are living out the cautionary tale urging us to live below our means. Consider that some estimate that we make roughly 35,000 decisions per day. A survey conducted by Dan Goldstein and Principal Financial Group indicated that although we make thousands of daily decisions those who lack financial confidence are 64% more likely to postpone major financial decisions- such as managing investment or retirement accounts.
We live in a consumerist society filled with things we likely do not need to impress people we probably have no business trying to impress. Consider what might happen if you spend a weekend with friends who own a large home and two new cars. Or maybe a long weekend with parents or relatives who own a beach house with a inground swimming pool. How might you feel coming out of that experience? I assure you that this recent experience will have you more likely to spend.
For most, success and failure seems to be judged by material possessions, especially in comparison to others. Worse yet, time spent with friends or family who are spenders subjects us to a psychological theory known as recency bias. This type of bias is an error where we place greater importance on events that occurred more recently compared to events occurring further back in time. That explains why you suddenly want a new car or to upgrade your kitchen after you spent time with anyone who is a big spender concerned with the display of high social status.
Financial Awareness is more elusive that you think!
Taking a moment to stop and assess whether your financial decisions are related to competing with others versus your long-term goals is an enormous step worth taking. Taking that step is more difficult than you might initially think. Remember that we make 35,000 decisions per day, many of which I bet are around finances, or making the decision to further procrastinate finances. Amidst all those decisions, you need to discover a way to consciously address those related to financial decision making.
This process of becoming aware of your financial situation will bring about many challenges. Admittedly, I have often experienced the strong urges to display my financial status to others by competing with their purchases. Yet I resist because it is in the best interest of my future self to do so.
Given the context above, imagine the frustration of sitting with friends and family who readily assume that we are not "doing well". Imagine the outrage I might have of knowing what real financial strength means, and listening to a dozen people sit around talking about who "has money" and who doesn't. This is a fruitless conversation often coming from those who have no real financial values of their own.
Displaying financial prowess with the purchase of material possessions should not be top priority along your path to financial independence. Very few people around us actually have any idea how much wealth we are actually accumulating. Why? Because we don't buy things that display how much money we have. The reality of the situation is you have to become alright with nobody knowing how much you are worth. You have to realize the only person who needs to know your financial worth is you and a significant other, provided you have one. Living a life of frugality and wealth accumulation is often not very attractive early on in the process. Unless you want to walk around and show people your account balances (I do not recommend this), the only person who really needs to knows how "well" you are doing financially will be you.
4 Questions to develop increased financial awareness
I suggest regularly, perhaps even daily, going through the following reflective steps to incrementally build awareness:
1. What are you thinking about, or regularly, purchasing?
Like it or not, purchasing decisions are always near the forefront of our minds. Whenever you see something you like, you immediately picture yourself possessing it, wearing it, driving it. This is just basic human nature and the sooner you realize you are drawn to acquiring more things, the sooner you can begin to break the habit of purchasing needlessly. This is the foundation for developing awareness. You are thinking about either consciously or subconsciously, it's just the nature of our being.
2. Why are you thinking about, or regularly, purchasing?
3. How much are you currently saving and investing?
4. Why are you saving and investing?
Contemplate these four questions everyday and you will be amazed at how quickly you start to build financial prowess and control over your finances. As the old saying goes "you don't know what you don't know". Walking around on autopilot only knowing how much you have in a checking account to make a small purchasing decision is not the path to financial independence and strength. Take control of your financial future and break the habit of letting finances hide themselves inside of the 35,000 decisions you make everyday.
What exactly is investing?
The definition of the word invest is:
to commit (money) in order to earn a financial return - Merriam-Webster
Further, an investment is:
the outlay of money usually for income or profit : capital outlay - Merriam-Webster
The purpose of investing is to make an initial purchase of something (the outlay) in hopes of income our profit in the future. The income or profit is typically assessed as a return on investment (ROI) and could come in the following forms:
How can you start investing?
There are actually many ways you can begin investing but perhaps the simplest and most common way is investing in the stock market, online.
Whether you choose to begin with automated savings to a retirement plan with your employer, or elect to manually make deposits into your savings and investing account, you first need to identify if you will "do it yourself" or utilize a professional money manager. Doing it yourself can save a significant amount of money over time, but if you are not willing to learn and study about investing and finances, consider hiring a professional.
Here are some types of accounts where you can invest in the stock market:
With all of the accounts listed above, I like to purchase low cost index funds in either a Roth IRA or 401(k)/403(b) plan due to the tax advantages of retirement accounts. Many in the financial independence community also utilize retirement plans to purchase low-cost index funds due to the specialized tax treatment for retirement accounts. Ultimately, the decision is yours.
For traditional 401(k) and 403(b) and traditional IRA plans, you may be able to lower your current taxable income, but note that you will still have to pay tax later on withdrawals once you retire (based on age 59 1/2 or older for these types of accounts). This "tax break" occurs by notifying the IRS that you set money aside to these tax-advantaged accounts, thereby lowering the amount the IRS can tax you on. With traditional accounts, there is also required minimum distributions (RMD's) starting at age 70 meaning you have to take out at least some money, even if you do not wan to. Keep in mind that their are income limits for these tax breaks so if you are a high earner, find out what income level phases you out of these tax advantages.
For Roth 401(k)/403(b) plans and Roth IRA's, you get to withdrawal the money in retirement tax-free (typically starting at age 59 1/2). The downside is no "tax break" now like the traditional accounts offer outlined above.
Be advised that there are limits to the amount of annual contributions you can make to these types of accounts. Visit IRS.gov for present year contribution limits for all types of accounts.
By no means is this investment advice nor is it designed to be a comprehensive outline of the entire investing world.
The most common problem remains that most people get scared off by the "complexities" of investing. In reality, as highlighted above, getting an account open to start investing is actually quite simple. After your account is open and you put in your first small sum of money, then you can consider yourself a beginner investor. Realize that over time, you will fill in the gaps in knowledge just by having an account and asking questions (and making a few mistakes along the way).
Leave a comment below on how you feel or felt about first entering the "investing world".
Are You Worth What You "Should" Be?
Net Worth = Assets - Liabilities
Your net worth is an excellent indicator of how well you accumulate money over your lifetime. Certainly, net worth is inclusive of more than just cash savings, as the equation indicates above.
Consider however, net worth is really an indirect (or arguably a direct) measure of your spending behaviors. If you accumulate "things" instead of "assets" in your lifetime, you likely will likely have a very poor showing when it comes to calculating your net worth.
Purchasing depreciating assets such as cars, boats, clothes, shoes, etc. contributes to a low net worth because you are spending what should instead be saved and accumulated.
If you were to purchase a house, or securities, or any other appreciating asset, you would otherwise expect your net worth to increase.
Here is the catch... having a big house and displaying high social status by mortgaging and borrowing can give the appearance of high net worth, but actually leaves you worth next to nothing.
What should my net worth be based on age?
My favorite simple equation for determining how much you "should" be worth is based on annual income and your age. It comes directly from the book The Millionaire Next Door by Thomas Stanley.
Expected Net Worth = (Age x Pre-tax Annual Household Income)/10
I really like how this equation actually provides an excellent reflection of your spending vs. accumulating behavior to date.
Essentially, if you make $600,000 a year and you are 50 years old, with a present net worth of $450,000, you are actually a fairly poor accumulator of wealth. Per Stanley's equation, you should be worth $3 million!
Why $3 million? Using Stanley's equation, Expected Net Worth = (Age x Pre-tax Annual Household Income)/10, simply plug in the theoretical numbers listed above.
If you are making this type of income and have only managed to save a small portion of it, you live a high-consumption lifestyle.
A high-consumption lifestyle is the plague of the West in the 21st century. Displaying high social status to others instead of attaining a high net worth - which typically nobody sees - is a no contest. We tend to lead a lifestyle geared more towards impressing others as opposed to improving our own character and merit. It is truly a sad state of affairs for the average American household. Is it really any great mystery why rates of divorce, unhappiness, and depression maintain such high rates? I think not.
What if I don't make much money?
Let's consider a more realistic scenario with more pedestrian numbers than the ones used above. Take a household earning $70,000 combined pre-tax income presently at age 35. Cut them a break right? After all, they are only 35! They aren't doing too bad.
Not so fast...
Using these numbers we figure this 35 year old couple should already be worth $245,000
Consider for a moment that most people in the United States, even one's who are much older than our example couple, barely have enough savings to cover a month's worth of expenses let alone $245,000.
There is a solution however...
Start living below your means, not above them!
Closing thoughts on net worth
Best-selling author James Clear eloquently describes how certain outcomes can be a lagging measure of your habits. Poor financial habits and high spending behavior almost always equals low net worth. Frugality, savings, and investing are typically habits that yield an eventual outcome of extraordinarily high net worth's, even with very modest incomes of $70,000 or less per household!
Stanley's equation above is certainly not a perfect example because maybe you are at the very beginning of your journey. Perhaps you just paid off a significant amount of student loan debt or paid for your own wedding. Of course this equation would not capture this event in such a unique situation. I believe that this equation would be something to turn to after you finish eliminating your debt to help keep you motivated along your path.
No matter where you are now remember, net worth is timestamped and very specific to a particular point in your life. This means that you can change it, significantly. All you need are better habits.
Not sure where to start or how to improve your habits? I suggest taking a look at Clear's book Atomic Habits. He gives great insight on why goal setting is dead and achievement is largely based on relatively mundane "habit stacking".
Let us know in the comments below what you learned when you calculated your "expected" net worth using the above equation.
Until next time...
Net Worth = Assets - Liabilities
Pretty straight forward stuff here, right?
Perhaps we should take a deeper look, just to make sure we are all on the same page.
The first step I recommend taking is to tabulate what you possess that holds financial value. These are your assets. Calculate your assets by adding up the present value of the following categories to find the present value of your assets.
Next, we need to figure out what you owe. This is also known as your liabilities. Add up the following categories to find your liabilities.
Subtract the total number found for your liabilities from your assets, to get your net worth. In other words... Net Worth = Assets (present value) - Outstanding Liabilities
Your net worth with fluctuate over time
In other words, it is snapshot unique to the day and time that you calculated it. It will go up and down with fluctuations in the market and differing seasons of saving and spending throughout the year. This also means that just because you got to a point where your net worth crosses a certain threshold, it may not stay there forever. The present value of your net worth is very transient. It is based on both individual behavior and market behavior.
A word of caution: purchasing a depreciating asset (like a boat) is nearly as bad as any other liabilities.
What should my net worth be?
My favorite simple equation for determining how much you "should" be worth is based on annual income and your age. It comes directly from the book The Millionaire Next Door by Thomas Stanley.
Expected Net Worth = (Age x Pre-tax Annual Household Income)/10
I really like how this equation actually provides an excellent reflection of your spending vs. accumulating behavior to date.
Essentially, if you make $600,000 a year and you are 50 years old, with a present net worth of $450,000, you are actually a fairly poor accumulator of wealth. Per Stanley's equation, you should be worth $3 million!
Tell us what you think in the comments below. Are you worth what you should be? Are you now motivated to save and invest even more than you already have?!
The downside of focusing only on earning more money
Earning more money can either turn your life around or turn it inside out. There is a difference between earning to spend and earning to save. The mindset is completely different between the two.
Poor accumulators of wealth spend more as their income increases. Good accumulators of wealth learn to save some, or all, of their increased earnings. This is the difference between displaying and accumulating wealth. Those who "display" wealth, are interested in spending on things that show to others some resemblance of wealth. Savers are frugal with their habits and are more interested in their net worth increasing over what friends think of what they have.
Increasing your net worth is simple and it necessitates that you become a good wealth accumulator. It does not mean that you earn a high income and spend everything you make because despite your façade of high social status, you are essentially poor from a net worth perspective.
A word of caution: more income is not always better. You can actually be a good wealth accumulator if you practice mindfulness and frugality with your money.
Here are some questions to ask yourself before chasing a higher salary at all costs:
If we are always focused on productivity and output, we may miss the very things that are right in front of us. Further, many activities listed above (exercise, sleep, nutrition, meditation, cognitive challenges) are actually scientifically proven to improve BDNF and neuroplasticity thus making our brains even more productive.
Does more income always result in more freedom?
Not always. We highlighted above that earning more money can potentially lead to increased psychological, and occasionally physical, stress.
Another axiom worth mentioning is about "working smarter, not harder". At baseline, most people work relatively "hard", they just tend to be inefficient. Efficiency would be working aggressively for a short period of time and then taking a break. For example, the Pomodoro technique is surrounded around taking 25 minutes for a task and then given yourself a break at the end of 25 minutes. This technique is centered around the concept that we have very limited attention spans. Instead of trying to work for 8 hours straight, try instead to break your work down to short intervals interspersed with stretching, standing, or walking breaks. Doing this throughout the day will likely increase your productivity quite a bit.
Our work inefficiency and arbitrary 40-hour work weeks actually reduce our freedom greatly. If you work remote, this might be easier to pull off. If you work at the office, you will look like anybody else who is frequently taking breaks throughout the day, they are just doing it at random. You are going to pre-define your time periods and rest intervals. Set the clock for 25 minutes and do not stop and take a stretch break until you get their. Once you reach the 25 minute mark, try taking a true 5 minute rest by breathing, stretching, walking around, or anything else that can allow you to practice mindfulness.
"Money Doesn't Buy Happiness"?
The typical belief is that we need to have "nice things" and buy more stuff to display a high social status to prove to others how wealthy we are. In spending more, you fail to realize that you are inherently saving less and therein drastically slowing down the accumulation of your net worth. In the long term, spending more will effectively create more financial strain and stress, not less. This is not likely to result in long-term happiness.
Efficiency and happiness maximizes your freedom
If your six-figure job requires ruthless hours then you are not in control of your own freedom. There are certainly ways to make more money with less stress, but those opportunities are few and far between. More stress traded for more money is almost always the deal.
Think of the promotion to management. Now you have more employees to manage, scheduling to do, deals to close, handling poor performance and lack of motivation. Management is somewhat akin to "adult babysitting". Consider if this is truly something that you want and go into a promotion like that fully aware of how increasing your earnings might impact your job satisfaction.
What about the successful business owner who sits in his backyard while earning $10k a month from his business? Where were you the first 35 years he was rolling around on the floor like one of the employees? All you see now is the snapshot of what he has become due to all his time spent, holidays missed, birthdays not attended. All so that he can enjoy the "twilight years" of his life just to have you assume he always did it that way.
My ultimate proposal is that we improve and optimize our efficiency. Researchers indicates that happiness plateaus at an annual income around $70k per year. After that, the return is insignificant. This might mean that if you are already above this income level, earning less by taking a role more aligned with your values is more valuable than the increased earnings.
I am not averse to hard work and discipline, far from it. However, you need to enjoy life and enjoy what you do. Be careful about becoming beholden to your job. Buying more than you can afford is the number one way to feel stuck in a job you hate. If you are going to participate in periods of life with higher income and higher stress, please do so wisely by accumulating, saving, and investing your increased earnings, not spending it all away!
If you are frugal, disciplined, and value-oriented, focus on the following:
Happiness is more important than income
I encourage you to see if there is more to life than determining success based on earnings. Money can only buy certain things, most of which derive very little happiness.
There are plenty of things that move the needle on happiness that are free:
Perhaps your best life is about separating "what you do" from "who you are". Do not think about work after hours or on days off. Be mindful and figure out "who you are" when you are away from work. Spending too much of your precious time at work and thinking about work will make your job define you. From my experience, MOST people do not want to be defined by their jobs.
Let us know your thoughts below in the comments section. Are there any other free activities that you really enjoy to share with the frugal community?
What Is "Investing" and How Can I Participate?
If you want to a crack at the big bucks but aren't 7 feet tall with a smooth jump-shot or a square-jawed Hollywood big shot, you need to invest.
There are many different methods of investing from baseball cards to stocks, comic books to silver. Truth be told, you can invest in anything you anticipate will increase in value over time. I would estimate, however, that a great majority of investors build their life and wealth around the stock market or real estate. Entrepreneurship or small business ownership is a close third option.
Technically, you can invest in nearly anything understanding that not all investments are not created equal. All you really need is just one person willing and able to purchase something at a higher price than you originally paid to have a positive investment.
If you purchase something that is not reasonably expected to increase in monetary value over time, then you are probably making a poor (or negative) investment.
Investing is essential for wealth building
So where do you start? What are the very first steps of investing if you are a beginner?
If you are just starting out, I suggest you begin doing some light reading in the areas of personal finance and investing. Reading this blog is a great start and take a look at some of my all-time favorites on personal money management. ducate yourself. Read, study, and immerse yourself in money management, investing, and personal finance. It is imperative to understand money
I am not saying be the next Warren Buffet and read financial statements all day for the next 80 years, but educating yourself would be a good place to start.
The two most common investment options, both with fairly small barriers to entry, are investing in the stock market or real estate.
How do you invest in the stock market?
You actually have many options. Wall Street and the stock exchange began in 1792 under a buttonwood tree and involved actual in-person trading of securities.
Nowadays, nearly everything is done online. To open any individual retirement accounts or brokerage accounts, I like to use Fidelity or Vanguard for my account. For workplace plans, you may not have the option of either of the aforementioned so work with your HR department and a financial advisor in discovering what approved vendors you have for your 401(k)'s, 403(b)'s, and other deferred compensation or pension plans.
The primary types of accounts to invest in stocks are:
Again, for IRA's and brokerage accounts I always have used either Fidelity or Vanguard, but the choice is entirely yours to make. These two vendors give you access to some of the lowest fees and expenses available in the industry.
My favorite funds to own for each company are listed below. Disclaimer: This is not investment advice.
If you have any trouble figuring out how to purchase stocks and index funds, or how to transfer money into these accounts, call your investment company or financial advisor and ask how to get started purchasing these securities. Vanguard and Fidelity have some of the best customer service departments I have experienced yet.
What's the long-term plan once the first investment is made?
My personal preference is to "set it and forget it". I add money to my account incrementally over time and continue to purchase my favorite stocks and index funds in expectation that they will dramatically increase over time. I typically set my investment horizon for at least 20 years, especially my index funds, where I do not expect to sell or withdrawal any of these securities for 20 years or more.
A common long-term for the financial independence community is to continue the aforementioned, year after year, until you have enough money to cover your expenses My plan is to do this year after year until I am ready to start withdrawing this money which will be when I no longer need to work for money and can live off investment income.
Please, do not worry about timing the market. Do not worry about crashes. Do not worry about corrections. Just invest in low cost index funds for life and allow your money to compound over time.
Use caution when you have anybody telling you they have access to unique metrics and can protect you from market crashes. Unfortunately, actively managed portfolios rarely ever beat passively managed ones. Guess what, they don't. Their "pick of the week" and "insider information" has never historically proven to be accurate. Consider that almost every single long term investment advisor has failed to even match the returns of the S&P 500. That's why I choose to invest in index funds to allow me to match the S&P 500 thereby beating 95% of all professional investment advisors.
What About Real Estate?
I have not personally began investing in real estate as of 2020, but I expect that to change over time.
One of the best real estate investment books I have read is How to Buy and Sell Real Estate for Financial Freedom by James and JW Hicks.
The two most common real estate investment strategies are:
These two strategies oppose one another greatly. Long-term rental strategies are geared for those looking for many years of residual rental income and who do not mind either managing the properties themselves or paying somebody else to do it.
"Fix and Flip" is exactly what it sounds like. Buy a crappy place for cheap, fix it up either yourself or with low cost contractors, and sell it for a profit after factoring in expenses to fix it up.
Regardless of how you start investing, whether it be real estate, stocks, or otherwise, you need to get your money working for you as early in life as possible.
The most assured way to generate significant long-term wealth is saving and investing. Boring? Maybe. But you can laugh your way to the bank someday when you are counting all the zeros behind a big number in your investment accounts.
The purchase of your home or primary residence
Most people forget that a home is a type of purchase. When we hear the word purchase we tend to focus on small-ticket items like clothes, shoes, or groceries. Perhaps it is because we tend to associate loans and mortgages with large-ticket items, while purchases tend to be geared towards small-ticket items.
In reality, a mortgage is really just a loan to purchase your home. When deciding on this purchase and larger purchases should be given greater contemplation. Yet it seems that we spend about as much time evaluating home prices as we do shoe prices. We need to be more disciplined and cognizant when considering a home purchase, especially if this is your first one.
Choose wisely when deciding how much you are going to pay for the price of your next home as purchasing too much home can have devastating long-term financial consequences. Without question, a home is certainly an investment.. You borrow money to purchase the asset (a house) that you expect to appreciate in value over time. Truth be told, I do not believe that purchasing a home is a significant wealth generator nor does it appreciate well over time. Residential real estate barely beats inflation to the tune of about 1% per year. I would hardly call that a significant wealth generator.
However, a home can be a wealth eliminator, if purchased incorrectly. Purchasing too much home will have long reaching implications that will devastate your finances. If you do not have at least 20 percent to put down on a home, you are looking at too high of a purchase price.
The benefits of putting at least 20 percent down on a home are:
Be advised, the purchase of your home- especially your first home- sets off a chain reaction that may last for decades to come. Many of the successes (or failures) of your future financial journey depend on the decisions you make when you are young. If you overextend yourself on the purchase of your home you dramatically reduce the power of your savings. That should be reason enough to purchase a home well within your means.
The reality is nobody actually cares what house you are presently living in. Nobody cares how many square feet it is, how many bedrooms it has, or if it has a pool or exposed wood beams. Truth be told, the only person any of these things should ever have any meaning to (aside from yourself) is whoever you try to sell it to down the road. That's it. Technically, you will only ever need two people to "judge" the value of your home, you and whoever buys it from you.
With that out of the way, the single most repeated mistake in American society is over-mortgaging themselves on a home. This is commonly referred to as being "house-poor" or being "married to your mortgage".
A more expensive home has implications beyond just a larger monthly mortgage payment. Consider that a higher purchase price will also have the following effects:
If there is one thing that I consistently see that dramatically alters the trajectory of a financial journey, it is the purchase of your home, especially when considering a first-time purchase. If nothing else, understand that a home is a place of shelter and comfort. Truly assess whether you require such luxuries that high-priced homes afford or if you can delay those wants until you can truly afford them down the road.
Especially when you are young, the goal is to save and invest as aggressively as possible. Far to often, the roles are reversed. Mistakenly, people are doing things backwards by spending when they are young and trying to save when they are older. It should be the other way around. One of the largest impacts you can have on your savings is by diligently assessing the purchase price of your first home. Buying a house for even $5,000 over your true budget can have lasting implications that will be difficult to recover from.
Until next time...
Where It All Comes Together
Two major steps are out of the way at this point. To review, they are:
Step 1. Calculating Your Net Worth or Lifetime Earnings and Savings
Step 2. is broken down into 3 phases.
After eliminating toxic debt and building an emergency fund, you will finally be in a position of relative financial strength. For step 2, focus hard on paying everything off. Some of you may want to keep your mortgage, but please realize that the interest on the loan (even if it is only 3%) can dramatically reduce the amount of money you are putting toward investing over the course of 30 years (average mortgage duration). Remember, over the course of a 30 year mortgage, the average homeowner pays 2.5 times the original purchase price due to interest.
The third and final step
The first two steps of this journey were highlighted in Part 1 and Part 2. If necessary, go back and review those. The sole purpose of putting those two steps together is to get to the point of attaining a positive net worth.
After crossing the threshold into a positive net worth, now you can begin to focus on your savings rate. Savings rate is defined here as the percentage of your take-home pay put towards savings.
Here is a typical way to begin figuring out your savings rate. It is broken down into 2 phases.
A. Find out what your after-tax take-home pay is by assessing:
B. How much you are adding to the following accounts on a weekly, biweekly, or monthly basis?
To calculate your savings rate, what percentage of your after-tax, take-home pay (section A. helps you determine this) goes towards accounts listed in section B. above.
Savings rate = (monthly savings amount/monthly take-home pay) x 100
Once You Know How Much Your Saving, Find Out How To Increase It!
Now that you have determined how much you are contributing to saving, look at this figure at least twice per year to see if you can increase it.
Never stop doing this step. Ever. You want to see throughout the "seasons of life" if you can be more and more aggressive with your savings efforts. Only you will be able to determine for how long and how much money needs to be accrued before you relax this plan.
Many have used The Shockingly Simple Math Behind Early Retirement article as a means for figuring out their "FI number". Perhaps this will be your next step as well.
To increase your savings rate, you can focus on income and expenses. Ideally, focus on both for the biggest impact.
The goal: Increase income and decrease expenses simultaneously
Ways to increase income:
Ways to decrease expenses:
The wider the gap between income and expenses, the greater potential your savings and thereby investments will have.
If you only have $100 saved, who the hell cares if you invest in something that generates a 25x return... you'd still only have $2,500 dollars---hardly enough to make you rich. This is a 2,500% return on your initial investment of $100. Guess what, "the market" typically returns 8-10% over time, not 2,500%.
Remember, your most powerful weapon at your disposal is compound interest. The way you make compound interest even more powerful is by saving, early and often!
Step 1 - Calculate Your Net Worth or Figure Out Your Lifetime Earnings vs. Savings
Step 2 - Attain a Positive Net Worth (most often by eliminating debt) and create some breathing room with a fund of at least 3 months worth of expenses
Step 3 - Determine your savings rate and find ways to increase it
Step 2 of Better Money Management
In Part 1 of this series, I discussed the importance of getting a grip on how much money has flowed into and out of your life. You had two choices on getting started:
We start here to paint a very clear picture and teach you just how inaccurate your lifelong story about money truly is. You need to understand what your previous money management routine has yielded because it creates an excellent way to track where all your money has gone over your earnings lifetime.
The first step of this program was to find out how much your worth. Now what? Step two has three phases - debt elimination, emergency funds, mortgage payoff.
Phase 1 - Debt elimination
If you are in debt, and have a negative net worth, there is no such thing as good debt vs. bad debt.
It's all bad debt if you owe more than you have saved. If you are living beyond paycheck to paycheck, stay away from borrowing any further. Slowly begin to turn the ship around on your debt. Start with all forms of debt except for your mortgage (that comes later).
Begin with the debt snowball or debt avalanche methods. They have been hashed out in great detail and people love Dave Ramsey's Total Money Makeover book for strategies on how to kill debt as quickly as possible. To that end, I will not repeat what others have already outlined better than I. Go read Dave's book or Google search "debt snowball" or "debt avalanche" to pay off all forms of debt except for your mortgage.
Phase 2 - Build Emergency Fund
Age old wisdom advises 3-6 months worth of expenses in your savings account. That is your emergency fund. If you have had difficulty with savings in the past, especially if you have accumulated a history of significant debt, then aim for 12 months of expenses in an emergency account. History tends to repeat itself and the larger cushion you have the greater space you put between yourself and toxic debt.
Above and beyond your emergency fund, maximize your effort to phase 3 (highlighted below).
How much for an emergency fund? Anywhere from 3-12 months worth of expenses. The way to decide where you fall in the 3 to 12 month spectrum is being honest with yourself about your previous spending and saving habits. If you have never owed significant debt and are already a disciplined with your savings, 3 months works out just fine. If you previously owed more than $100,000 (excluding your mortgage), aim for closer to 12 months in an emergency fund.
To has this out further, let's use an example. Say you previously had $25,000 in student loan debt and $30,000 in car debt, after you pay off the full $55,000 consider having 6 months worth of expenses in your emergency fund (right in the middle of our 3-12 month range). If your monthly expenses are $2,000, you would want to accumulated $12,000 in savings and/or checking accounts to fully load your emergency fund. This is not money earmarked for spending however. You are not to touch your emergency fund unless there is a major repair, accident, or true emergency that requires immediate cash-flow.
After eliminating all forms of debt (excluding your mortgage) and building 3-12 months in an emergency fund, the next step is to finish off your mortgage debt.
Phase 3 - Mortgage Payoff
Many self-proclaimed professional money managers disagree with this one. However, consider that the average person who takes the full 30 years to payoff their mortgage pays 2.5 times as much for their home as the original listing price.
Even in a market with all-time low rates under 3%, the effect of interest can be brutal when factoring the full cost of homes. Consider that the average American has $202,284 in outstanding mortgage debt according to Experian. Even at historically low rates of 3%, that can be $6,000 per year in interest alone early in your mortgage due to the typical amortization schedule. By the same schedule, nearly all of your initial payments for the first few years of a mortgage go towards interest payments. This means you will initially live in your home without actually paying down your principal whatsoever!
Paying off your mortgage as quickly as possible is like earning a guaranteed rate of return on your money. Early on, you will be getting a rate of return equal to the interest rate on your loan.
I do not make this recommendation likely however, have you ever met anybody who has significant financial trouble who has a fully paid off home? Neither have I. Not yet, at least.
Part 2 of this series has three distinct phases. Phase 1, eliminate debt excluding your mortgage. Phase 2, save 3-12 months in an emergency fund. Phase 3, pay off your mortgage in full.
In part 3 of this series, we will discuss what to do once you have established and completed Steps 1 and 2.
How to Quit Complaining About Having No Money
Money is something that needs to be managed. Whether you make minimum wage or well over six figures, you must understand how to manage your income if you ever expect any of it to hang around.
The first order of business in managing your finances is to understand when, where, and how much money flows into, and out of, your life. To solve this mystery, first begin with finding out where you spend your money, on average, every month. It is imperative to understand where you money ends up at the end of every month so you can begin to identify how you can keep more of it around!
At the end of most months, most Americans have little to no disposable income. In the present situation, most of us are actually able to spend more than we earn thanks to the world of creditors and financing.
However, there might just be hope for you yet.
Ponder the following: if you are over the age of 30, you likely have already had more money pass through your life than you realize. Don't believe me? Take a look at this example:
Chances are, most of you make more than just $10k per year. Where has it all gone?
Consider that he average single individual income is just north of $56,000 (according to 2015 US Census data). So how much money does a person making an average of $56,000 earn in their lifetime? Answer: $2.2 million by the age of 65.
Where does all the money go?
"In one hand, out the other" typifies money management in the United States. Worse yet, many are spending well beyond our earnings as evidenced by the $8,398 credit card balance of the average American.
Perhaps you find yourself in the same situation. Somewhere along the ride you decided keeping more of your income was not all that important. You may have decided a new car, new clothes, a brand-new house were all worth having savings in the "slim to none" category.
You may have decided that it was more important to own something, rather than own your own life. Your decisions make the indentured servitude of regular "nine to five" employment a guaranteed certainty until you meet an early grave.
You are responsible for this. Not your neighbor, Not your brother. Not a divorce. Not the weather. Not your injured knee. Not that tree that fell on your uninsured home. It's your fault. End of story.
Why do we need the pressure of it being "our fault"? Because by assuming it is your fault, then you can begin to understand that you are the one responsible for changing it. Life happens to all of us. Unexpected expenses will continue to come. They do not end and they come at the worst time. Even innocent expenses like birthdays, holidays, baptisms, wedding, you name it, will continue to come at the most inopportune time. This is life my friend.
I take the extreme "my fault" approach to money management because it carries with it a zero-tolerance policy for excuses. Excuses are wasted energy. They rarely, if ever, do anything to change the actual situation at hand. Excuses are a coping mechanism that are designed to make you feel better about why you are not doing better. They are also used to help explain to other people why you aren't doing better in the hopes they won't judge you (trust me, they still are judging you anyway).
In the words of the late Jim Rohn, "Don't wish it were easier, wish you were better".
While the lifetime earning numbers that we calculated above might be very impressive (especially if you make more money than the example I provided), you may actually find that you are spending more than your annual after-tax income.
To make the examples above more accurate, use your actual tax returns from previous years and add up what you have made in your lifetime (note: if you need these but don't have them, visit the IRS Website's "Get Transcript" page to learn how much earnings have been reported on your behalf to date) . This can be a very enlightening exercise, good or bad. If nothing else, it should merely demonstrate how little awareness you have about how much money you actually have made.
The concept of calculating your lifetime earnings is a great place to start to introduce you to your income and create a visual of how well (or poorly) you have managed it throughout your lifetime. It is an important first step to understanding how to manage your money.
*If you would like greater depth on the concept of lifetime earnings, take a look at Your Money or Your Life by Viki Robbin.
Where To Start If You Want to Improve Your Money Management Skills...
Choose one of the following to get started:
Calculate Your Net Worth (assets minus liabilities)
Calculate Your Lifetime After-Tax Earnings - for increased accuracy, use the IRS Website for attaining prior transcripts of your tax returns
You must begin this journey knowing where you are so that you can figure out where you want to go. All directions require a starting point.
If you insist that you never have enough money, start by looking at where your money actually goes. I don't mean simply looking at your checking account every other week, I mean look at your longer term trends. If someone is 200 pounds overweight, it would be wrong to assume that only last week was to blame for this situation. We need to look at things longer-term.
Pick one of the above, and get started. Increasing your net worth can literally be as simple as gaining a deeper understanding of your personal financial snapshot. Just knowing how much money flows into your life (lifetime earning) or simply understanding how much you have saved in your lifetime (part of net worth), you can begin to identify areas where you require significant input (expenses, savings, tax efficiency, retirement accounts, investing, etc.).
Part 1 concludes with encouraging you to understand where you are starting from. Two choices:
Regardless, you decide.
Better Money Management Series
Why you need to calculate your net worth annually
No matter where you are along your financial independence journey, running the numbers by calculating your net worth is an invaluable way to determine your financial health.
By keeping an eye on your finances, you will inherently increase your awareness and money management skills quicker than you think. If you are the type of person that considers themselves a poor money manager, then perhaps it is time to change that skill.
Is it possible that you are bad with money because you don't track it? Do you think you would get better or worse with your finances if you started paying more attention to them?
The basics for calculating net worth are as follows: assets - liabilities = net worth
An asset is anything you can exchange for future monetary or economic value and are assessed at present value to the marketplace.
A liability is a debt or expense that you owe. This is also assessed at present value. Include everything here, no matter how embarrassing the liability might be. People finance everything these days from furniture to pets, so don't be discouraged and include every last outstanding debt.
The reasons you should track your net worth regularly
First and foremost, you need to track it because it provides instant feedback on how well you are doing managing your financial portfolio. Only those saddled with debt and living check to check don't know what a portfolio is. Truth is, I believe all you need for a portfolio is a positive net worth.
Once you attain a positive net worth, by eliminating all of your debts (the mortgage is the only thing that could possibly stay), then you can worry about managing your investments.
The real-time feedback that your net worth provides gives direct insight to the following questions:
Besides gaining insight into your overall financial picture, tracking your net worth allows you to learn something new about yourself or even become a different type of person altogether. As the late Jim Rohn always said (paraphrasing), "Don't do something just for the sake of doing it, but rather do it for what you will become in the process". If you were previously the type of person who is terrible at money management, now you can start to become the type of person who is rather skilled at it. Imagine what you will learn along the way. You certainly don't need to know much more than the difference between an asset and a liability to get started, but I promise you will pick up many more money-related skills along the way.
Another reason to consider tracking your finances (at least annually) is because it helps you stay motivated on your financial journey. Make a game out of it and embrace the milestones along the way. Find economical ways to celebrate when you hit certain savings and net worth goals to keep you motivated. The reality is that far too often I hear of tracking finances as a source of anxiety instead of motivation. Some years you will make large strides and other years will feel like a standstill. Just remember, the path to financial independence is not supposed to be a smooth and linear road.
You will be amazed at what you learn as you practice tracking your net worth every year. For example, just four years ago I had no idea what a 457(b) was. Fast forward four years and my wife and I not only have 457(b) plans, but we have saved over $50,000 in them. I am not gloating but rather illustrating to you my very point in which I started the paragraph: you are going to learn a tremendous amount about money along the way. You will discover things along the way that you never imagined will accelerate your net worth just because you will be searching online and asking questions about terms to which you did not previously know. It is by searching and asking that you will expand your financial knowledge, and almost assuredly your net worth, along the way.
Lastly, you will be able to share with others and help them along their path as well (if you so choose). Use this superpower with caution and do not be condescending when offering others advice. Be helpful and encouraging and share with them that you had little to no knowledge of any of this just a short time ago. Imagine the satisfaction you would have in starting to teach others about personal finance knowing you once were as bad, or maybe worse, at managing money than they are. This last reason is optional, yet I argue one of the most important reasons to stay abreast of your financial snapshot, and therefore stay on top of all the financial education out there.
The morale to the story is that you have the ability to improve your financial situation just by keeping track of it. What gets measured can be improved. If you don't measure something, it is very difficult to know if you are improving it. So quit procrastinating and start tracking. Track your net worth. Track your expenses. Track your investment contributions and savings rates. If it causes you anxiety initially, that's alright and often to be expected. Stay the course and keep going. If you simply cannot get over the stress of managing money, then perhaps it's time to seek the guidance of a financial professional after all.
Leave a comment below. What have you learned by tracking your money over time?
Do you really need to live a life of extreme deprivation?
Extreme deprivation isn't really that much fun. To most folks, the idea of putting on 4 layers in the winter instead of turning on the heat is not that appealing. Standing in the grocery store comparing the cost per ounce of beans is, for many, not a recipe for a good time. The cost savings of single-ply toilet paper is just too abrasive for most (literally).
Don't get me wrong, frugality tends to come with some weird savings hacks that are the centerpiece of your friend's jokes. I have even heard of someone using industrial CO2 containers to make their own seltzer water. Frugal folks tend to be a pretty strange flock.
If you are motivated by cost cutting and frugality on small ticket items, go right ahead, I won't stop you.
But if the idea of penny pinching on the little things drives you crazy then perhaps you need a much needed re-frame on your concept of frugality.
"The Big Three" Expenses
For those of us who cannot tolerate the idea of skipping our latte factor items, there may be bigger fish to fry for you yet.
Saving on housing, transportation, and food is a hell of a good place to start. In fact, it may be the only strategy you will ever need.
Housing. Buy less house than you can afford, nothing more. Married with one kid and no plans for more? Why the hell do you need a 5 bedroom, 3 bathroom house? You don't. Be smart. Warren Buffet still lives in the home he bought for $31,500 in 1958.
Transportation. Don't buy a new car. Ever. It's really that simple. Buffet, one of the wealthiest men alive drives a midsize sedan, a 2014 Cadillac.
Food. Don't eat out. Split meals when you do go out. Cook at home a great majority of the time.
My thoughts on "The Big Three" expenses
Show these guidelines to your mortgage or real estate professional if you have trouble computing a price range off of these numbers.
Rule 1: Always buy less than you can afford
Rule 2: Purchase all necessary insurances - don't skimp on these!
Rule 3: Buy a house with at least 2 bathrooms - the more bathrooms in a home the better the resale value
Rule 4: Always get a termite inspection and order a plan that covers treatment.
Rule 1: When it comes to cars, buy used. Never buy new due to massive depreciation as soon as you drive it off the lot.
Rule 2: Bike or walk more often. If you cannot bike or walk, combine your trips to save gas and mileage on your vehicle.
Rule 3: Shop around for more affordable car insurance.
Rule 1: Drastically reduce, or eliminate, dining out and take out orders.
Rule 2: Cook at home.
Rule 3: Buy in bulk. Especially buying and storing the following:
If you happen to know you need a budget, but cannot see yourself trading in your 2-ply toilet paper for 1-ply to save a few Shekels, then focus your efforts in these three areas.
Comment below on how you have saved in these areas.
Can saving a few dollars a day really make a difference?
Frugality does not automatically imply you need to move out of your house, sell your car, ride a bike and live in a tent for the rest of your days. Frugality does not have to mean extreme deprivation.
In the financial independence and frugality community a term referred to as "the latte factor" has arisen. The literal translation of this is if you saved the cost of a latte and instead invested it, that over time you would become rich. I suggest that we can expand this beyond its' literal meaning however. Your "latte" could be any recurring expense, it does not have to be an actual latte.
Note: I believe the term latte factor originated with author David Bach. He even has written an excellent work titled The Latte Factor: Why You Don't Have to Be Rich to Live Rich.
The true cost of your daily "latte"
First, figure out what your daily "latte" expense is. Perhaps it is literally a flavored morning beverage, but I suspect for many it is something else. Do you buy lunch everyday? A pack of smokes (saving money is another reason to quit)? A donut every morning? Essentially, what is the item that you immediately identify as a regular expense that you purchase at least once every few days, if not everyday?
Figure out how much that item costs you every month. Then take that monthly expense and plug it into this calculator.
Say I purchase a sandwich at work everyday at work. Say that sandwich costs $7. What if, instead, I could make lunch for $2 and bring it to work instead of buying that $7 sandwich? The answer to the riddle is that you would save $5 on lunch. Following me so far?
Such a simple example yields over $100,000 difference over the span of 30 years.
Just assessing your lifestyle habits from a true monetary cost-benefit perspective will change your mindset. It has the potential to train your brain to think differently about seemingly innocent recurring expenses. It might even eventually make you frugal.
Taking this one step further, imagine you are able to find more than one item to save on over a lifetime. Now use the example above to calculate how the recurring expense of a particular item could instead be utilized to harness the power of compound interest.
Is this deprivation or frugality?
The most common rebuttal to compounded savings is the concern that you will be depriving yourself. Yet that is not the point!
The point is that by choosing to limit yourself for a definitive period of time- like packing your lunch instead of that delicious hoagie for lunch everyday- you can ultimately choose to start purchasing that item again someday. The difference is that by limiting yourself for a defined period of time, when you ultimately choose to start spending that money again, you can restart the original behavior and then some! You can have your sandwich, and a new car, and a boat if you so choose. How? Because you chose to not spend on something for a defined period with the ultimate expectation to gain far more in the long term. This is the classic marshmallow experiment in action!
In 1972, a study was published from a group of researchers out of Stanford which later became know as the "Stanford Marshmallow Experiment". In this aforementioned study, children were given the choice of having one marshmallow immediately, or avoiding eating the first marshmallow until the researcher returned to the room in exchange for receiving two marshmallows.
That's the power of choice. That is the power of delayed gratification.
Ultimately the choice to be frugal now is because you can. Because you will never be younger than you are right now. You can possibly handle more now. Work more now. Cut spending more effectively right now. Delay your gratification. That's what frugality ultimately is!
Leave a comment below. What's your "latte factor" item? How do you anticipate this delayed gratification to benefit you in the long term?
Misleading claims by "Real Estate Gurus"
Many self-proclaimed real estate gurus espouse the idea that you cannot live an asset. By the same meaning, they would therefore declare your primary residence a liability. I believe that this type of thinking is misleading at best and incorrect more often that not.
The reasoning behind the claims that housing is a liability are centered on the argument that as long as you live in your home, it is unable to generate rate of return for you. With the failure to generate a rate of return, the industry "gurus" would likely inform you that your house is disqualified from being an asset.
Rate of returns in real estate involve more than just rental property income however. Just because you do not have positive monthly cash-flow in the form of rental income, does not mean that your primary residence cannot be an investment.
An asset is can technically be classified as anything that has the potential to produce positive economic value. Unless your house became worthless the second after you signed at closing, it cannot possibly be considered anything other than an asset. Whether your home is an appreciating or depreciating asset however, is an article for another day.
What kind of return on investment (ROI) can you expect from real estate in general?
According to data collected by Jorda et. al. (2019) from the time period of 1870 to 2015- over a century's worth of data- equities (stocks) beat real estate returns 8.46 to 6.10% respectively after being adjusted for inflation.
That 2.36% difference (8.46 vs. 6.10) in returns is actually attributed largely due to the inclusion of rental yields into the equation. The reality is, capital appreciation is much closer to 1% over the long term, according to Shiller (2000).
Many will argue that the measly 1% capital appreciation on homes is bringing down the real number associated with total real estate rental yields. They insist that rental yields are much higher than just 6.1%. The only problem is, there is insufficient data to support those claims. The reality is that rental real estate yields are very wide ranging and extremely difficult to predict ahead of time due to known long-term costs associated with the property.
Why are the costs of rental real estate relatively unknown and difficult to predict?
The expenses associated with owning this property are variable and largely unknown throughout the lifetime holding of any given property.
Consider just some of these unexpected expenses associated with ownership in real estate:
I digress, because we are talking home ownership as an investment, not rental real estate. To evaluate a home as an investment, we will need to know how much a house appreciates over time. This will allow us to measure it's monetary value as an investment.
How much does a typical home appreciate in value?
To find the best answer to this multi-factorial question, we can take a look at the Case-Shiller Home Price Index. This appears to be the best index associated with the national home price index. Keep in mind, the Case-Shiller index excludes new home construction (there is a separate index for that) and focused primarily on resale of existing homes within a given time period. This is good news because most of us in the FI community focus on used real estate for purchase and ownerhsip.
When digging through Shiller's website data (available on his website for free), I found historical data---measured with a 3 month moving average---since 1953 (I chose 1953 as a starting point because that appears to be the year they began updating the index on a monthly basis).
Now, the data is broken into real and nominal values. The difference is crucial. The real home price index is adjusted for inflation and is updated for "today's dollars". The nominal price index does not adjust for inflation.
What's the difference between real and nominal home value?
The real home price index from 1953-2019 increased by 54.16%
So why is there such a difference between real and nominal home prices?
Again, the nominal home price increase is much larger in the example above because it fails to account for the fact that the market value of $1 in 1953 is not the same as the market value of $1 in 2019. This is primarily due to inflation.
In other words, a single dollar went "much further" in 1953 than it does today. Plain and simple.
That is why the real home price index is a more useful tool in calculating the expected annual rate of return of housing. The index essentially equates yesterday's dollars with today's dollars by adjusting for inflation.
By evaluating the change in real home price index figures from 1953-2019, I calculated an annualized rate of return of 0.81% per year of capital appreciation of a typical home over that 67 year period
Admittedly, I will occasionally round up and use a full one percent per year figure in my articles since many market critics will recognize a full percentage point as an accurate figure.
Now that we have calculated the expected annual rate of appreciation of your home, let's dive into the discussion of seeing your home as an investment.
Plenty of confusion surrounding the word investment
Most people simply do not even understand the basics of what is considered an investment. An investment is something that you attain now with the prospects of benefit in the future.
Typically, this is referred to in terms of financial gain. However, this is entirely misleading due to the fact that there are many types of investments don't even generate a positive return.
Some examples of investments that fail to generate positive returns over the long-term:
These are all acknowledged as investments, yet they lose money. So sure, your house can still "lose money" if you sell it at the wrong time, but it's still worth something.
Technically speaking, an investment is simply something that you anticipate will be worth something in the future. You hope it will be worth something in the future that is of benefit to you. But remember, beauty is in the eye of the beholder. Your definition of "benefit" is not a universal definition, it is unique to you only. Many would simply be happy knowing that their house will be worth something someday, regardless of how it compares to the original purchase price--especially if it's paid for.
But can your house make your rich like other investments?
Yes. At least indirectly it can improve your overall net worth.
One of the best write-ups I have seen on this conversation is found here, written by Michael Bluejay. This guys does a great job of analyzing the entire circumstances of a home ownership in a simple, one-page article. He breaks down the concept of "Rent we didn't have to pay" as line item in expenses.
Rather than reinventing the wheel, Bluejay discusses how the average person will have to pay hundreds of thousands of dollars in rent over a 30 year period---which is also the length of the average mortgage.
He breaks down the difference in value of two scenarios:
The math is extraordinary but the numbers are very practical and they do check out. See them for yourself here.
The punchline in Bluejay's article is that by renting you lose over $300,000 over a 30 year period, even if you invest the difference between renting and buying. He recognizes in his example that home ownership may appear to lose money as well, but that's if you forget to include "Rent you didn't have to pay". Basically, this is what he considers to be an objective measure of "having a place to live".
Paying rent over 30 years--at $1,200 per month--would cost you a total of $432,000. At the end of that 30 years you have nothing to show for the $432,000 spent in rent. What's even worse is that this calculation does not even account for the fact that your rent will most assuredly increase over the course of the next 30 years.
Even if renting costed you $300 less per month than buying---which is lunacy because in many desirable areas renting is actually just as expensive, or even more expensive, than buying---and you invested that difference over 30 years with an 8% return. You would have $407,819. You didn't even break even! Not to mention that you also don't have a place to live after 30 years of hard work. That's a terrible trade-off.
So yes, home ownership is considered an investment.
Why Your Primary Residence is the Best Real Estate Investment out there.
First and foremost, let's address the intangibles. Home ownership, subjectively, is:
You get the idea. A home is a chance to actually have a stake in something in the world. Your own plot of land (be careful though, it's not really yours until you pay off that mortgage).
Objectively, a home is a place to build equity. To realize appreciation, even if it is only 0.81% per year. Further, the faster you pay off your home, the less interest you will ultimately pay.
Many will argue that mortgages and home ownership will leave you paying nearly 2.5 times the original purchase price. I agree with that math if it takes you the full 30 years to pay off the house. That is why I recommend early and aggressive principal reductions---or buying your house in cash if you are in a position to do so.
Your home is definitely an investment. Although it does not return as much as other types of investments, it provides many intangibles (highlighted above) that are irreplaceable.
1. Shiller, Robert J. 2000. Irrational Exuberance. Princeton, N.J.: Princeton University Press.
First, Let's Clarify a Few Things Regarding Funds
Today we assess the difference between mutual funds and index funds, active and passive funds respectively.
Mutual funds are professionally managed investment portfolios. They are funded primarily by the shareholders (investors) like you and I. Typically, their goal is to generate the highest rate of return annually for the shareholders of the portfolio. They do this by actively trading investments inside of the fund. Marketing and advertising for new shareholders (investors) is typically done by comparing recent returns of the mutual fund to that of a benchmark- typically an index fund.
Index funds are actually a type of mutual fund. An index fund is a passively managed that seeks to match a given index. The Dow Jones or S&P 500 are two of the most common indices.
So why is there so much confusion out there about mutual funds vs. index funds?
Although index funds are technically a type of mutual fund, they differ significantly in almost every other way.
For the sake of clarity, it helps to divide the entire category of mutual funds into actively managed and passively managed. Therefore,
What's the difference between mutual funds & index funds?
Fees and management style.
The typical fees of a mutual fund are in excess of 2%. The typical fees of an index fund are often less than 0.1%. Doesn't sound like much? Well, it is!
Let's look at an example headline from our friends over at NerdWallet:
Millennials have decades to save for retirement, but also decades of exposure to avoidable investment fees. NerdWallet analyzed a variety of scenarios and in one case found that paying just 1% in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
What is even worse is that this only looked at a 1% fee. Compounded over time, the loss of that measly 1% fee is extraordinary as outlined above. Remember, the average active mutual fund fee is well over 2%.
To make matters worse, if you happen to hold an actively managed mutual fund in a taxable brokerage account, you would need to beat the passive fund by 4.3% just to match the return of the passive fund. Why 4.3%? Professor Mark Kritzman of M.I.T. conducted a study reported in The New York Times.
So if your so-called "index beating" mutual fund was held in an taxable brokerage account.
If you held this actively managed fund in a tax-advantaged retirement account, you would still need to generate at least 2% higher returns just to break even with the passive index fund.
The average actively managed mutual fund consists of the following fees:
Why choosing actively managed mutual funds is a mistake
There are professional money managers who spend their whole entire life's work trying to time the market and, guess what... 92% of actively managed funds fail to match the returns of the market (i.e. S&P 500 index) over a 15 year period.
If your investment horizon is 15 years or greater- which includes you unless you plan on dying in the next 15 years- you stand practically no chance of picking the 8% of actively managed funds that will outperform the market. What's worse is that not only would the actively managed fund you chose have to beat the market, but it would need to beat it by at least 1.5 to 2.0%.
Why would it need to beat it by at least 1.5%? Fees and expenses. The average index fund has less than 0.1% in fees compared to the 2 plus percent fees of active funds.
See why you are better off choosing index funds instead.
I know many are thinking that 1 or 2% in fees doesn't sound like a lot, but trust me, it is. For example, saving even just 1% on fees could result in big differences compounded over time. Remember, the cost of a 1% fee could cost you $590,000 over 40 years, which is a very typical investment horizon.
WARNING: Your Financial Advisor Will Sound Very Convincing!
Remember, index funds- passively managed funds- do not generate revenue for your advisor's company. The index funds simply don't make money for your advisor because they do not have all of the above fees associated with them. Beware, your advisor might still charge an "advisor fee" or an "administration fee" which is why I am a firm believer in the DIY method of investing in index funds.
I promise that your current advisor will pitch you something like this:
Our advisement provides you expertly managed portfolios with industry leading research tools that often outperform index funds. We have an experienced staff dedicated to selecting blue chip funds that have demonstrated superior returns in recent market conditions.
This is literally what my advisor emailed me when I exited a high-cost fund through a previous employer's 401(k) program.
It's bullshit. Complete nonsense. Even if they do generate higher returns, it does not last. Never has. Likely never will.
I am certain you will be able to find funds that outperform the market over 1-, 3-, or even 5-year periods. But outperforming index funds over your entire investment lifetime? Outperform for 30 or more years, in a row? They don't exist. Not one ever has.
Perhaps some of you are in a position to require a financial advisor. Some might need to receive tax advice. There are even some of you who are not willing to take just a few minutes to open your own account or call your advisor and inquire about fees and how to lower them by switching to passively managed index funds in your portfolio.
To those of you which this applies, I encourage you to seek the professional help that you require. Do not do so blindly however. Ask. Pick up the phone and have a few conversations with money managers and financial advisors. Be up front with them and ask immediately if this conversation will cost anything. Ask for free consultations as most money managers will be happy to provide a free initial chat.
Ask about fees. Ask about expenses. Ask about commissions. Be inquisitive and remember it is their job to answer all of your questions, even if most of them are about how the advisor gets paid. It's your money and to them, it's a job, so ask them about the costs associated with their account.
Your failure to ask could result in hundreds of thousands of dollars of expenses over a lifetime.
It's not unreasonable to think that if you start investing in your twenty's, and you live to be 90, you may be invested in the market for 70 years! Now imaging what those 2% fees will do to you compounded over 70 years.
Be smart. Be curious. Don't be shy and don't be afraid to ask some questions. Even if you were able to save 1% in fees just by switching to passively managed funds, it could result in you retiring much earlier with a lot more money someday. It's worth it.
Until next time...
Comment below with your experiences with active vs. passive funds. Index funds vs. mutual funds. Run-ins with your advisors commissions. Please share with your community.
Financial Independence Retire Early (FIRE) Movement
Personal finance seems to be making a comeback. Books are written, podcasts recorded, and Youtube videos are increasing in abundance, all centered around the topic of financial independence. The theme continues by extending the conversation into a concept known as early retirement. Early retirement is predicated on demonstrating discipline and consistency with your finances, all in an effort to quit working as quickly as possible. Could it really be that simple? Has everybody been missing the bus on finances? Will this financial independence retire early (FIRE) movement last?
Why the "FIRE" movement can be misleading
I must admit, I am fairly skeptical when it comes to large groups with common agendas (this stuff sounds cult leadership to me). Don't get me wrong, I do believe the FIRE community has produced many positive outcomes, but my concern is that there is no platform to host the individuals who failed. We only ever hear about the success stories in this community.
Focusing on early retirement, as a sole motivator to get your financial house in order, is a rather dangerous game to play. When pursuing finances as a means to an end, one has a tendency to lose sight of the joys of life, or even stop pursuing them altogether. I am certainly not advocating for the collection of material possessions but rather restarting the search for meaning and happiness in life. There is a level of diversion that is difficult to quantify when we take a myopic view towards any one particular outcome - in this case, early retirement.
What concerns me the most about general guidelines and universal advice on finances is the notion that personal finance is inherently personal. It is unique to your own individual needs. Your path to financial freedom and financial independence does not have to be based on retiring early, although it certainly can be.
Most of us want to work. Some of us even enjoy some of our current work. Yet it is not enough to keep us from wanting something more. That something more is a definitive purpose which our day job presently interferes with.
The FIRE community tends to focus too heavily on residual income strategies, passive income development, and advanced blueprints for access to retirement funds through Roth conversion ladders. These strategies are aimed at using money as a means to an end and using money as a means to an end is a slippery slope worth investigating further.
The fact is, money is a necessary medium of exchange for goods and services, especially in the United States. We find truth and solace in adages like "no free lunches" as most things in life are not without monetary cost. The simple truth is that the less that you have in savings and the more you have in debt, the greater difficulty you will likely have navigating through life.
Accumulating wealth and eliminating debt will certainly open up opportunities and breathing room necessary to explore and pursue your passions. On the contrary, I am not convinced that you need as much as they say you need before pursuing your passions. Going well beyond debt elimination and attaining positive net worth of 3-5 times your annual expenses seems to provide diminishing returns and takes too long for most people to stay with. I believe that saving and investing anything beyond 5 times your annual expenses might be completely unnecessary and a source of undue stress for many of us. There is not a huge difference, in my mind, between 5x annual savings and 25x annual savings (a popular FIRE milestone) when considering your freedom to pursue alternative occupations. Most of us cannot even fully quantify what it is like to have 5 years worth of expenses saved, let alone 25 years worth. The trick is learning when enough is enough.
Consider the difference between having a financial buffer of 5 years of expenses compared to 25 years of expenses. Obviously, the answer is there is 20 years difference. However, getting to the 25 years mark still does not address the underlying problem (neither does 5 years). Your overall lack of a definitive purpose in life.
I have little confidence that an aggressive pursuit to save 25 times your annual expenses to achieve a FIRE milestone will actually contribute in any way, shape, or form to your ability to discover meaning and purpose. Certainly you will become an excellent savor and a savvy investor along the way. But will you become a better person? Will you generate value for others along the way?
Of course you could just wait to save the requisite amount and then begin your pursuit but you need to ask yourself one serious question: Are you willing to wait that long?
The infamous post by Mr. Money Mustache suggests that finding out how many years before your can enter early retirement is much easier than you think. This is an excellent post and has been life changing for many folks. If you have not read his post, go do it now and then come right back here. If you are already familiar with it, keep reading.
I do not want to ruin the moment for anyone but after assessing the numbers highlighted in table and graphical format on his pillar post, I could not help but wonder if everybody is willing and able to wait that long. For example, consider that it still takes 17 years to achieve early retirement by saving 50% of your take-home pay. That's a long time. If you can bump your savings rate up to 65%, you can do achieve FIRE at just over 10 years.
The math above assumes a starting point of zero net worth. Many are already ahead of that and many are well below zero, in the negative net worth category. If you are close to early retirement, already have a significant positive net worth with no debt, by all means finish your pursuit of FIRE. For those of you who are much further away (most of you are), I urge you to consider much more attainable and realistic milestones for your medium to long-term goals.
Debt elimination is huge. If you are not there yet, this is one of the best places to start.
If you have finally broke even and said goodbye to toxic debt like car loans and student loans, it is time to start building a positive net worth. I don't know about you but starting at zero and saving 50% of my take-home pay for 17 consecutive years (204 months) seems like a very long way off and would be nearly impossible to stay motivated for.
Contemplate some important questions when considering if 25x annual expenses is really worthwhile:
My concern with the FIRE movement is that it causes a lot of individuals unnecessary levels of suffering along the journey. Sure, we hear about all the folks whose lives were "changed" the moment they reached the coveted quarter century savings mark. How many are we not hearing about that this advice caused obsessive or pathological levels of focus around money and savings? The truth is, I was one of them.
My personal truth about early retirement
When I first began learning about personal finance and discovering the concept of early retirement, I was all in. Along the way I listened to the ChooseFI podcast, read many personal finance books, and listened to the latest advice from "influencers" about how to attain financial freedom. It was great, while it lasted.
Then I started accumulating a positive net worth. Six figures. A quarter of a million. $400k. My wife and I kept hitting these milestones but, admittedly, felt diminishing returns and satisfaction along the way. We had to stop and take a moment to consider whether we needed to keep pursuing the 25 times annual expenses mark, or whether we actually already had enough.
Forgive me but I am just not convinced that we truly need much more than a few years worth of expenses saved up before we can take a giant leap of progress towards pursuing our passions in life.
Early retirement does not seem to encourage the pursuit of purpose in life, until after you reach early retirement. What if that is not soon enough for most people? What if we are only really hearing about the success stories, and there are many more failures that go unknown? We all need purpose. Dr. Viktor Frankl famously discussed the importance of purpose in his personal memoir about surviving the holocaust, Man's Search for Meaning.
The FIRE movement is centered on the concept of achieving your number, the target net worth and savings so that you can have "F-you" money and walk away from your present job. I agree, having F-you money is very valuable in life. But the real value is in attaining that number so that you can do the things you really want to do in life. Does it really need to be a full 25 times your annual expenses? For some it might. For many others, we can get to work on pursuing our passions on much less.
Trust me, as badly as you think you want to, you may not really be seeking to retire. You may be convinced this is the solution to your problems but I would suggest that your lack of definitive purpose is the real tragedy at work here.
Remember, retirement means doing nothing for work. Consider the Oxford definition of retirement quoted below:
Retirement - "the action or fact of leaving one's job and ceasing to work"
Now that we know the true definition of retirement, is that really what you are looking for? I enjoy working when the tasks I do are meaningful, purposeful, and impactful to others or myself. I like the notion that somebody else is willing to pay me for my time. Are you really hoping for that to end completely? Or do you just want to be paid for your time to do something else? Perhaps something you enjoy much more that provides much greater purpose and service to your community.
Using money as a means to an end is the enemy of happiness. Really, using anything as a means to an end is the enemy of happiness. Do the things you do in life because you want to, not because you expect something in return. This concept is hashed out in best-selling author Mark Manson's work Everything is F*cked: A Book About Hope. If you are the type of person who would not do the current job you are doing if it did not pay, then I encourage you to get your financial house in order so that you can pursue something else.
What society certainly does not need is a bunch of retired 30 and 40 year-olds not contributing positively to society and the workforce. Society does need more people pursuing purposeful work.
Reaching financial independence, for me, is about permitting myself to do the type of work and choosing my own suffering in exchange for long-term benefit. In his book, Manson introduces the concept of choosing your own suffering as a form of "self-limitation". The example he provides to the reader is that the ability to choose your pain in life is the real magic. Take physical exercise for example. You choose to suffer through the short-term pain of exercise in exchange for the long-term benefits of greater strength, endurance, mobility and improved health. That is the power of choosing your own suffering in life.
So What Are We Doing Instead of FIRE'ing Ourselves?
We are setting ourselves up to choose our own suffering. Picking our pain in life, not trying to avoid it. Life will be filled with pain and suffering regardless of whether we try to avoid it, therefore quit trying to avoid it. Rather, set yourself up so that you can choose your pain points in life such as physical exercise, financial planning, sauna bathing, cold showers, proper nutrition, meditation, and whatever other hormetic stressors you can devise that will benefit you in the long-term.
When you are paycheck to paycheck, saddled with debt, you are not in a position to choose your suffering. You need your current job with the long hours, arbitrary rules, and tedious demands that come along with it. You rarely can afford to step away and fully pursue your passion. You're stuck. Many of us are there. Many of us have been there for decades. Even I was there. It wasn't pretty.
"25x annual expenses"
"4% withdrawal rates"
"Passive income strategies"
The above are all common terminology of FIRE community. You may certainly use some, or all of them as you so choose, but make sure you are using them for the right reasons. Make sure you have assessed whether you really need a full 25x annual expenses, or whether you can take a leap of faith much sooner in life. An emerging, and increasingly popular, pivot on FIRE is instead referring to attaining a "work optional" status. When you hit work optional, you have many months, and hopefully years, worth of savings and investing accumulated so your reliance on your present job is minimal.
I encourage you to separate the "FI" from "FIRE". Focus solely on financial independence (FI) aspect and move towards a position of financial strength to allow yourself to pursue your passions in life sooner rather than later. Financial Independence permits many opportunities for you to no longer be beholden to your present job, especially if you dislike it greatly and do not find purpose in your work.
The biggest problem in the FIRE community is the underlying concept that we should eventually be able to attain a life with freedom to recline in a hammock everyday if we so choose. The major flaw of this underlying ideology is that there will always be a part of your life that will suck. Always. Therefore trying to avoid it altogether is a fruitless endeavor.
Assuming that we can eliminate hardship and suffering in life is completely impractical and ironically tends to lead to greater suffering and unhappiness.
The real power is when you are in control of choosing your suffering. As mentioned above, physical exercise is a great example of choosing your suffering. The short-term costs are certainly worth the long-term benefits. Me sitting down and writing this post when I would rather do just about anything else, is another example of choosing your suffering. I am choosing to do this, rather than something else, with the concept that there will be some future return.
I encourage you to move forward and pursue your passions as quickly as possible. Plan, save, and invest along the way and assure your financial house is in order before doing so. Eliminate your debt and attain a positive net worth and then quickly move onto more meaningful aspects of life, such as defining your purpose.
As always, leave your comment below on how you felt about today's article. Love it or hate it, life is not about retiring. Going through your entire life with one goal, to retire, seems like just about the worst form of hell on earth. I challenge you to look further and realize that your problem is not that you are not retired, your problem is that you just haven't yet found out why you are important to the world, however big or small that importance may be.
How small purchases could add up to big savings
I read and hear about too many cost-saving methods that are impractical and simply do not produce quite the return they promise.
First, figure out why you want to save money.
Are you saving for a house? Saving for college education? Saving for an investment? Saving for anticipated expenses such as repairs or maintenance?
Second, please realize that saving money does not have to be difficult. It also does not need to lead to massive deprivation where you use candles instead of lights (plus candles are a fire hazard).
To prove my point, here are 3 stupid items that I save real money on every single year. Results may vary.
3 Simple Ways to Save Money Every Year
1. Eat Almonds
Almonds, my number one snack food item.
I buy a ton of them. Not literally a ton, but damn close. I buy a 40 oz. bag of whole raw almonds online for less than $13.
A typical 16 oz. bag of almonds at the store is $8. The bag I buy online is 2.5x larger but costs less than twice as much. 40 ounces of almonds would cost me over $20 at the store therefore I save about $7 per 40 ounces. I go through a full 40 ounce bag every week which means I save $7 every single week. This adds up to over $350 of savings every single year.
2. Single-Ply Toilet Paper
Actually there are two paper products to be aware of here: single-ply toilet paper and half-sheet paper towels are two game changers.
I can buy a 1000 sheet single ply toilet paper that lasts for 6 months for less than $7 at the store. Supposedly the average American uses $10 worth of toilet paper per month. By switching to single-ply TP I have been able to spend only $14 per year, per person in our household. This comes out to a little over $1 per month of TP usage. This equates to a savings of over $100 per year compared to the average American 2-ply user!
Half-sheet paper towels allows me to be significantly more mindful of how much paper towel I was using. Full sheets are bullshit. Rarely do you ever need a full sheet. I cut my paper towel usage in half my first year using half-sheets. How much could this switch realistically save? I use two less rolls per week at which saves me over $150 per year.
3. Filtered instead of bottled water
Using a water filter could potentially save you big money every year. If the typical household purchases a case of water every week, and bottled water is approximately $5 per case of 24 (depending on where you live), you could save $250 in bottled water every year. If you buy two cases per week, you might be able to save over $500 per year.
Some of these companies even claim you can save up to $1000/yr, but that's a pipe-dream in my opinion.
There are two popular options depending on how often you want to change the filter and how easy you want your experience to be:
Saving Money is Easier Than You Think
Here is proof that even these 3 ridiculous ideas can save you serious money every year without effecting your quality of life via deprivation.
These don't involve turning the thermostat to 45 in the winter or 90 in the summer. They don't involve biking 30 miles to work. They sure as hell don't include eating noodles everyday (just almonds).
What are 3 things that save you real money every year that might surprise fellow readers? Comment below with your answer.
Understanding what a mortgage actually is
A mortgage is a loan used for the purchase or refinancing of a home. Practically speaking, it is the amount of money given to you by a lender for the financing of a home.
The mortgage loan has many parameters including, but not limited to:
Mortgages are typically used when you do not have all of the money upfront for the sale of a home. If you do happen to have the entire upfront cost, you might still choose to mortgage the property if you do not want to give up such a large sum of money, all at once.
Is a mortgage the same as any other type of loan?
Yes and no.
A mortgage is specifically a loan given as financing for a home purchase, or refinancing. As collateral for such a large amount, the home is typically put up against the value of the home just in case you stop making payments to them. If payments should stop, the home could then be used as collateral for "repayment" of the loan. I use the term "repayment" very loosely because you lose more than just a home in this process. In the process of losing a home due to missed mortgage payments (essentially a foreclosure), your credit score will be ruined.
Keep in mind that this black mark (i.e. foreclosure) stays on your record for 10 years. Avoid this at all costs if you ever hope to receive any other loans or favorable terms on lines of credit.
Lenders typically get into business to lend money, not to own homes. They want your money, not the house. I have heard of many people getting away with up to a year's worth of missed payments prior to the lender foreclosing on the property. This is proof of concept that lenders really don't want to be homeowners.
What is a mortgage "pre-approval" or "pre-qualification"
The initial process of obtaining a mortgage is to receive a pre-approval or a pre-qualification. Be advised, these are not the same thing. These two terms are often used interchangeably, but they differ in some important ways.
A pre-qualification is solely based on information that you provide to the lender. This is simply a way to help you "ballpark" the amount of money you can hope to spend on a home. This is by no means a commitment nor is it a hard number to use when making home buying decisions.
A pre-approval is a much deeper dive into your history including, but not limited to:
The pre-approval is a much firmer commitment to lend you a given amount of money. Essentially, a pre-approval is a mortgage loan application without a specific property affixed to the loan application.
How does the rest of the mortgage process work?
After obtaining a pre-approval letter (highlighted above), the potential buyer includes this in an offer on a particular home. If the offer is accepted, the potential buyer typically has a period of less than 10 days to officially apply for a loan with a lender. This is the time where most people "shop" around for the best quotes before submitting a formalized application. Beware however, you really do not have a ton of time to do your shopping so move forward wisely.
Around the same time as you are gathering documents for your mortgage application, you will be arranging to have the property inspected (if you choose) and place "earnest money" in an account based on the terms of your contract.
As for the application process itself, the lender will now perform any final verification of employment, income, and assets. The lender will also attain details on the specific property for which you intend to purchase following the seller's acceptance of your offer. The lender will look to have the following done prior to fully approving your loan:
If everything checks out and terms are acceptable (interest rates, loan duration, loan type, etc.), you will move towards closing on your mortgage.
Closing on your mortgage involves meeting with the lender and your real estate agent (and any other necessary parties depending on your state's rules/regulations). This is where you will sign your mortgage papers. This is also typically when your down payment and closing costs are due, in full.
As always, this is not to be interpreted as financial advice. Check your local rules and regulations as some of the information will ultimately differ according to where you live or desire to live.
Above is a summary of the basic "moving parts" surrounding mortgages. It is important to understand the nuts and bolts of a mortgage since it will likely be the largest financial transaction of your life.
The creation of mortgages permits many to attain home-ownership where it would otherwise be impossible due to limited income and finances.
There are many more things to know about mortgages. Learn everything you can. Knowledge is power.
Best of luck.
How credit cards got such a bad name
The financial independence community often demonizes the use of credit cards. The words of advice that are commonplace in the personal finance realm suggests you pay for everything in cash. Guys like Dave Ramsey even go so far as to encourage that you cut up your credit card.
But wait, this cannot be the only way. We should not have to carry pockets full of cash around just to fit in with the financial freedom crowd. Why do I have such a problem with this "cutting up the card" advice? I will tell you why. Cutting up your credit card to avoid spending does not correct the actual behavior of overspending.
I agree, it adds friction to the process which many psychologists believe will interfere with the participation in an undesired behavior. In this illusion of self-control, you would add friction to your undesired habit as a means to decreasing the likelihood you will participate in said habit. A smoker would lock their cigarettes in a cabinet and hide the key down the block as a method for increasing friction between them and their undesired behavior. Cutting up the card is like hiding the cigarettes. It fails to address the poor habit head on.
Where credit cards shine
First up is credit card rewards. The fellas over at ChooseFI have a great section on their site about travel rewards and credit card rewards. Cash back, bonus points, airline miles, travel rewards and hotel credits are some of the many perks that certain cardholders can participate in with disciplined use. Without a credit card you cannot participate in these rewards. Remember however, these credit card rewards are not actually for your benefit (at least they are not supposed to be). These rewards exist to encourage spending behavior. Period. You are lying to yourself if you say that rewards will not encourage you to spend more. It will, unless you are hardcore about recognizing your spending habits and budgeting. This is why you have to "game-out" rewards and turn the tides in your favor so that you can benefit from something that was originally intended to cause you harm (in the form of overspending).
Next up, cards can help build your credit score. To do this, you need to pay particular attention to some important factors in order to build your score:
Why is building a credit score important?
The benefits of a high credit score (720+) include:
The final credit card benefit worth mentioning is the added safeguards of carrying a credit card vs. carrying cash all the time. If you think this doesn't apply to you, think again. Lost your wallet? Just immediately call and freeze your credit card. If there was cash in your wallet, likely forget you ever had it.
Pulling out your wallet or money clip and revealing some serious paper is asking for trouble. Remember, criminals are looking for targets. If they see you at the checkout shuffling through your $100 bills to pay for a light bulb you might have an expected encounter on your way out to your car in the parking lot.
Good credit habits to abide by
Yes, you can be both frugal and have a credit card. Just manage it responsibly and it can be an asset instead of a hindrance. Spend wisely and continue to find ways to improve your saving habits and spending behavior.
Let me know your thoughts in the comments below.
I started this blog because friends and family often asked me similar questions regarding personal finance. I was surprised just how much people were interested in improving their financial situation, yet had no idea where to start. It made perfect sense to start a blog and share all the information that I have learned along the way with others. You will find many resources and links referred throughout the blog. I have found all of this information useful and continue to grow my knowledge and understanding in the personal finance space. Admittedly, even I struggled heavily in the beginning with understanding how to improve my financial situation. The power of reading and note taking got me where I am today and will continue to provide a return on investment for years to come. I look forward to sharing with you along the way.