Spending and debt can control your financial situation, unless you control them. To build wealth, you have to limit spending and borrowing. Few people inherit large sums of money. Most of the wealth in America comes from saving and investing. Money is easy to spend, but hard to come by. Don’t part ways with it easily.
Debt is detrimental to your wealth. It is a reverse investment and reduces your ability to save. Investments give you interest, dividends and capital gains. Debt charges you interest, which is the reverse of receiving gains. Pay off your debt and borrow only for the really big items, like a house or cars. Eliminating debt leverages your ability to build wealth.
Should you save first or pay down your debt? First, make sure you have an emergency cash fund with enough for 3 to 6 months of living expenses. Next, if you have a 401(k) or similar account that includes a matching contribution from your employer, fund the account enough to get the entire matching contribution. If you don’t have an employer match, contribute 5% of your income to the 401(k) account so that you’ve at least begun the process of building wealth. Then pay down your high interest rate debt, which will usually be credit card debt. After that, do what gives you the biggest bang for the buck.
Budget. Yucko. You were expecting budgets to come up sooner or later. Okay, make a face. You can even say a bad word. But have a budget. It can be rigid or flexible, depending on your needs and ability to save. People who have trouble controlling their spending should have a strict budget, where specific amounts or percentages of your income are used for specified expenses. People who have financial self-restraint can use a flexible budget, where you don’t limit how much you spend on particular items, but you limit total monthly spending.
If you have an uneven income, use it to your advantage. Try to live at the level that lean years support. Set aside the extra money from good years to boost your retirement savings.
1. Who’s in control of your money?
In order to build wealth, you have to get control over your finances and ensure that part of your earnings are put into savings. You should ask yourself whether you control your financial situation or whether it controls you. Do you lurch from paycheck to paycheck, barely making the minimum payments on your credit cards and juggling the monthly payments on your car, house and student loans? If your financial situation controls you, turn the tables and take over. Spend less and start reducing your debt. Funnel some of your income into savings. Maybe you’ll have fewer meals in fancy restaurants, but you’ll also have more nights of good sleep.
2. Debt is Detrimental to Your Wealth
Debt is hinders the building of wealth. Pay it off as soon as possible. Why is debt so detrimental? Because it is a reverse investment. Investments pay interest, dividends and other gains. Debt bears interest, which is an expense that erodes your ability to save. Interest payments go to the bank, not to you.
Remember from our Introduction that saving and investing steadily, and reinvesting your gains, compounds (or increases) the growth of your assets to impressive amounts. Debt reduces the amount that you can save, and therefore reduces the compounded growth you receive from your investments. The more debt you take on, and the longer you take to repay it, the more debt erodes your ability to build wealth. Your debts won’t fund your retirement, so get rid of them.
Sometimes debt is necessary. Many, and perhaps most, people have to borrow to pay for college, a house or a car. In those situations, borrow, and pay off the debt as soon as you can. An education and a house will eventually return value to you, in terms of higher income or appreciation in value. But debt used to enhance your lifestyle gets you little or nothing of lasting value, while reducing the amount of your finite lifetime income available for retirement. If you’re living above your means, you’re probably financing it with debt. You have to get control over your finances. Live within your means. Stop borrowing. If you have to cut back on lifestyle, cut back. As we discussed in our Introduction, if you don’t economize now, you’ll have to economize later, when you have only Social Security. Reductions in your spending today can be recouped in champagne and caviar during your golden years.
It’s important to pay down the principal of the debt (i.e., the amount you originally borrowed). Don't just pay the interest charges. If you’ve built up a lot of debt, this may take a while. But the principal amount of the debt generates interest charges every month and you can’t eliminate the debt until you pay down the principal. Don’t just look to consolidate debts in order to reduce the monthly payments. That may help, but only if you use the income you’ve freed up to pay off your debt faster. The most important thing is to pay off the principal amount of the debt. Structure your budget so that some of it is designated for reduction of the debt's principal. (In other words, pay more than just the interest charges). Debt is like the Hydra from Greek mythology—the creature with many heads. If you cut off one of the Hydra’s heads, another would grow in its place. Interest charges are like the heads on the hydra. If you only pay the interest each month, the principal of the debt will grow more interest charges the next month. The only way to kill the debt monster is to pay down the entire principal of the debt.
One thing that’s worth noting is that the more you pay down the principal of the debt, the lower the subsequent monthly interest charges will be and the faster the principal of the debt can be paid down. In other words, paying down debt principal has a positive leveraging effect on your ability to reduce the debt even more.
Once your debts are paid off, don’t borrow any more. Cut up all credit cards, except perhaps for one—unfortunately, everyone needs one card to avoid carrying large amounts of cash. Credit cards offer better consumer protection than debit card. Given the rampant identity fraud these days, using a credit card is safer than using a debit card. Just don't run up the balance of the credit card beyond what you can fully pay off each month. The only times you should borrow long term are to buy big ticket items like houses and cars--and if you can pay cash for the cars, all the better.
3. Should You Save First or Pay Down Debts First?
First, you should have an emergency cash fund. It’s important to have an emergency cash buffer against the ups and downs of life. Illness, job loss, maternity or paternity leave, and other interruptions in employment can seriously disrupt your financial plans if you don’t have some cash set aside. Keep about 3 to 6 months of living expenses in a money market fund or a bank account that is separate from your regular checking account (to make it hard to tap into these funds for ordinary expenses).
Next, if you have a 401(k) account (or an equivalent account, like the Thrift Savings Plan federal employees and the military, or a 457 or 403(b) account), invest at least enough to get the full amount of any employer match. The employer match effectively gives you a 100% return instantaneously on the amount of your contribution that is matched. This is the kind of profit you shouldn’t pass up. Further, retirement savings with employer matches, appropriately invested, have a way of compounding marvelously over the long term. If there is no employer match in your retirement account, put at least 5% of your salary into the retirement account to get into the habit of saving (the tax deferral on this account will give you a nice financial boost even without an employer match). For more detail, look at our discussion of retirement accounts.
Then, do what gives you the biggest bang for the buck. If saving gives you the largest return for your money, save. If your debt has high interest rates, levels that significantly exceed what you can earn from investments, pay down the debt. Compare the interest rate on the debt against the potential gains on investments you could make. If the interest rate on the debt exceeds the potential gains from the investments, concentrate on getting rid of the high interest rate debt. Most credit card debt will have much higher rates than you can expect from investments. So paying off your credit card balances is likely to be the next step.
Consolidating high interest rate debt into lower interest rate debt is worthwhile, but only if you use it as a way to reduce your debt faster. Debt consolidation will probably free up some of your cash flow. Use the additional cash flow to pay down the principal of the debt. If you use the freed up cash for lifestyle enhancement, you’ve simply gone from the frying pan into the fire. The debt will continue to hang over your head and accrue interest that will erode your ability to save for retirement. Debt consolidation leads to greater wealth only if you use it as an opportunity to pay off the debt faster. Don’t miss the opportunity.
If you’re wondering whether or not to pay off a mortgage first or save, the analysis can be more complicated. If you have a fixed rate mortgage, you can compare the interest rate on the mortgage against the anticipated returns from your investments, and choose the alternative that provides the bigger bang for the buck. If you deduct mortgage interest on your tax return, you would use the net interest rate remaining after deducting for this comparison (but remember the potential for deduction phase-out if your income is high enough). But many homeowners don’t deduct, and they should compare the full mortgage interest rate against the anticipated investment returns on their savings.
If you have an adjustable rate mortgage, this comparison is much more difficult (unless you have the ability to foresee the direction of interest rates, which very few people—even Wall Street pros and Ph.D’s in Economics--have). You should save in a retirement account up to the point of getting the full employer match, or at least 5% if there is no match, while doing everything you can to get rid of the adjustable rate mortgage. As we discuss in our section on real estate, adjustable rate mortgages have a siren call that can lure you to financial doom if interest rates rise. While most people need to borrow to buy a house, that doesn’t mean that any kind of loan is a good idea. Some kinds of loans stink. Playing with adjustable rate mortgages is like playing with financial fire. Only people with substantial financial assets (i.e., not counting home equity) in the range of six or seven figures should touch these puppies.
Okay, we just said the b-word and now a lot of you probably are tempted to switch over to a sports website and see who’s winning. But remember that the world rewards those who do what it takes to succeed. Successfully financing your retirement will depend, for most people, on sticking to a budget.
Many think of a budget as a rigid set of controls that forces you to live on rice and beans, and drink weird tasting generic brand soda. They think they’ll have no fun except a cheap DVD rental every other Saturday night. They envision a lifetime of secondhand clothing and used cars.
A budget doesn’t have to mean these things. A budget, in essence, is a mechanism for helping you to live within your means. Ultimately, we all have to live within our means because we will get only a finite amount of lifetime income, and a budget is a simply a way of limiting spending so we can build wealth. As we discuss in our section on smart spending, you can still live well by buying quality and maintaining value.
Some people—those that need clearly defined limits on their spending—should have a strict budget. If you can control your spending only by having $400 a month for groceries, $120 a month for gasoline, $300 a month for clothing, etc., then calculate the limits for each item and stick to them.
People who can control their spending without a fixed budget may do fine with a flexible budget. That’s one where you don’t have predetermined amounts for each expense item, but you keep your total spending below your monthly income. To make a flexible budget work, keep a running total of your spending in your head or on your computer. You can’t cheat—if your expenses are high one month, keep them low the next month so you can stash away a little more savings than usual. If you cheat, you’re only cheating yourself. Flexible budgeting reflects the fact that most people have uneven expenses from month to month. During the holidays at the end of the year, you are likely to spend more than some other times of the year. In a summer month when you’re on vacation, your expenses will also rise. A flexible budget lets you spend more at these times, but you should make up for it by spending less at other times. Another advantage of a flexible budget is that you can take advantage of sales and discounts. If there’s a sale on suits one month, you can buy three at a great price. But don’t buy any more suits for a year. And never buy something simply because it’s on sale. Only purchase things you’d buy anyway, and then pocket the savings.
One way of looking at flexible budgets is that you have savings goals, rather than rigid limits on spending. You look for ways to control your spending so you can save more. You are unhappy any month in which you are unable to save anything. If your savings levels drop one month, you cut back on spending the next month to make up for what you didn’t save before. If you have to dip into savings to cover a large expense, like a long vacation, you build up your savings in the preceding months so you don’t have to borrow.
Flexible budgets are suitable for people who like having money. These are the people who feel happier with a large bank balance than with a large flat screen TV. They are slow to part ways with their hard-earned cash, and regard every cash windfall as a joy in itself. Strict budgets are for people who have trouble keeping two nickels between their fingers. If you can’t control yourself, use a strict budget. Do whatever works. The important thing is to find the budget that works for you. Once you have your finances under control, you can begin a steady march toward prosperity.
Sample Budget
There are as many ways to establish a budget as there are people. Each of us has spending idiosyncrasies, and there’s nothing wrong with a special monthly allowance for chocolate as long as it doesn’t prevent you from building wealth for retirement or covering your basic expenses. The correct budget is one that helps you go somewhere financially. Budgets should be simple enough to carry around in your head—anything that requires hours of work every month in front of a computer probably won’t be practical. With that in mind, we offer the following sample budget. It’s for a hypothetical couple in their 30’s with one child. One parent works, making $60,000 a year, and the other stays at home with the child. We’ll assume they have employer subsidized health insurance, buy inexpensive cars, have no credit card debt carried over from month to month, and live in a relatively low cost area. This model budget can be adapted for other household situations--just try to keep things simple.
Sample Budget Monthly Income 401(k) Contribution Income, Soc.Sec., Medicare Taxes Health, Disability & Life Ins. Auto transfer to money market fund Net Income Rent or Mortgage, Taxes, Insurance Utilities & Home Maintenance Car payments, gas, insurance, maint. Groceries/restaurants Clothing Entertainment School loans Miscellaneous Balance at end of month
It’s important to note two things. First, this couple saves both by automatically contributing 10% of their pre-tax income to a 401(k) account, and then by saving $100 of after-tax income as well. Altogether, they put aside about 12% of their monthly income—a good amount for building a comfortable retirement. The savings are included in their budget and are taken out of their income before they start to spend. This is an ideal way to save. You won’t miss the money if it never reaches your hands; you’ll learn to live without it. Second, this couple lives comfortably but stays within their means. They chose to build for the future, and are likely to have one.
5. What If You Have an Uneven Income?
Many people have uneven incomes. Business proprietors, self-employed professionals, sales people, and seasonal workers are examples. Entertainers and other show biz people often work on a piecemeal basis—when there’s a show running or a film to be made, they are employed; otherwise they are bartenders or servers in restaurants, if they’re lucky. Employees in factories and other manufacturing jobs may be laid off from time to time as business booms or busts, or sometimes because they go on strike. While blue collar workers get steady hourly wages when they’re working, the reality of life for many of them is that their incomes can fluctuate. All persons with uneven incomes face a challenge managing their finances.
First, maintain a cash reserve to cover periods of low or no income. The amount should be enough to cover your expenses for a long time—six months or more. Use your experience to gauge how much is needed, and keep your spending down during dry spells. Collect unemployment, union benefits and any other assistance you can get.
Second, when things are going well, save a healthy percentage of your income, like 15%, 20%, 25%, or more. Max out retirement accounts like your IRA, SEP, 401(k), etc. Then put more into after-tax accounts. Since the one thing you can count on is uncertainty, pay yourself well when times are flush.
A large number of America’s millionaires are self-employed--people who often have uneven incomes. Nevertheless, they’ve attained wealth by treating financial security as a priority. Remember that back in the days when your great grandparents tilled the soil, or roamed the frontier with Daniel Boone, just about everyone had an uneven income. But some people still became wealthy. An uneven income isn’t a barrier to accumulating wealth.
Now let’s discuss the problem of serial consumption.