I have to warn you first: this article talks about really simple things that can be applied during both good and bad times, for achieving financial sanity isn’t complicated. But before you disdainfully call this advice cookie-cutter, you’d better make sure your own house is pretty damn clean and that you already follow all the steps!
Eradicate bad debt
Before you even start anything else, you must pay off any bad debt you have. By bad debt I mean any liability with sky-high interest rate and/or that does not build any equity. Credit card debt by definition is the most lethal kind. With its double-digit interest rates and zero-equity building, you have everything to lose.
If you don’t have any “plastic debt”, then hats off to you. By all means keep doing what you’ve been doing so far. Stay on top of your bills and keep paying all bills (credit card, utilities…) in full, and on time.
Remember that high interest rates are common in the credit card world, which means accumulated debt grows extremely fast month after month. In this situation, paying the bill’s monthly minimum is insufficient because it usually doesn’t offset the debt’s growth rate – and your tab starts snowballing out of control. Of course, the more you wait, the more expensive it gets – exponentially, that is.
The only way to avoid this vicious circle – and to actually see your debt decrease as you pay – is to make sure your monthly payments cover not only the monthly interests, but also some of the debt’s principal.
When dealing with accumulated bad debt, you have little choice but grab the bull by the horns and set up a drastic reimbursement plan so you can erase it within a few months. Pay as much as you can each month – which means way more than the required minimums. Use any extra money you’d have left towards slashing part of your debt’s principal, so you converge towards zero. If this means not saving any money for a few months, so be it.
Of course this might not always be possible depending on your income situation or the amount of debt you owe. If the hole keeps getting deeper, your last recourse might be teaming up with a qualified debt consolidation service. These professionals specialize in negotiating lower interest rates with creditors, wrapping up fragmented debt into a single loan and setting up payment plans tailored to their clients’ capabilities.
Stack up some chips…
By this I mean you need accessible cash in the bank – and lots of it. Not socked away under your mattress or hidden in the freezer; but preferably at the bank in a FDIC-insured yielded account. So stack up those chips day after day and have the discipline not to use them under any petty circumstance. Just let them grow and save them for a potential rainy day.
Don’t laugh – most working middle class families have way too little cash savings, and unfortunately crash and burn when life (or their career) takes an unexpected turn. Sometimes having cash at hand is the only way to face trouble and make up for it.
How much cash is enough will you ask? A good rule of thumb is to save at least 6 months worth of your net salary so you could still get by without income by living off your savings. Calculate how much life costs you each month by adding vital expenditures such as lodging, food, transportation and utility bills (phone, internet, gas and electricity).
According to the Census Bureau, American households earned a gross average of $50,000 in 2008. This means living with roughly $36,000 after tax, or $3,000 per month. Most people should therefore aim at having $15,000 to $18,000 in their emergency savings fund. Of course you might need less – or more depending on your standard of living.
Don’t take this lightly. If you currently have a job with a steady income, but have no readily available funds, then I have to pull the big “red flag” string on you. Your lack of chips is a serious emergency; you need to adjust your lifestyle so you can start saving TODAY.
… And stash them in a safe place
Be strategic: make a large portion of your cash work for you in FDIC-insured yielded accounts, instead of letting it sit on a simple checking account where you’d make a paltry 0.000001% (if you’re lucky). Ignoring that is equivalent to throwing some of your money down in the toilet, and flushing it.
Shop around and find the savings accounts or CDs (Certificates of Deposits) that offer the highest reward. Almost all mainstream banks allow you to open one with no fees and without a matching checking account (like ING Direct, Emigrant Direct or HSBC to name a few). Look at what smaller local banks and credit unions have to offer too. They may offer similar products to grow your money at higher rates, but might require opening an accompanying debit account. The idea is to find a safe, flexible product that will beat inflation over a year.
Banks are constantly changing interest rates and terms on savings and CDs. So stay sharp and look into their limited time offers every now and then, because you might find a much better deal than what you currently have. I remember that for a few weeks in fall of 2008, Bank of America offered a 4% CD – an incredibly attractive interest rate compared to what you could find shortly thereafter, let alone now in 2009. I’m kicking myself for not making a quicker move at that time. When they pulled their limited offer, I had to settle for their next best product that barely made me 2%. Ever heard of “Cost of Opportunity”?
I know it doesn’t sound like such an attractive option nowadays. CDs and savings rewards are ridiculously low right now because of the Federal Bank’s inane obsession with slashing interest rates (this is like saying: “money is cheap!”). But it won’t always be like that. So be ready to visit your banker when more attractive rates (4, 5 or even 6% like in 2006) make a glorious comeback.
Remember: unlike a savings account where the funds are readily available, a CD is a contract between the bank and you so your money is locked for a certain time (unless specified otherwise). Therefore make sure you won’t need to withdraw any of it before the CD’s maturation date to avoid any penalty.
Beef up your retirement fund (or open one at the very least!)
Unless you plan to work until the day you die, you’re going to need some money to retire on and live off in your old days. I know the excuses are plentiful not to start a retirement fund, especially when you are young: “This is so far ahead…”; “I need that money now!”; “Social Security will take care of us… right?”; “I’m going to retire in Africa where I can live on a dollar a day”.
Sure, it’s difficult to know how much money is actually enough to retire on, whether you will outlive your retirement money or not, or how much life will cost in 2045. The truth is no one has a clue, but everyone knows that being old and broke sucks big time. Your only option is to accumulate enough wealth so one day you can sit back and live off residual income. What’s more, at the rate our national foreign debt is ballooning, I wouldn’t count too much on any Social Security checks; you might have to solely rely on your own retirement accounts. If so you’ll need a hefty amount; to give you an idea, a frozen $1 million principal “only” yields $30,000 a year (before taxes) at a conservative 3% rate.
Financial products like 401(k)’s and IRAs are necessary evils to cushion your golden years because they make your money somewhat inaccessible before you do retire. Therefore you’ll resist the temptation to spend it – unless of course you enjoy paying high withdrawal penalties.
There’s a lot to love about 401(k) plans. But since they are employer-directed, they do not offer as much flexibility as self-directed IRAs do. That means you may have to roll it over into a plan that does not depend on your former employer when you decide to change jobs. You best bet? Having both. Get an IRA no matter what your situation is, and to try to max it out ($5,000) every year. Then decide to enroll into your employer’s 401(k) plan (but be aware of a few caveats).
Don’t procrastinate anymore, because the longer you wait, the harder it becomes to catch up. Even though regulations allow you to contribute more when you are older, it is mathematically almost impossible to make up for the lost years, especially if you skipped contribute during most of your twenties. Why? Because compounded interest only works its magic over long periods of time.
To get the point across, imaging stashing $12,000 in an IRA at age 22. Let it grow by itself at a 5% average, and you’ll have over $100,000 before taxes at 65. To pull off the same results starting at age 45, you need a principal close to $40,000. Not to mention it is easier to ride through the ups and downs of the economy over a period of 40 years than it is over 20.
Buy more guns and less butter
Badass actor Ving Rhames said it best in a famous monologue about return on investment (ROI) in the 2000 movie Baby Boy. There are only 2 categories of goods an individual can acquire in this world:
- The “consumable” kind that, once purchased, starts irremediably depreciating. Also known as butter. They can never be worth their initial purchase value anymore, and therefore only offer negative ROI. These are for instance food, clothes, cars, mass-produced furniture and jewelry, electronic appliances.
- The “investment” kind whose value fluctuates once purchased, depending on offer and demand, economic volatility, market trends – and even people’s tastes. Also known as guns. They can potentially deliver a positive ROI if sold to the right person at the right moment. These are for example real estate, stocks, bonds, mutual funds, collectibles, memorabilia and artwork.
In a nutshell while butter melts, guns are here to stay. Don’t laugh; some people lack the most basic financial education and sail through life without really knowing the difference – or worse, even confuse one with the other! Of course, butter is necessary to satisfy everyone’s basic needs in life, but always ask yourself what you are about to acquire when writing a check. Everyone knows the story of the naïve superstar athlete that spends his fast millions on gifts, jewelry and luxury cars – only to find out he only gets pennies on the dollar for all that when his career ends.
To become good at telling guns from butter means learning to control your natural fear of leaving your comfort zone. Why? Because butter usually comes in the form of a pleasurable, reassuring and instantly satisfying consumable. Whereas guns are often complex, volatile and may require some work to get familiar with. They also come with some risk. But only will you elevate your financial game by learning to operate the latter.
Get a contract on your life
Hold on now, don’t go out and sucker-punch a Mafia boss! By this I meant shop around and purchase a life-insurance policy.
If you are married, support loved ones financially and own a home, then it truly is criminal not to have life insurance coverage. In this situation, your untimely death could ruin a lot of lives; just imagine your spouse left alone with less (or no) income, having to deal with mortgage payments, college tuitions and your funeral expenses. God forbid! With a policy, your spouse can maintain your family’s lifestyle thanks to a lump sum or installments.
If you are single and do not have anyone’s welfare depending on you, it still is a good idea to have a policy at least covering your funeral – not to sound too morbid. Besides, you can still add anybody you love and trust as a beneficiary – your parents, siblings, accountant or gardener.
It is never a bad time to get life insurance, and like anything else, the sooner the better. It is much easier to get a competitive policy when you are young and healthy, regardless of what your plans for life are at the moment. You may be happy you got it later on. It also makes you used to paying the premium each month if you chose a permanent life insurance.
Life insurance policy types are numerous and can be somewhat complex, therefore it’s important not to rush head first and get the wrong one.
- A permanent life insurance policy provides coverage all through the insured person’s life as long as the monthly premiums are paid or the insured doesn’t request cancellation. This product bundles insurance and investment as it builds cash value over the course of the contract, which can make the premiums quite expensive. When old enough, you can choose to terminate the contract and pocket the cash value (after paying taxes on the compounded interests).
- A term life insurance policy is a temporary coverage for a chosen duration, and for which you pay a preset annual premium. Unlike the previous kind, it is not an investment and does not build cash value. Money is collected only if the insured dies. At the end of the term, the policy (and its coverage) ceases.
If you feel squeezed after paying for your family’s living expenses, then you probably need all the cash you earn every month, and therefore should opt for term life insurance.
If you are a single professional not living too lavishly, then purchasing a permanent life insurance policy is an excellent choice. Cash value usually builds slowly for the first seven years. However by that time not only has paying each month’s premium become a routine, but compounding has also been working its magic!
Of course you could get equivalent coverage for a lesser premium with a term policy. Dave Ramsey bluntly shuns permanent life policies and advises to always "go term and invest the rest". But reality is not so simple. Most people do not have the skills, knowledge, time or diligence to routinely beat the market with self-managed investments. A permanent life policy just does that and securely locks the profits away from any temptation of compulsive spending.
Explaining all the details of life insurance would not fit in this article. Read this excellent source if you want to know more.
The mother of all rules
… Also known as the quiet millionaire’s secret. What do financially healthy people all have in common? They’ve consistently followed the wise adage: “Always live beneath your means”. Yet considering our recent economic meltdown and chronic addiction to overspending, it does not sound that modern American consumers want to hear it.
The secret to financial success is that there actually is no secret; just have the discipline to always spend less than you make. It simply is a mindset that you choose to adopt for the rest of your life… or not.
Also, take note that the quiet millionaire’s adage says “live beneath”, not “within” - which is quite different. If at the end of each month when all the bills are paid, your lifestyle has cost 100% of your income and not a cent more, you are definitely living within your means… but you aren’t going anywhere financially speaking. When you live beneath your means you always have a few chips left for saving – without depriving yourself or your family of any necessity.
In a similar fashion, it is very important not to get carried away and start spending more after receiving a fat raise, a large bonus or a hefty tax refund check. Under such circumstances, it is easy to give in to temptation and make costly mistakes such as: trading-in a perfectly running vehicle for a more luxurious one; moving into a larger, more expensive home when the current one is adequate. People that do this may appear successful, when in fact they are never really better off! This is a classic economic pattern that is greatly summarized by C. Northcote Parkinson: “Expenditure rises to meet income”. You can bet quiet millionaires never fell for it.
Do not get discouraged and stay focused. Applying these golden rules of positive frugality will make your life easier, increase your net worth and maybe allow you to get your own share of the American Dream.
