I hope everyone had a great holiday weekend! Now that we are back, I thought I’d write about some of the basics of building wealth and getting out of debt.
Building wealth and paying down debt both follow a similar course. To me, the main difference is what side of $0 net worth one finds him or herself on. Also, in most instances, generating wealth involves more investing. However, if you are in debt, you can continue on a similar path once you have paid it off.
Below, I have listed what I feel are some the “rules” of both building wealth and reducing debt. You may have seen similar lists before, as most financial bloggers have compiled their own. However, I feel that these are the ones you should learn now because they lay a good foundation for what I plan on teaching. Notice, I said “foundation” because these are just some of the basics, and I will be later adding to this list, as well as introducing some more advanced topics.
So, without further delay, let’s take a look at these financial rules. Note, I tried to highlight key words and phrases to make the learning process simpler:
The rules
1. Start ASAP!: Just a couple of years of putting off saving and investing will have drastic effects on your accumulated wealth upon retirement. That’s just how the rule of compounding interest works. However, if in debt, you will have to take care of that first, so don’t put it off any longer!
Think of this example I found at Fortune.com:
“Employee A starts putting away $100 a month when she’s 22. Her money grows at 8 percent a year, and after ten years she stops contributing – and lets her stake grow. Employee B waits until he’s 32 to set aside $100 a month, also growing at 8 percent a year, and he keeps it up until he hits 64. When they both retire at 64, she will have $234,600, and he’ll have only $177,400.”
2. Identify all of your recurring expenses: Having a list of all your weekly, monthly, and annual bills gives you an idea of where your money is going. Once you can visualize your expenses, finding areas to “trim the fat” becomes an easier process.
Categorizing may also help in this process, and I recommend it to help stay organized. Just make sure you get everything – monthly rent, water bill, electric bill, phone bill, internet, cable, credit cards, personal loans, gym membership, private school tuition, etc….
3. Cut back on all of your bills: This goes hand and hand with the previous step. Don’t start telling yourself there’s no place to cut costs. I’m the Michael Jordan of saving money, and I still find places where I can save on a regular basis. For example, you could switch to a cheaper phone plan, start packing your own lunches, and/or move to a cheaper apartment.
In some instances, you should slash expenses from your budget entirely. For example, if you are deeply in debt, you don’t have time to be watching cable television. Also, things like magazine subscriptions and gym memberships should be first to go, since you can exercise for free and use the library
Remember, every dollar counts! Just cutting your phone bill down $10/mth will give you an extra $120/year from which you can start accruing interest. The possibilities here are truly endless!
4. Make a budget: I will be the first to admit that I don’t have a budget. (However, I’m a pro, so don’t try this at home!) After you have slashed your recurring expenses, adjust your budget accordingly and stick to it. Don’t forget to include food, clothing, rent, entertainment, etc…
Giving yourself a tight budget for everything will force you to shop around and become inventive. This, in turn, will cause you to research your expenditures, which will ultimately result in the discovery of cheaper sources and/or alternatives.
5. Start an emergency fund: Before beginning to conquer your debt, establishing an emergency fund is critical. Most experts say that any emergency fund needs to contain enough cash to cover 6 months of your living expenses. However, I believe that if you have borrowed extensively, you should stop contributing to it once it reaches about $1000-$2000 and then start paying down your debt.
No matter how much you have in your emergency fund, remember it is for emergencies only! The idea is that you will go to it instead of your credit cards when disaster hits.
6. Attack your debt aggressively: Debt is a destroyer of wealth and must be dealt with as soon as you have established an emergency fund. It makes no sense to put saving into an account earning 5% when you have thousands in credit card debt financed at 18.9%.
My recommendation is to make a list of all your outstanding debts including the name of the creditor, amount owed, and interest rate. Once you have your list, pick one debt and throw everything you have at it.
There are 2 schools of thought as to which outstanding debt one should target first. One school says pick the highest interest rate. The other, however, believes that small victories are crucial in the beginning, and thus recommends choosing the smallest amount instead.
To understand exactly how these differing philosophies work, consider the situation in this example:
Bob Smith’s outstanding debt:
Student Loans $50,000 4%
Car Loan $3,400 8%
Personal Loan $700 5%
Credit Card 1 $9,800 12%
Credit Card 2 $11,100 21%
Credit Card 3 $2,000 18%
Credit Card 4 $6,000 16%
Total $83,000
As one can easily see, our friend Bob here is in a lot of trouble. However, the two above-mentioned schools of thought would approach his situation entirely differently. Both would agree that the Student Loans would be handled last, given high balance and relatively low interest rate. The rest, however, is up for argument.
The 1st group always argues attacking the highest interest rate first. Thus, someone following this line of reasoning would go after Credit Card 2 first, followed by Credit Card 3, then Credit Card 4, and so on. On paper, this is the most rational approach, since in the end, you save the most money.
Group 2, however, would likely first target the Personal Loan, then move on to Credit Card 3, and then finally start on the highest interest card, Credit Card 2.
This strategy might seem random, but there is actually a reasonable theory behind it. You see, small victories keep morale and motivation up, which in turn increases the likelihood of success. Since both the Personal Loan and Credit Card 2 are of relatively small amounts, they can be paid off quickly thus reinforcing to Bob that he can overcome this problem. I for one would probably actually choose this approach, if I were in Bob’s situation.
One thing to remember is that no matter which route you take, you have to keep making payments on the other debts besides the one you are attacking. Thus, you would pay the minimum payments on all but the one you have targeted for immediate termination.
7. Pay yourself first: Every time you are paid, you should immediately put a certain percentage of your earnings into an account reserved for long-term saving. Try to aim for a minimum of between 10%-20% of your gross pay. Treat it as just another monthly bill that must be paid and include it in your budget. After reducing all your expenses, you’ll likely never miss it, and soon transferring the cash will become second nature.
8. Live below your means: You have probably heard the phrase, “live within your means.” Unfortunately, I think that’s bad financial advice. Sure, it’s better than living above and accumulating debt. However, living within your means could be living paycheck to paycheck, since that sort of lifestyle is within your means. Thus, the only way to build wealth is through saving and investing which requires you to live more modestly than your full potential would allow.
9. Invest in a Roth 401k or IRA: I chose Roth for a reason. That being, our government is spending money as fast as they can print it and racking up enormous amounts debt that will eventually have to be paid off. All of this spending is a recipe for increased taxation in the future. Thus, pay your retirement taxes now while the rates are lower.
However, don’t worry about switching to a Roth if you are close to retirement. I don’t foresee any rapid increase that will affect the baby boomers, and this advice is strictly for us younger folks.
Final thoughts
In the end, I really hope this post inspires you think about your own financial situation. Remember, getting out of debt and building wealth can both be long processes, so patience is key.
No matter how grim the situation looks, there’s always a way to pull yourself out of it. If you don’t know where to start, just look at rule number 1. Taking the first plunge is always the hardest part of any life action. Fortunately, I know you have it in you. Now, take a deep breath, and just do it!
After chipping a tooth recently, I have been overly occupied with my teeth. Mostly, I’ve been obsessed with taking extra good care of them, given they are the only set I’ll ever have. As a side effect of this new-found concern, I have discovered a lot of secrets for providing them great care, without spending a lot doing it.
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