Joseph Cerqua, CFA | Elmwood Income Partners
“How much should you have saved for retirement?” If you have ever seen that headline, the numbers that come next can be overwhelming. They are usually followed by some tips like skipping your morning latte to save a few bucks. But we are talking about the need to put away hundreds of thousands of dollars. If you are drinking that much coffee, money is not your problem. So go ahead and enjoy your morning brew. Today, we will talk about real ways to build your wealth.
HOW DO THEY DO IT?
Many of us know someone in the same stage of life who makes about the same money yet, seems to be in a much stronger financial position. But how? For the typical household, there is no single thing that you can do to get rich. The truth is that your finances are a system comprised of income, expenses, assets, liabilities, borrowing costs, taxes, etc. Understanding their connections and optimizing the decisions that impact your system is the key to building meaningful wealth.
Below, we will discuss the opportunities to make a real difference. Canceling some of your streaming services can certainly save you some money, but that is not how people get rich. We are targeting moves that create tens of thousands of dollars. Money that can be invested and grown into six figures over time. Individual situations differ, but we will detail some common ways to increase your net worth dramatically.
Source: The Tortoise Mindset - based on the 4% rule
CREDIT CARD DEBT
One of the great mysteries in the world is how credit card companies have managed to maintain their excessive interest rates while rates everywhere else have plummeted. When writing this, the average rate on a credit card in the U.S. was 16.15%. This compares to an average of .07% from a bank savings account or .18% from a 1-year CD.
If you consistently carry a credit card balance while owning a savings account, pay off the credit card to the greatest extent possible. Do it now. It is one of the easiest ways to save significant money.
For example, consider an individual with $10,000 in credit card debt who routinely maintains that balance while just paying off the interest. He will shell out more than $16,000 over ten years. By contrast, if that person used $10,000 from a savings account to pay it off and continued paying $1,615 per year – but now invested that money in an IRA instead of paying interest – those payments would build to about $24,000 over the same time frame assuming a reasonable 7% annualized investment return. Not to mention that money can continue to grow well beyond that. So, long story short – get out of credit card debt!
PAY YOURSELF FIRST
Some have never got in the habit of saving. One way to get there is to eliminate the choice to save or spend. It is easy to make a direct contribution from your paycheck into a retirement account. The advantage of doing so is that the money is never available to spend. You have now set up a savings plan that is consistently growing. The best version of this idea would be to contribute to your employer’s 401k plan. Not only are you consistently saving, the employer often matches your contribution. This is free money – you have to take it!
The tax benefit from this is an added attraction. If someone making a $50,000 salary allocated 5% of it to a 401k plan, many companies would match this with another 3%. That would equate to a $2,500 annual contribution + $1,500 employer match totaling $4,000 in savings per year. However, your paycheck is likely to be just $1,800 lower, given the tax savings. So, you can easily turn $1,800 of your income into $4,000 every year, plus whatever investment returns are earned on top of that. Repeating our example above, investing that $4,000 per year in a strategy that generates an average annualized return of 7% would compound to over $55,000 in ten years. That is how you grow your money!
INCREASE YOUR EARNINGS POWER
Forget the side hustle. Sure, you can bring in some extra cash, but all you are really doing is working overtime. That does not enrich your life. Below are some ways to leverage your skillset and permanently increase your ability to make money.
• Get Credentials – Professional credentials can be very valuable in a variety of jobs. For instance, studies have shown that accountants who have passed the CPA exam can make up to $1 million more over a career than those without the certification. Credentials take some work but are typically very affordable and worthwhile to pursue. Below are some examples of jobs that provide significant jumps in salaries to credentialed workers.
• Negotiate – Many people never ask for a pay raise. We suggest you do but not just because you want more money. You need to show evidence that the work you have done has increased the value of the enterprise. For instance, if you have picked up all of the work from a co-worker who has left, you have directly saved your employer money and should see a benefit. Commit to adding specific value and then make a case for a raise. When you can clearly display your work’s benefit to your employer, a pay raise is much more likely to follow.
• Get out of structural traps – This is a common dilemma that many find themselves in. Persisting in jobs with these traps can significantly reduce your lifetime income. Some examples of this include working for a wealthy owner who has no incentive to grow the business or working in an industry with a shrinking market. You may be excellent at your job, but the environment surrounding it may confine you to a world of minimal pay increases. It can be hard to shake up your world by changing jobs but taking a critical eye to your situation may save you years in missed earnings potential.
IMPROVE CASH FLOW
Your salary is one thing. Your cash flow is quite different. Living expenses, taxes, borrowing costs all reduce cash flow. Optimally managing these maximize how much money you actually keep. The more you hold onto, the more you have to save and grow through investing. It is how two people with the same salary can be in very different financial shape. Below are some moves that can generate significantly more cash flow for you over time:
• Refinance your house – If you purchased a $250,000 home 10 years ago, a 30-year loan might have charged you a 4.75% interest rate. Today, you could finance the remaining 20 years at a rate of 2.875%. Even with the additional closing costs, your monthly payment would actually be lower and save you more than $41,000 over the next 20 years.
• Get real with realtors – Like the credit card companies, it is stunning that real estate agents still try to charge a 6% commission. In the past, they provided intel on market pricing and showed the house to prospective buyers. Today, the internet can do much of that for you. The house in the prior example is probably worth $300,000 today. Planning to sell? Tell the realtor you will engage them for a 3% commission charge. If they will not, someone else will. That keeps $9,000 of the sale proceeds in your pocket.
• Get your car detailed – Everyone likes driving a nice car, but they are expensive, and the novelty wears off fast. It is better to pay off your car loan and enjoy it for a few more years. If you are getting the itch for a shiny new one, spend $200 and get yours detailed. It will look new and could keep you out of payments a while longer. The same can be said for staying out of any debt. Instead of making loan payments, you can save and invest that money. For example, let’s say you have paid off your car and feel like getting a new one which entails another 5-year / $30,000 loan. With interest that will drain over $32,000 from your world in the next five years. Instead, give your current car a makeover and see how it feels. Resist buying a new one for a while and let your money pile up.
Saving money is a great start. Growing those savings through investing is what creates wealth. Investing captures the magic of compounding. This is one of the most powerful concepts in finance. It basically means that not only does your principle earn interest, but the interest earns interest as well. The result is exponential growth in your savings. See its dramatic effects in the graphic below.
Investing entails risk, so it does require some care. Before anything is done, we should pay attention to the following:
• Have a plan – You have goals. Retirement, kids’ education, maybe a house on a lake someday. All of this will cost money. But how much? How far away are you from that amount? How much will you need to save? What rate of return will you need to earn on your money to reach this target? These questions need to be answered before one can design an investment strategy.
• The right strategy – Once an adequate rate of return has been determined, we must construct a portfolio with a mix of securities that can reasonably be expected to achieve that rate.
• Risk management – One of the most important factors behind your investment performance is volatility. This refers to the ups and downs of the markets. By itself, volatility does not kill returns. The pain that it causes as we watch our savings lose value does. By nature, we like to limit that pain. This often translates into the act of selling our holdings during periods of distress. That is the main reason that the average investor’s returns are well below the market averages and why your strategy must also manage risk. Understanding how much sensitivity your investments have to the economy and how they are correlated to other asset classes is critical to minimizing volatility and keeping you on track. A strategy that is too painful to maintain will never reach its goals.
"The most powerful force in the universe is compound interest.”
- Albert Einstein
How much do you need for retirement? That number is different for everybody but seems out of reach to many. It can be overwhelming but don’t let that discourage you. With a good plan and good decisions, there is no reason that you cannot meet all of your goals. A good plan can also make today more enjoyable by relieving some of the stress of an uncertain tomorrow. Take control of your finances so you can spend less time worrying and more time enjoying life.