WEALTH FOR TOMORROW

It is clear that making and saving money is essential to reach financial freedom. Not as clear is what to do with money when you have it. A pressing dilemma especially facing young adults today is how to best allocate your assets. We are going to go over three money components that are all fundamental to achieving financial independence: having an emergency fund, paying off debt, and saving for retirement. All of these are important, which is why it can be confusing to know what to go after first and how much to put towards each.

Emergency funds:

For who?  Everyone who cares about having a plan to fall back on, those who do not like living “paycheck to paycheck”, people not very established in a career or have much stability, people who are risk adverse, people who do not have great insurance.

What is it for?  It is for when you need additional cash for unforeseen events. The idea is to be able to use it in the event you lose your income for whatever reason and need money to cover essential living expenses. Or, an additional cost comes up that exceeds your regular income. Think of it as a lifeline of sorts.

How much do I need?  There is no set amount. It really depends on your situation and preference. Many professional estimates range from 3 to 12 months worth of expenses. How much risk are you willing to take and is there a better use of your current funds? (we will go into more detail below)

Where should I put it?  One factor in determining where to put an emergency fund is your need of liquidity. Meaning, your emergency fund should be easily accessible and safe from the volatility of the market. On one of Vanguard’s investing pages they say a money market fund is a good option given the low risk, competitive yield and easy access. Remember, the point of an emergency fund is not to make money; it is to give you a cushion of life’s “curve balls”.

How fast should I save it?  Again, this depends on your preference. Say you want a 6 month emergency fund and your monthly expenses are $3,000 per month. Your emergency fund would be about $18,000. What you have to realize is unless you are making a lot more than you are spending per month, saving 6 months of living expenses will potentially take a LONG time. To put this in perspective, if you are able to put $150 away per month every month, it would take you 10 years to save $18,000. Yes, your income may very well increase over the years, but so will your spending and, in turn, your emergency fund goal.

So, given the time it could take to save up your fund, if you wanted to have it in place before you started paying back your high interest loans or your retirement savings, you would be taking on a whole other kind of risk by not attending to the other two money components.

Paying off debt:

For who?  Everyone wanting financial freedom.

What is it for?  It is a way for those who have money to earn interest on it by lending it to others for an agreed upon rate and term. For the debtor (one who owes the money), it is a way to get extra capitol for a fee, ideally with the potential to increase income or net worth. This is where that phrase “it takes money to make money” comes in play.

What types are there?  As debt is simply money being lent from one entity to another, I see it inherently as neither good or bad, but rather smart or not smart. Smart debt may include student loans and mortgages due to the possibility to pay off in the future. Bad debt commonly refers to cars, discretionary consumer spending, credit card balances, and any high interest debt.

What strategy I should use to pay it off?  First off, make sure you have a system to organize all your loan information. This should include terms of the loan, interest rates, repayment dates, log in information, etc. Everything should be easily accessible in case you need something. Next, make sure you are able to make the minimum payments for each loan. From what I have seen, both private and federal loans often offer alternate repayment plans to make it easier in the beginning of the repayment phase. This includes graduated payments that start low and increase over time as well as income based payment plans. If you have financial hardship, it can also be possible to postpone payments for a time (before you change your repayment plan, you should know that most if not every alternate payment method will result in paying back a greater amount of interest over the life of the loan. Check with your loan provider for details).

For actual payment methods, a couple common methods are the “debt-snowball” and “debt-avalanche” methods. The debt-snowball refers to putting additional money towards the debt with the smallest amount, and once that one is paid off, putting all that money towards the next smallest loan, and so on. Each time you pay off one loan, you can put more towards the next one, giving you a “snowball” effect.

The debt-avalanche refers to paying off the loans with the highest interest rate first. This makes the most mathematical sense as you minimize the total interest paid during the life of your loans.

There are also ways to consolidate multiple loans into one large one with a single payment and interest rate. We are not going to get into that here, but make sure you do your research before jumping in to something like this to make sure it benefits you.

How fast should I pay it off?  Again, you can find a number of different answers for this depending on who you talk to. If you read my first net worth post here, you know I took loans out ranging from about 3%-8%. Although you can never know for sure what stock market returns will be (where typical long term investments stay), if I could somehow guarantee investment returns above 8%, it would make mathematical sense to put excess money in that investment rather than additional loan payments (or pay off my loans faster than I need to), which are lower than 8%.

Think about it like this, the money you put in your savings account is a loan to the bank. In return, they (may) give you interest on what you have in that account, something like .01%. Loans you take from the bank will be charged a much greater fee as you can see from my case, upwards of 8%! So, say I had my emergency fund all set plus an extra few thousand in my savings account for extra peace of mind. While I am getting next to nothing for having my money sit in a bank account, I am paying thousands of dollars a year while I pay back my loans. So, the argument can be made that the smartest choice would be to take money out of the bank account where I am earning a low amount of interest and use it to pay off the debt that has a high amount of interest.

At the same time, calculations by Dave Ramsey put long term investment returns on the S&P 500 at about 12% year over year since 1926. Considering this, the argument could also be made that it would make the most mathematical sense to put excess money into the stock market if your debt interest is in the mid to low single digits. If paying off loans is your goal, remember that while the stock market has averaged these gains over the long run, no future market returns are guaranteed. The interest on your loans are guaranteed, so when in doubt, paying off your loans is a safe bet.

Retirement savings:

For who?  People who want financial freedom sometime in their life.

What it is for?  You want to save to plan ahead for the future, retire, and provide for your family when you are not physically or mentally able to anymore. Retirement does not have to be the traditional 65. It can be whenever you have enough to realistically last the rest of your life.

How much do I need?  “How much do I need to retire?” is one of the most common questions I see in the financial industry. I see two simple ways to put it. Both require you to estimate how much you think you will need/want to have per year in retirement.

Let’s say the person in question wants to retire at 55 years old and would like to live off $150,000 per year until they pass away. To be safe, let’s assume this person lives until the ripe old age of 100. One way to estimate how much this person would need is to simply take the number of years in retirement (100-55= 45) and multiply it times the amount of money they want per year (150,000).

45 x $150,000 = $6,750,000

Of course, it would be ideal to gain interest on this during the retirement years, which would potentially reduce this amount considerably. However, this is how much the person would need under the conditions in the example, not taking into account taxes, interest or inflation.

The other way I like to think about it is, “how much would I need to have invested to realistically gain $150,000 per year in perpetuity (forever)?” To calculate this, I would need to have an estimated amount (percent) that I expect the market to return to generate my income from year to year. As I mentioned before, there have been studies that show the market returns in the low double digits over the long run. Let’s say I want to plan on 3% returns while I am in retirement to be extremely conservative. Taking the same numbers I used before, my estimation will look like this:

$150,000 / .03 = $5,000,000

This means that in this hypothetical situation, if I had $5,000,000 in the bank right now, and I had guaranteed returns of 3%, I could take out $150,000 every year, forever, and never even have to touch my initial 5 million that is invested. To make it even more fun, let’s do it again but say we could generate 15% return on investments. It would look like this:

$150,000 / .15 = $1,000,000

In this situation, if you had 1 million dollars in the bank making a stellar 15% per year, you would be getting $150,000 per year in return. Of course this is incredibly simplified as there are other factors like interest, taxes, inflation, etc. but this is a way to look at it for a basic picture.

Where should I put it?  Traditionally, your main accounts can include a 401k, IRA, and/or brokerage account. There are tax implications for each as well as pros and cons, but we will cover that in a later post. As far as what you actually invest in, that also depends on your situation and will involve things like age, risk tolerance, diversification, and preference.

How fast you should I go?  Like everything else, it depends on what your life goals are. The day you have the freedom to stop working is directly tied to your savings rate. Personally, retirement saving is at the top of my list of financial priorities (right after a couple of high interest student loans) because I want financial freedom more than I want nice cars, fancy clothes, or even a house. But that’s just me.

When I opened up my Roth IRA, I started with the minimum $1,000 investment and began contributing only $60 per month because that was all I could afford. I have slowly increased my contributions over the past couple years to put me at $150/month currently. I want to eventually max out both our IRAs which would be about $460 per month each, so we still have a ways to go. These will increase as we pay off more loans.

Summary

Emergency funds are like an insurance plan for your life. Debt is like a leech that sucks money out of your finances. Saving for retirement is best started early as possible and is the key to financial independence. It is tough to navigate through finances when there are so many decisions and so much at stake. What I wrote is a reflection of my experiences and opinions, not personal advice. But, I feel confident saying that understanding your financial situation and planning for the future is something that everyone should take seriously and worth seeking advice. Thanks for visiting!