"The best time to plant a tree is 20 years ago. The second best time is now"
- Chinese Proverb
This post will be a general overview of the foundation needed to building up your wealth if you are just starting out. I believe the elements to building up a person's net worth involves the following 3 steps in the diagram.
Allow me to elaborate:
1. Savings and investments
In order to actually build up any savings, we all know to save a portion of our income for a rainy day. The most optimal savings strategy occurs when you receive your payslip and allocate a portion of it to savings before you use it for any other purpose - aka paying yourself. Set aside at least 10% (more if you can afford it) of your after tax pay just for future savings. Why not play a game where you try to beat the previous month's savings and save just that little bit more. See how much you can save without actually starving or losing the roof over your head.
It's a psychological thing - if you pay all your other expenses first, and then promise to save what is left; chances are you will go over your budget and end up saving very little. If however you pay yourself first, you are setting yourself a limit and you have to find a way to adjust and workaround the lower after tax income.
Saving for something is easier if you have a goal in mind and a plan on how to get there.
Compare the following 2 statements:
"I want to save more money this year" or "In 4 years, I will need $75k in savings for a deposit on a unit".
The second statement gives you a target to work towards, and you know that you will need at least $18.75k each year or ($1562.50/month) saved up. Having a purpose for saving provides you with more motivation than just saving for the sake of saving and being a responsible adult.
The good thing about saving is that the hardest part is at the start, and then it gets progressively easier as you continue to save.
The reason - compound interest and development of saving habits. We all know in simple terms how compound interest works. Your savings earns interest, then next year you earn interest again, but also interest on your interest. Leave it for long enough and sure enough you have a huge pile of money on your hands. The trick is to start as early as possible and let the compounding do its magic.
If you put $10 a week into a savings account for 30 years, with a rate of return of just 3% compounded monthly, you will end up with $25,252 after 30 years. So the true cost of your weekly coffee runs is costing you over $25k over 30 years (or $43k if you can get 6% interest). Let me repeat. $10 a week.
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| From ASIC's Money Smart website: https://www.moneysmart.gov.au/tools-and-resources/calculators-and-tools/compound-interest-calculator |
There are multiple ways to build up savings - and the end goal is generally for you to have enough savings so that you can then buy investments with your savings (that and to afford to go on holidays). These investments will then provide you with income that you don't have to work for but still receive ('passive income').
Some ways people build up their savings:
- online savings account
- term deposits
- managed funds
- shares
- property
- super
A discussion of the various ways to build up a savings nest egg will be described in future posts.
2. Reducing expenses and debt
Once you have reached your limit of how much you can save on your current pay / sources of income, there are 2 options available to increase savings further. Either to reduce your expenses or find a way to increase income.
The easier option is obviously to reduce expenses. Anything that you can cut down on is money saved and also money earned. Cut out any non essential recurring expenses. Keep in mind the effect of compounding over a long period of time, even for small amounts like $10 a week.
- Gym membership $50/month
- Bringing lunch from home each weekday - $50/week
- Cable internet $30/month
- Quarterly train tickets vs weekly tickets - $25/month saving
When I say reducing debt, I need to clarify one thing. I'm not saying debt is bad. No, you'll notice all the top listed companies use debt to their advantage. What should be avoided is getting into debt that does not fund an investment. Debt is only good if you use it to purchase assets that will generate further income.
- Mortgage on house - okay, as your house can be sold for capital gains and also rented for income
- Higher education loans (HECS) - okay as it will increase your employability in jobs that pay more
- Credit card debt or personal loans - definitely a bad idea. Only get a credit card if you know you can pay it off in full and not pay any interest.
When dealing with debts, the magic of compound interest still applies, the earlier you can pay off the loan, the more you will end up saving in the long run. Don't let your bank/creditor have the full enjoyment of compound interest. Pay it back asap.
3. Managing cash flow
Cash flow is managing the timing of the inflows and outflows of your personal finances. It can depend on tax considerations (eg when to sell a share) or it can depend on when you get paid and when bills are due.
In this regard, credit cards with up to 55 days interest free is a good idea if you can pay it off in full each month. What you would do is take advantage of the up to 55 days interest free and purchase your necessary goods such as quarterly train ticket or groceries, and leave your money sitting in your savings account or offset account for as long as possible.
Later on when you do have a multitude of investments and outgoings, you will have to recognise which debt is (a) the highest interest rate and/or (b) which are tax deductible. You will obviously want to use the income you get to pay off the highest interest rate which is not tax deductible (main house you live in or 'Principle place of residence' PPOR). More on this later.
Once you start saving more from reducing expenses and increasing income, it just snowballs from there.
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