Posted by Frugal on July 15th, 2006
Once you create your wealth by having a good job or owning a business, and start to have money coming in, you can then slowly build your wealth by accumulation. The primary vehicle to accumulate a substantial wealth is obviously through savings. Yes, through savings. You may not want to believe it. But the old fashioned and traditional way is the way, and the primary way.
However small the monthly saving is, a persistant saving that is multiplied and compounded through 30 years can become a large sum. For example, a saving that is compounded at 6.0% APR after 20 years gives you a multiplication factor of 462.04 (instead of 240), which also means that for every $1 you save today, it’s really $1.93 twenty years later (Of course, this is the part of good news about compounding the savings; see the bad news about compounding inflation in the next advice to preserving wealth in 30s thru 50s). Irrespectively to inflation or not, saving is the very first step to wealth. Withou savings, you are always at the origin on the number line, at zero. With some savings, at least you are moving positively forward. So how does one save money without pinching pennies and driving oneself crazy? What is the proper balance between saving & spending money? How does one properly budget one’s expenses? These are the questions everyone ought to ask himself or herself.
There are no right answers to the these questions. Saving money is a personal choice. You can find my own answer to the proper balance between saving & spending money in the Definition of Being Frugal. I also have an article on How to Budget. But the bottom line of the process of increasing your wealth is (from Steps to Wealth)
Saving = Income – Expense
Networth = Asset – Liability
Accumulating networth is a process by which one controls the expenses and trickle down the savings into growable assets, while reducing liability.
Because the everyone’s income and spending needs are different, I don’t really think that anyone should have a saving goal as a percentage of their income, whether it’s 10% or 20%, unlike suggested by many personal finance books (see my comments for the mathematical version of the explanation). Just because you can spend more, doesn’t mean that you should spend more. Vice versa, just because you cannot save more, doesn’t mean that you should strangle yourself for that extra dollar or penny. It’s simply not realistic to apply the same rule to everyone. And it’s also the same thing with your saving goals. I don’t think everyone should use 1 million dollar for their saving/networth goal either. If you’re a medical doctor, or a lawyer, you may use a saving goal higher than a million. If you’re the average US household, I won’t advise you to use 1 million dollar for your saving goal at all. Why? While it’s feasible to reach 1 million dollar (not adjusted for inflation) for the networth eventually, it simply does you no good to set a goal that may be reached after 30 or 40 years of hard work. Setting a goal that can only be accomplished that far out will simply drive your mental mind sick of reviewing your progress towards the goal. Every month or year when you review your goal process, your mind will tell you that “boy, I’m so so far away from my goal. Why am I bothering to accomplish it at all?” Eventually, you will quit from even trying to accomplish your goal even when it is possible. I know of no one who can happily and objectively review their goal when the goal may only be accomplished after 30 or 40 years. Human mind just doesn’t work that way. You need to “feed candies” to nurture your mind. Setting a goal just for 1 year is much better. If you don’t know how much you can save, you should start with a monthly goal. If you can achieve your monthly saving goals, you can up your goal by a little more, and set up a goal for the following entire year. Little by little, your mind can be satisfied with being able to reach your saving goals in small steps. Then it is possible to discipline your mind to carry out your daily struggle between the choices of saving & spending, fighting against your desires for immediate gratifications. If your mind does not get this constant positive feedback of reaching your near term saving goal, you can pretty much expect it to retire from trying. It’s simply human nature. Why bother, when you think you can’t even reach it? In fact, if your mental mind cannot be satisfied with the abstract satisfaction of reaching a saving goal, I would even go as far as suggesting people to allocate a 5% or $50 (or whatever number that is suitable to your situation) to simply materially reward yourself/family. Yeah, a sweet bonus waiting for you at the end of month or year after all the hard work of saving money frugally and diligently. An extra and regular festival on reaching saving goals may set you back a little, but hey, it’s really a million times better than not saving at all. Alternatively you can also use an allowance system for everyone in the family. This system works the best when not everyone in the family is on the same page on signing up the saving goal. An allowance system for kids, and also husband and wife, gives each of the family members a personal space allowed by the allotted money which can be accumulated on an individual basis for a bigger individual spending need.
Savings can be done in various forms, not necessarily in your bank account. You can also save by paying down your mortgage debt under the regular amortization schedule, if you own a home. The amount of principle that you pay towards the mortgage balance is your true saving. Obviously, if you have those interest-only or negative amortization loans, you won’t be saving anything in your home, but rather may even be building additional debt when you negatively amortize the loan. Often, paying down your mortgage according to amortization schedule is the most practical way of saving, since you need to pay your rent in an alternative case anyway (see Why Is Your Home the Best Investment). Of course, you need to carefully evaluate the decision between rent vs buy carefully in this housing market. If the mortgage payment on a 30-year loan using a 20% down payment is much bigger than prevailing rent, I am not so sure that buying a home will turn out to be a wise decision. To carefully evaluate your personal situation, you can use my Rent vs Buy Calculator and compare whether you will come out ahead financially by buying a home (or investing in a second home).
Another very good way of saving money is utilize your 401K or IRA account. The money you save in your pre-tax retirement account gets an immediate boost of some 15% to even 45% simply due to your combined marginal federal and state tax brackets. Besides, your money can grow tax-free. Tax consideration is the primary benefits for pre-tax accounts. Unless you have very substantial assets in the pre-tax accounts, and that you’re expecting a higher tax rates than your current year tax rate, otherwise, most of the time, you could take tax advantage and build up your pre-tax assets. Roth IRA is a good alternative to consider when you don’t want to contribute to your 401k/IRA.
At last, you should begin saving as soon as possible. When you just got your first significant paycheck from your first job, you may be celebrating your financial independence, and tempted to spend it all. But wealth must be accumulated, and accumulated through time. It’s obvious that if you are only 5 years to your retirement, and you just started saving for it, it’s simply too little too late. I’m not going to be a cheer leader for you. That is just the cold and hard truth. Definitely start early. Stages in life often don’t give you second chances to go back in past to save your money. Demand for spending your income will simply keep growing without stop. It’s always better to have money in the bank, than worries in the head.
In summary, I advise (See my comments too for the mathematical version)
Save as much money according to your own financial situation. Use short-term saving goal for smaller steps forward, and/or an allowance system if you need them.
Save money in your home by paying down mortgage under a regular amortization schedule.
Save money in your 401k/IRA accounts to take advantage of the tax benefits.
Start saving as early as possible.
At last, you need to do any longer term financial planning for your saving goal or retirement needs, you can try my Saving Goal/Retirement Calculator. The calculator is for realist, and may depress you with the cold facts. But that’s where the next article comes in, My Advice To Preserving Wealth in 30s thru 50s, hopefully to give you some tips on investing to combat inflation.
P.S. The number of links to my own posts may seem excessive. But it simply shows how important I think savings is to one’s wealth.
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