The ABCs of Personal Finance

Do you want to be a millionaire?

The odds may certainly seem to be stacked against you. Less than 0.2% of the world’s population can claim to be millionaires. The average American household before the financial crisis in 2008 had a financial net worth of roughly $100,000. Today, the situation is even more dire, with half of all Americans having no assets whatsoever. Do you really think that you can buck the trend and be a millionaire?

The answer is yes. Becoming a millionaire is easier than you think, and within reach of the common man. You simply need to start young & learn the ABCs of Financial Planning.

Figure out your Goals

The very first step, is simply to figure out what your goals are. Do you want to retire at 65 with a million dollars? Retire at 65 as a multi-millionaire philanthropist? Retire at 45 with just enough money to live a frugal, relaxing life? Save up $200,000 in the next 20 years so that you can send your kids to the best private colleges? These are all equally valid answers, and there’s a different one out there for every person. You simply need to figure out what your own life goals are.

Some resources that can help you figure this out:

Guidelines for how much money you need in retirement

Calculator for how much money you’ll need in retirement

Guidelines for saving for your kids’ college

Budget your Savings

Once you have figured out your goals, the next step is to figure out how you can get there. Too many people spend whatever they feel like spending, and save the rest. The first step towards achieving your financial goals is to flip the equation.

First figure out what you need to save every month, in order to achieve your goals. And then, spend only whatever is remaining.

Calculators like this, can help you figure out exactly how much you need to save every month to achieve your goals.

Some of you may find this minimum-goal to be “too easy.” You may want to challenge yourself to save even more money, and are wondering how to strike the right balance between saving for the future & enjoying the present. If you’re one such person, give yourself a pat on the back. You’re on the right track. There is no single answer to this question, but the approach I’ve used is to split my money evenly between savings & luxury spending.

For example, suppose you’re making $5000 per month. Break down all your basic living expenses:

$1500 – taxes
$600 – rent and utilities
$75 – car insurance
$180 – medical insurance, life, ad&d
$500 – groceries
$1000 – minimum retirement savings to meet your goals

This leaves you with around $1000 left over. Split this money equally between your savings & luxury spending. Put an additional $500 into your savings every month, and allow yourself to spend the remaining $500 on whatever luxuries or hobbies you like, free of guilt. Whenever you get a raise or bonus at work, put half of it into your savings, and allow yourself to spend the other half on anything your heart desires. You may want to pick your own ratio, but I personally find this 50-50 balance helps me enjoy life to the fullest, while still sleeping soundly at night.

One quick note to mention here: There’s a huge difference between nominal dollars, and dollars indexed for inflation. One million dollars in 2040 is worth less than $500,000 when indexed for inflation. Whichever term you prefer to use when doing your calculations and looking up online tools, make sure to stay consistent.

Maintain Separate Accounts & Automate It

Once you know exactly how much you need/want to save, you need a surefire way of keeping your nest egg safe and separate from your spending money. Mixing the two of them together, is the easiest way to wreck all your careful plans & eat into your nest egg without even realizing it.

The best & easiest way I’ve found to do this, is to set up separate bank accounts. At the very minimum, set up one account for your savings, and another account for everything else. I personally keep 3 different accounts. One checking account for all my basic life expenses. Another checking account for luxury spending. And a third account on ETrade, where I keep & invest all my savings.

Once you have your different accounts in place, set up your paychecks to direct deposit money into each of the accounts automatically, from every paycheck. If you know you need $1500/month for your basic living expenses, have that much money direct deposited into your checking account directly from your paycheck. If you plan to save $1500/month, have that money direct deposited to your stock brokerage account directly from your paycheck every month. Arrange to have anything left over direct deposited to your luxury spending account.

If you ever find yourself wanting to go shopping or traveling, first look at your luxury account’s balance. Whatever money you see sitting there, is yours to spend guilt-free. But don’t even think about dipping into your savings, unless it’s an absolute necessity.

Minimize your Taxes

The average American pays $14,000 in taxes every year – enough money to become a millionaire over the course of their lifetime. Luckily, there are a number of tax benefits that we can all take advantage of, to reduce our tax bill. Every dollar not paid in taxes is an additional dollar earned & saved. Depending on how rich you are and how extensively you take advantage of these deductions, you can save tens of thousands of dollars every year. So definitely spend some time exploring these options fully.

The biggest tax benefit that you should definitely take advantage of, in order to save for your retirement, is the 401k and IRA plans. At the very minimum, these plans allow you to invest your savings without having to pay any capital gains taxes. That will single-handedly boost your savings by 15%. Another advantage of 401k plans is that many employers will match a good chunk of your contributions. Taking full advantage of these matching contributions is like getting a 5% wage raise for free; don’t ever leave that money sitting on the table.

Traditional 401k/IRA contributions are also exempt from Income Taxes for that year. This will significantly reduce your immediate tax bill, allowing you to save even more money. Keep in mind that you will eventually have to pay taxes on this during your retirement, but if you were to use it on charitable giving, significant medical expenses, or other such exempt uses, you may never have to pay taxes on it at all.

One tradeoff you make for getting all these benefits, is that the money in your 401k/IRA accounts can only be taken out after your retirement. This can be a blessing in disguise, preventing you from blowing your savings on unnecessary expenses. But if you do have legitimate expenses to handle before your retirement, you should save up for those expenses in a non-401k account.

There are quite a few exemptions that allow for early withdrawal, to account for unexpected hardships & life necessities. For example, you can withdraw money early from your 401k account to pay for qualified educational expenses, medical expenses, and to make the downpayment on your first house. If you plan to take advantage of these exemptions, make sure you research it thoroughly before committing your money to the 401k account. In general though, the 401k is an excellent way to save for your retirement, and significantly reduce your tax bill in the process.

If you’re investing your savings, as you definitely should be doing, you should certainly make sure to minimize your capital gains taxes as well. Whenever you buy a stock that appreciates in value, always hold on to it for at least one year before selling it. This will cut down your taxes by half, or even eliminate it completely. If you want to go one step further, there are other fancy tricks you can use, like Tax Loss Harvesting. I personally avoid it, because I find it too much trouble and too easy to get wrong, but it’s certainly an option that’s available.

The home mortgage interest deduction is another excellent way to minimize your tax bill, if you decide to buy a house. All you need to do is simply not pay off your mortgage early. This is a very good idea for other reasons as well, as covered later, but one additional tax benefit is that any money you spend in mortgage interest payments, qualifies as a tax deduction.

If you know for certain that you’ll be spending some amount of money on educational expenses or medical expenses in future, you can also set up special accounts for those. For educational expenses, you can set up a 529 plan. For long-term health expenses, you can set up a Health Savings Account. For immediate dependent-care and health expenses, you can set up a Flexible Savings Account. Be careful that if these expenses do not materialize, much of the money in the account could be penalized heavily. I don’t have first-hand experience with these special plans, but if you know for certain that you’ll have certain educational/medical/dependent-care expenses in future, you should explore these plans as a way of reducing your tax bill further.

The last and potentially more lucrative tax exemption of all, is Charitable Giving. Every dollar you give to charity is a dollar you will not have to pay taxes on. Note that your tax savings will always be smaller than the amount of money you’ve given to charity. So you will never become more wealthy by doing this. However, if you find yourself wanting to give back & help those less fortunate, this tax deduction is an excellent way to pay less in taxes while simultaneously making the world a better place.

Managing your Investments

In an earlier section, I linked to the following investment calculator. Try spending a few minutes playing with the Rate-of-Return field, and see what effect it has. Spoiler alert: It’s huge. Every 1% increase in your rate-of-return, can gain you an additional $100,000. Managing your savings & investing it wisely, will have an enormous impact on your retirement nest egg. Every small detail will make a difference of tens of thousands of dollars, so definitely educate yourself thoroughly on this topic.

There are some excellent services out there, that manage all your investments for you. If after reading this section, you still feel uncomfortable managing your own investments, you can further explore using such services. But knowing the basic principles of investing is still something that will serve you very well.

The very first decision you’ll want to make, is finding a balance between stocks and bonds. The stock market has historically averaged ~10% returns per year, but is also a lot more volatile. Long-term bonds (US Treasuries) have historically averaged ~6% returns per year, but are much less volatile (particularly if held to maturity).

As you earlier saw from the investment calculators, the difference between 10% and 6% can easily cost/gain you half a million dollars. Finding the right balance between the two depends on a lot of factors, such as your age, income and temperament. The conventional rule of thumb is that you should invest your (age-10)% in bonds, and the rest in stocks. There are also more sophisticated questionnaires out there, that will recommend a more customized asset allocation to fit your specific circumstances & outlook. You can use these to figure out the stock-bond balance that is right for you.

A quick note about CDs and savings accounts. In contrast to stocks and bonds, CDs cap out at ~2% returns, and bank savings accounts barely reach 1% returns. Their returns are so abysmal, that you should never rely on them except as temporary holdings. If you ever find yourself in an emergency where you need money immediately, you can always sell your stocks/bonds from your brokerage account, and raise the money you need within a day. Even if you were to realize a loss due to market conditions, it still beats tying up your money in savings accounts offering abysmal returns every single year.

At this point, if you don’t already have one, you should set up a brokerage account from which you’ll be able to buy & sell stocks/bonds. I personally use ETrade because of their low costs, and have always been fully satisfied with their service. Once you’ve set up your brokerage account, you can get the associated routing number, and have your savings be automatically direct deposited into it from every paycheck. ETrade also allows you to electronically transfer money for free, from any checking account to ETrade and vice-versa.

Once you’ve figured out your plans, set up your brokerage account and have the money to invest, let’s discuss the nuts and bolts of making an investment. There are all sorts of financial wizardry you can engage in, but since this is intended to be an introductory guide, I recommend the following bare bones approach to get yourself started

For stocks, buy Vanguard Total World Stock ETF (Symbol: VT)
For bonds, buy Vanguard Total Bond Market Index Fund (Symbol: BND)
When placing an order:
1. wait until the market is in session (M-F, 9.30am – 4pm, ET)
2. set the order-type as “Market”
3. divide how much money you want to invest, by the latest price, to get the quantity
Because ETrade charges a $10 commission for every trade, do not place small orders
1. wait until you have ~$500-1000 saved up, before placing an order

Once you get more comfortable, you can deviate from the above and pursue other investment strategies. For example, you can invest specifically in Emerging Markets, International Developed Markets, the S&P 500, US small-cap, and various Bond Funds. I personally like to divide up my investments equally among all of the above.

Quick note about Bond Funds: Ignore all numbers listed except for SEC Yield. The SEC Yield tells you what interest rate you can expect to receive on that fund, and that’s the only statistic that has any relevance whatsoever for the future.

You can do your own research before committing to portfolio, but always keep in mind your two goals:

Diversification, across all different companies, sectors, markets and locations
Minimal expense ratios: 0.2% or lower

For example, when you invest $1000 in the Vanguard Total World Stock ETF, you are literally investing in thousands of companies, in every single market segment, across ~50 different countries. Even if a number of these companies were to go bankrupt, or their countries were to fall into civil war, your overall portfolio would still hold up reasonably. And you are getting all this for an extremely low expense ratio of 0.2%.

In contrast, buying individual company stocks places a lot of risk on your portfolio, and actively managed mutual funds charge expense ratios of 1% of more, despite consistently getting trounced by passively managed funds. No matter what specific strategy you decide to pursue, always buy Index Funds & ETFs.

One last point to make here, and this might be the most important of all. We are absolutely horrendous when it comes to market timing. The average investor’s track record over the past 30 years is an abysmal 1.9% returns per year, in painful contrast to the 10% returns that the S&P-500 index has achieved during this same time. The reason for this? People consistently & repeatedly sell their stocks, or stop making new investments, whenever the markets are panicky. As a result, they then miss out on the dramatic upswings that happen right after a crash.

Do not let this happen to you. The smartest & most business savvy investors out there have tried very hard to time the market just right, and they have mostly failed. Once you’ve set up a 20 year plan for yourself, stick to it, paycheck to paycheck, no matter what the talking heads on television might be saying.

Buying vs Renting a home

Housing tends to be one of our biggest expenses and/or investments. Hence, the decisions you make about your housing situation, will have a very large impact on your long-term financial security.

It can also be one of the most complicated to figure out and get right. Under some circumstances, buying a house is an extremely wise move. Under other circumstances, it will prove to be a big financial setback. To figure out what is right for you, I highly recommend using the following NYTimes Rent-vs-Buy calculator. It can help you make sense of your local property market, and figure out whether buying a home is a financially savvy move for you.

One caveat to mention here, if you choose to rent a home. Renting is certainly cheaper than mortgage payments in the short term, and if you choose to rent, these calculators are all assuming that you’ll be investing the difference in stocks and bonds. Hence why renting can sometimes be a better decision than buying – investing the difference in stocks and bonds can sometimes be more lucrative than buying real estate.

However, this only works if you remain disciplined about maintaining your own personal savings plan. If you simply pay your rent and save a minimal amount of money on the side, you’ll be shooting yourself in the foot.

Buying a home & signing a mortgage is like enrolling yourself into a forced savings plan. Every month, the bank will give you a call and very forcefully suggest that you stick to your savings plan, by making your mortgage payment. Nobody likes others telling them what to do, but if you’re lacking in financial discipline, this can be a godsend. On the contrary, if you choose to rent your home, the pressure will be fully on you to make sure that you remain disciplined & invest significantly in your own savings plan.

To be sure, buying a home can certainly be an emotional decision, as well as a financial one. If you choose to buy (or rent) a home, despite the numbers recommending otherwise, that is certainly a valid choice to make. But be honest with yourself about what it really is – luxury spending. There’s nothing wrong with spending money on the things that make you happy, as long as you’re aware of the choice you’re making and can afford to do so.

Building up your Credit Score

If you ever find yourself wanting to buy a home, or take on a loan, having a great credit score can save you thousands of dollars in interest payments. Fortunately, it is also one of those things that don’t require much conscious effort to attain. With a few small tweaks, and good financial practices that you should be following anyway, you can be on your way to building a great credit score.

Always pay your bills on time, no matter what. In fact, I’ll go one step further and say that all credit card balances should be paid off in full, every month, no matter what. If you don’t, the interest rates on those balances will bleed you dry. If you can’t afford to pay off your credit card balance in full, you should not have spent the money in the first place.

If you ever have any loan that charges you 10% interest rates or more, you should similarly pay it off as soon as possible. On the flip side, if you have any loans that charge 4% interest rates or less, make all your minimum payments, but do not pay it off early. You’ll be better off investing the money in stocks & bonds instead, which offer 6-10% returns.

Use only a fraction of your available credit limit. Ideally, 10% or less. For example, if you have 2 different credit cards with a combined credit limit of $20,000, you should only use $2,000 of it. If that isn’t sufficient for your expenses, request a credit limit increase, or pay off your credit-card balance multiple times during a single month.

Build up your credit history, and hold on to it. Open up your first credit card as early as you possibly can, and hold on to it for decades. Use some amount of credit regularly. If you have the choice of paying for something using your credit card or cash, use your credit card. If you have the choice of buying your car outright or taking on a low-interest loan, take the loan. Every 2-3 years, ask your credit card company to raise your credit limit, even if you don’t need it.

You don’t want to have too many different credit cards or loans, but it does help to have around 3 sources of credit active at any one time. This will allow you to build up your credit history and establish your reputation as a reliable borrower.

There are websites out there that will give you free copies of your credit report, and others that will help you monitor your credit rating and give you customized recommendations on what you can do to improve it. It might be worth your while to explore these for a few months, just so you can better understand your credit score and what you can do next to improve it.

Career Planning

I’ve put this section last because it technically doesn’t fit into the category of personal finance, but it can have a larger impact on your finances than anything else mentioned above. The best possible investment you can ever make, is an investment in yourself. More specifically, an investment in your education & skills.

If you’re a high school dropout making $30,000 per year, you’ll have to scrimp and save just to have a financially stable future. In contrast, if you’re an MBA grad making 6 figures, you can afford to really enjoy life, while still saving for a luxurious retirement. Investing in yourself to bridge the gap between the two can be stressful in the short-term, but can pay off spectacularly within a decade or two.

A word of warning here: Bad investments do exist, and so too does bad educational expenses. If you’re spending $200,000 attending a private college and majoring in Art History, that may not be the best financial investment.

However, there are many other degrees and career paths that one can follow, which are very lucrative. For example, you can become a Registered Nurse simply by attending community college, and it pays $65,000 per year on average. Similarly, there are plenty of other lucrative career options that can be unlocked by enrolling yourself in an Associate’s Degree program at a nearby community college. If you’re willing to study longer and aim higher, there are plenty of college majors available at public universities, with extremely strong career prospects as well. For someone with a college degree and looking to grow their career further, doing a 1-2 year Master’s in a related field, or pursuing an MBA, can help them take their career to the next level.

There is no easy answer here, and the ideal way to grow your career will differ for each person. But considering the outsized impact it will have on your financial future, it’s certainly worth some serious thought, research and active planning.

Conclusion

There certainly is a lot of information covered here, and it’s very easy to feel overwhelmed if you’re coming across this information for the first time. Rest assured that there’s no way anyone can put into practice all the advice given here, in a single day. Start off slow, and start off small. Bookmark this page, or make a list of all the things that you need to do. Every day, look at the list and work towards ticking one item off of it.

It may take a few months to get everything done, and that’s completely fine. Life isn’t a sprint, it’s a marathon. Focus on taking just one step at a time, and before you realize it, you’ll be amazed by how far you’ve come.