Everyday More Salt & Less Pepper: FI Wisdom From Years Of Mistakes & Miscues

While recently getting my hair cut by the same person who has cut my hair for the past 12 years or so, she looked at me sheepishly and said “Mike, times are a changing…it seems like every time I see you, you have more salt and less pepper.” After a moment of bewilderment, I realized she was telling me that my brown hair was gaining more and more gray hair over time. Her statement, while funny, and true, was also a reflection of the years that have gone by in my journey to financial independence. Then I thought about it. Its been 30 years, 8 homes, 6 jobs, 3 kids and 2 careers since I started my FI pursuit. I have learned a lot. Some learning has come from wise decision making, but most, it seems, has come from my mistakes and the steps to overcome them. Here are four FI lessons from many years in the FI pursuit:

 

Tortoise & The Hair

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Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – Warren Buffett

Warren Buffet, perhaps the single greatest investor of our time, is credited with this famous quote. Unfortunately, it has taken me the past three decades to get it through my head that loss prevention is the higher priority over the risk of chasing huge returns. See, I have been invested in the stock market all this time. And for most of the time, I only invested in what I knew, which was high tech stocks. At the time I was in the industry. The good news was that high tech stocks have had some incredible returns. Years like 1995 through 1998 come to mind when the annual returns ranged from 20% to 37%. The bad news is that those same stocks had some horrible losses. The years 2001, 2002 and 2008 come to mind. The net result was that I made, and lost, two huge fortunes in the stock market since 1983 with very little to show for it as of the 2008 financial crisis. Hence, starting in 2009, I started to put Warren Buffet’s rules into place and have been rewarded handsomely for it. What I have learned: Slow and steady wins the race, just like the story of the tortoise and the hair. You don’t have to chase high returns with high risk stocks to get a good return. Preventing losses is more important than sporadic years of high returns. In terms of my stock investing, that means investing in high quality stocks, with a proven record of profits, growth and good management operating in good markets. For the most part, I invest in strong dividend stocks which also helps guarantee a decent return. I also re-balance my portfolio to lock in profits and lessen the chance of large losses should the market turn. While I have not had huge annual returns in the past nine years, I have not experienced ANY negative return years. The end result is that compounding the small but regular annual returns have produced more wealth than the previous 25 years of investing combined.

The Few, The Proud, The Life Goals

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“If you aim at nothing, you will hit it every time.”― Zig Ziglar

Early in my FI pursuit I had vague, long term goals: Something about retirement, kid’s college, independence and travel. Blah, blah, blah. I focused on climbing the corporate ladder and thought regular promotions would take care of meeting my eventual goals. It wasn’t until the first major stock market crash in 2001 that I realized that my goals were too vague and too long term to foster the best FI actions. It’s true, when you aim for nothing, you hit it every time…and go nowhere! What I have learned: Have specific goals in all aspects of financial independence. That includes quantitative giving goals, savings goals, investing goals, as well as qualitative goals for gratitude, contentment and peace. The reason why? The quantitative goals provide concrete targets that are easily measured for motivation and a sense of accomplishment. The qualitative goals help us round out the true independence spirit (Freedom from worry or anxiety) as well as give more meaning to what FI is all about.

Set It & Forget It

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When I was younger, I would invest regularly, but only after I paid all my bills. Some months I had a lot to invest, but others, not so much. It was irregular at best. Also, as mentioned above,  in those early years, I really didn’t have stated financial goals. The end result was I never knew if I was on track with my saving and investing. What I have learned: As I have aged, and truly learn to appreciate having financial goals and the power of compound interest, I have learned, first, to order the allocation of money as such: Give first, save second, then spend the rest. Meaning, I give to my church and God first because He deserves it. Then I save (pay myself) second after giving to ensure all my savings goals are met. Then, I make my spending plan (budget) based on what is left over, never spending more than I have. Here’s the best part: I use technology to automatically give, save and pay bills so that I am faithful, regular and not consumed with handling money. Simple and easy.

Sacrifice Good For Great

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“There is no progress or accomplishment without sacrifice.”
Idowu Koyenikan

Sacrificing to reach a goal has never been foreign to me. Sacrificing time and effort to get in shape to play high school and college sports was normal for me. Sacrificing fun and parties to get good grades was expected of myself. But somehow, when I got into the working world, and made good money, I didn’t want to sacrifice the trappings of success for the purposes of reaching a bigger, and better, goal. What do I mean by that? I wanted, and got, the bigger house, the nice cars, the big vacations. In some ways, I was trying to stay up with the Jones…and it was very unfulfilling. Bigger homes and nicer cars cost more money and take more upkeep. After a while it felt like my stuff owned me. What I have learned: Foregoing good things, like a bigger home or a nicer car, and using that money for great things like financial independence, helps speed up the process to independence and true wealth, in a big way! I have learned to cherish my smaller home (low taxes, less to clean, less room for stuff to build up) and my old car (paid for) so that I can use the money instead to fuel financial independence! Sacrificing good stuff for great stuff also helps me appreciate everything I have even more. And guess what? I don’t miss the bigger home or nicer car. Sure, they were fun to have but they are not as fulfilling as the long term goal of financial independence.

More Salt – More Focus, More Intention, More Better!

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“There are no mistakes, save one: The failure to learn from a mistake.” – Robert Fripp

Yes, the hair is getting gray-er and the time is flying by. But, a lot has been learned and hopefully, that knowledge can be helpful to others on their way to financial independence:

  • Consistent investment gains in solid stocks are better than the vicissitudes of high risk/reward stocks.
  • Quantitative and qualitative goals help focus FI efforts,
  • Automated Fin Tech tools help assure the Give-Save-Spend prioritized relationship,
  • And, sacrificing good stuff for the sake of great stuff speeds up achieving your FI goals.

Financial independence is not easy, but it is worth it! As one of my kids would say when they were young: It’s more better!

 

What Do Aging Athletes And Financial Independence Have In Common?

I am passionate about sports and I have been that way for as long as I can remember. More so playing them than watching them but nevertheless, passionate. It was football, baseball and basketball in high school. Then, football and baseball in college. Followed by softball, basketball, tennis, cross-fit and competitive running thereafter. And all the while, I have lifted weights and worked out as a way of life. I love it. It makes me fit, I feel good and it’s cheaper than a psychiatrist when it comes to working out your daily problems! But over time, or more specifically, advancing in age, has a way of catching up to you when it comes to physical performance!

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I remember playing sports in my twenties and it was so easy to perform: Stretching the muscles was easy, as was gaining strength and endurance. If you got a little bit out of shape, you were able to get it back really fast. It wasn’t until I turned 34 that I realized my first reduction in athletic ability. I lost a step. I was moderately fast and running the bases while playing softball I was thrown out going from first to third on a base hit. For the first time ever!  This was my first dose of reality that athletic ability diminishes with time.

Then, I went into my forties. Now I was introduced to regular soreness after working out, coupled with a longer time period to fully recover from the workout. What used to take 24 hours to recover now took at least 48 hours. In addition, it took considerably longer to get in shape. At a twenty something, it felt like three weeks of solid work would produce a great fitness level. But by forty something, it took every bit of eight or nine weeks to feel really fit and even then, I wasn’t sure if I had reached the highest level of fitness. The other side of it was also true: As a forty something, it felt like six or seven days of not working out resulted in losing every bit of fitness and you had to start over again from the bottom of the fitness ladder!

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Then I reached my fifties…and a further reduction in athletic ability, with more aches and pains, and longer recoveries. It was in my fifties that I had to fully accept my physical limitations as an athlete. I could no longer deny that past performance levels were long gone and unreachable.

What Do Athletics Have To Do With Financial Independence?

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At this point, you might be asking, what does athletic ability have to do with financial independence? And I would understand if you did. But follow me here for just a moment. Because the lessons learned as I have aged as an athlete are directly applicable to the process of obtaining and maintaining financial independence. How, you might say?

First, It’s About Time

As an aging athlete, it takes time to get ready to perform. Much more time than it used to as a younger athlete. You need to take the time to fuel your body right before the workout. You also need to stretch and stretch a lot. In other words, you need to be patient  and prepare correctly before you can really perform.

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The same is true with the pursuit of financial independence. It is over time that one can develop wealth. It usually doesn’t happen overnight, and, expectations to the contrary can build unwanted anxiety or stress. To build wealth that can lead to financial independence requires saving and investing money over a long period of time, in order to produce a return. This patient approach to building wealth, and as a result, financial independence, is both time proven and considerably less stressful. There’s one more piece to the time element to develop wealth and that is compound interest.

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Saving money over time is only the first part of the equation. The second part, and largest part, is investing the money and letting compound interest work to develop an exponential wealth effect. What does that mean? It means that investments over time will produce far more profits than the amount of money you actually put into the investments. It is a multiplying effect. An example: A one time $2000 investment with a 6% annual return will yield $xxx after 40 years. But if you left it accumulate for only 20 years, half the time,  you don’t have half of the 40 year amount, you have only xx% of it. It takes an investment in time, using compound interest, to develop wealth, and it grows more and more each year. Just like it takes time as an aging athlete to prepare for a workout to produce athletic results.

Limitations Can Be Your Friend

As an aging athlete, you have to recognize your limitations or else run the risk of hurting yourself. When I was 21 years old I ran a five minute mile as part of a fitness test in college as we were getting ready for my junior year of college football. I’ve got NO CHANCE of running that same five minute mile now, regardless of my preparation or efforts to perform at my best. I need to accept my limitations or risk being deeply disappointed or getting hurt when I tey. In essence, I need to be content with my diminished performance level.

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Contentment is also a key foundational element when it comes to financial independence. Without contentment (Being happy where you are, while on your way to where you are going), what you have will NEVER be enough. You will always think in your mind: “I need more to be happy, or rich, or successful, or wealthy, or (fill in the blank).” Part of being financially independent is to be independent of envy or perceived need for something to make you complete or happy. In fact, only when we can learn to be content in the moment, combined with gratitude for what we have, can we be truly independent of envy, covetousness and the sense of lack. There is certainly nothing wrong with ambition, but when that ambition prevents you from ever feeling secure, peaceful or blessed, you can never truly be financially independent.

Three Cheers For Consistency

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As an aging athlete one of the most important fundamentals of working out is consistency. You need to consistently stretch, consistently eat right, consistently hydrate and consistently work out because of what I mentioned before about losing your fitness level fast! When you can get into the appropriate consistent rhythm, your workouts and performance can be very rewarding.

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The same is true when it comes to financial independence. I have found that most financially independent people I have met didn’t hit the lottery or write a best selling novel to develop instant wealth, but built that wealth over time with consistent savings and investing. What do most of the financially independent people do consistently:

  • They save money consistently
  • They invest consistently
  • They live on a budget in order to meet their goals consistently
  • They track goals consistently to stay focused and on track

Consistency also lessens the sting of living below your means. If you consistently put money into an emergency fund, a retirement fund and a vacation fund, you eventually get used to that money being “gone” and you don’t miss the spending power in your day to day budget. Consistency is so important to old athletes and people pursuing financial independence alike.

Taking Advantage Of Technology

As you get older, an aging athlete is wise to take advantage of new technology to increase their performance, and comfort. There are new fabrics on the market that wick away your sweat while you perform. Running in the Texas heat, I depend on moisture wicking clothing. There are new shoes of all types that help you run faster, farther and with more comfort. There are new training apps that help you work out at peak performance. There is an abundant amount of new technology that can help you better perform.

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There is also new technology to help you obtain financial independence. There are tools like Mint to help you track your expenses and budget, Acorns to help you save spare change, Robinhood to help you invest and most banks now have automatic deposit and withdrawal for 401K plans and emergency savings accounts. Use technology to achieve your financial plans: In most cases it is easy, cheap (as in free), automatic and efficient.

Last, Know Your Why

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Motivation is paramount when it comes to working out or achieving financial independence. People ask me all the time: At your age, why do you workout so hard, and so consistently? It’s easy. I do it because it makes me feel great, it clears my mind, it challenges me and it helps me sleep so soundly. In other words, my “why” is to feel better and, God willing, live longer. It is worth it to me to put the effort in now, to feel better later. We need to “know our why” in the pursuit of financial independence too. We need to know why we are budgeting, saving and investing because it sure would be fun to live life unrestrained now. It would be fun, but it would not help us reach our goal of financial independence. Our financial independence “why” we sacrifice now is so that we can be independent later. Independent of money worries or stress and to be independent to follow our heart’s desire. To move working from something we have to do to survive, to something that we choose to do if we want to. Financial independence is not easy and it does not happen overnight. Just like trying to get into and staying in shape as an older athlete. But by using time to our advantage, practicing contentment, being consistent, taking advantage of technology and knowing our why, we can better enjoy the process and eventually achieve the goals of feeling good and experiencing financial independence at any age!

If you want more information on financial independence and/or the steps to get there, consider Dave Ramsey’s book “The Total Money Makeover”. Click the image to enjoy instant savings.

The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

I Think I Have A Better/FASTER Way To Financial Independence! Fact or Fallacy?

I’ll get right to the point:  I think there’s a better and faster way to grow passive income in order to achieve financial independence! We are committed dividend stock investors looking to build wealth through stock market investments. But I’ve been learning/studying for the past two years and implementing a new investment strategy the past nine months and the results are promising. Let me run this income producing investment strategy by you and help me figure out if this is sustainable or just a short term phenomenon that can’t be maintained to and through retirement from full time employment.

Path To Financial Freedom

We’re not much different from your average FI enthusiasts. My wife and I live below our means, have eliminated all debt except the home mortgage, have a six month emergency fund and invest aggressively, including in retirement and taxable accounts,  to develop long term wealth. We have set aside money for our last child’s college fund (two are already out of the house) and we invest in our Health Savings Account for current and future medical expenses. In terms of investments, we are deeply invested in dividend producing stocks and our account is equally dividend between stable, high dividend yield stocks and faster growing dividend growth stocks. Our stocks produce an average 2.8% annual dividend yield, growing about 11.5% annually. All in all, our stock portfolio has averaged a total annual return of 18% including dividends and appreciation over the past eight years. Everything mentioned so far is pretty straightforward and consistent with most FI practices.

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Also consistent with standard FI practices, my wife and I have been planning to develop wealth that is 33 times our expenses (assuming a 3% annual drawdown in retirement to be conservative). While we are well on our way to meet that goal, a new (to us) passive income path presented itself a couple years ago that I have studied and now implemented for the past nine months with incredible (to me) results. The results have been so good that we are re-thinking our FI goals, amounts and timeframes. In addition, the new (fairly) passive income stream seems to be sustainable into retirement.

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Conservative Options Trading As A Significant Passive Income Source

Hear me out. Monthly dividends are and have been a consistent income source. If we didn’t invest another dollar in the stock market and retired in a couple years from now, dividends would produce one third of our income needs in retirement. But its not enough to be safe as the rest of our financial needs would need to come from asset (stock) appreciation and sales. So two years ago we started studying option trading, focusing on a fairly conservative approach to produce additional monthly income. Then, nine months ago, we implemented the following monthly options trading plan:

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  • Each month, we sell out of the money (OTM) puts on premiere dividend and dividend growth stocks to produce immediate income and give us the chance to buy well researched, desired stocks at a discount. If the option expires OTM, then we keep the premium. If the stock price falls and the option is in the money (ITM) then we get the premium and we “get to” purchase a dividend producing stock on sale. Both are wins to us. (In general, we target to earn 1% or more on the monthly option premium each month and use an OTM strike price that is at least 5% lower than the stock price.)
  • Each month, after much research and analysis, sell OTM covered call options on the dividend stocks we own at strike prices that meet or exceed our researched sell price target. If the option expires out of the money, we keep the premium as income. If the strike price is met, we get the premium AND a nice profit from the sale of the stock. All proceeds from the sale of stock are then reinvested in more dividend producing stocks. (In general, we target to earn .5% or more on the monthly option premium each month and use an OTM strike price that is at least 10% higher than the current stock price.)

That’s it. Each option has a one month duration. If the option expires OTM, the money is then reinvested in options for the next month. Some call that “Stock Option Rinse and Repeat”.

The Results, So Far

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Thus far, the options trading income nearly quadruples the monthly dividend income. Take a look at these results:

  • We are averaging a monthly return of 1.79% (or over 21% annually) on the sale of put options. We have made over 250 put option trades in the nine months, with 236 expiring out of the money and 14 put options being assigned. We have purchased great dividend champion and dividend growth stocks on sale, such as ABBV, LOW, QCOM and CSCO.
  • We are averaging a monthly return of .99% (almost 12% annually) on the premiums of covered call options! We have made over 100 covered call option trades in the nine months, with 94 expiring out of the money and 6 call options being assigned. We have sold some great dividend stocks but got a large premium for the sale, at least 10% higher than our target sales price. Usually these sales result because of a higher than normal run up of the stock price. So our covered calls allow us to cash in profits on unusual spikes in price. Then all proceeds from the sales of stocks are reinvested into other dividend stocks. Sales have included stock in CSCO, STX, SBUX and ETP.

Summing up the performance of this income strategy over the past nine months we find that the total income return by adding the monthly option trading premiums to the monthly dividends equals 18.15% on our entire stock portfolio not including stock appreciation. (The stock appreciation during that timeframe was 19.1%) After taxes, fees and other costs, the net return on trading and dividends, or net income, was slightly over 12%.

 

The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

So, Working Backwards, Doesn’t That Mean…

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Let’s take that 12% net annual income return and reduce it by a small safety factor to 10% to be conservative. And let’s assume we do not want to spend any of the stock assets nor any of the stock appreciation. Just keep letting that build. Let’s also ignore social security and any other side income. Where does that leave us? I think that leaves us needing an investment base of 10 times expenses to meet our total retirement needs. Let’s take a look at some actual numbers to this situation: If we need $7,000/month to live comfortably in retirement, or $84,000 a year, doesn’t that mean we will need $840,000 of investable assets to produce that income ($840,000 X 10% = $84,000)?

But let’s continue to make the case more conservatively. Let’s assume that you trade options on only a portion of your investments, say only half of your investments. So, for option and dividend income to cover $84,000 in annual expenses, you would need roughly $1.2M of investable assets (This assumes dividends from all of the investments but options trading on only half of the investments).

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The net result: I don’t think we necessarily need an investment account that is 33 times expenses to retire comfortably. I think with conservative options trading in conjunction with a stock portfolio of dividend and dividend growth stocks, that a couple could retire with an investment account that is only 15 times expenses.

Fact or fallacy ? Set me straight…

 

Now for something different: A look into the life of the most polarizing president of our time:


Understanding Trump

Miter Boxes, Mallets & Money: Just A Bunch Of Useful Tools, Sometimes!

Know Your Tools

It is important for a carpenter to know his tools. For instance, a carpenter who is a cabinet maker intimately knows how to use a miter box. And most people, especially carpenters,  know what a hammer is and basically how to use it. Actually, there are several types of hammers that specialize for different functions. There’s is the claw hammer, sometimes called a common hammer, a ball pein hammer, a club hammer, a framing hammer, a sledge hammer and many more that make up the hammer family. Then there is a mallet, which is similar to a hammer but not exactly the same thing. A mallet is a hammer with a large, usually rubber or wooden head, used especially for hitting a chisel. It is the right hammer for wood carving and delicate wood working. But when you use the right hammer in the wrong application, it can be bad, even painful. See, one day, a while back, I used a mallet to try and knock some flooring into position. The flooring was heavy and I  didn’t want to mark the flooring so I used a rubber headed mallet to try and knock it into place. I should have picked up the flooring and moved it by hand, but I was tired and it was late and I had the mallet readily available. So I pounded at the flooring to move it across the floor into place. All went well until it didn’t…on one particular swing I got distracted, took my eyes off the flooring and proceeded to hit myself in the foot with a heavy blow. My initial reaction to hitting myself in the foot was one of embarrassment. But as the sensation made its way to my brain, my embarrassment was quickly replaced with severe pain. It hurt so bad. Bad hammer!

You see, this was a classic example of using a perfectly good tool the wrong way, which resulted in the tool not being productive at all, but being a pain (literally) that hinders progress instead of contributing to it. I guess the moral of the story is that tools are very useful when used (and viewed) correctly, but can be counterproductive if used incorrectly.

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Money Is

Money is similar to a hammer in that when viewed and used properly, is a great tool that can help you achieve your goals, but when used incorrectly, can be counterproductive and possibly painful. Money, being a central part of financial freedom, must be viewed and used properly or else be counterproductive to the pursuit of freedom. This is a good lead-in to defining what money is, and by extension, what money isn’t.

  • Money is: A medium of economic exchange and a tool to build wealth. As a tool, it is like a hammer in that you have to get it (some), learn how to use it, take care of it, use it correctly and manage it so that it provides value to you.
  • Money is: A temptation. If you let money be your goal, be the focus of your desires and the answers to your problems, it can tempt you to worship it, hoard it and let it define you.
  • Money is: A test. As we learn each lesson about money we walk away a little bit wiser and a little better equipped to use it going forward. But if we don’t learn our lessons, we are doomed to repeat our mistakes.
  • Money is: A testimony. Our decisions (wise decisions or struggles) with money and finances in general, are a large part of our testimony to our spouses, peers, neighbors and children.

 

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Money Is Not

It is just as important to define what money is not. Although our western culture wants to paint a picture that money is the root of happiness, power, status and popularity, money is just a tool, not the basis for our identity. Let’s take a look at what money is not:

  • Money is not: A measure of success or our sole goal. There are many successful people that have a lot of money, but not having money does not make you unsuccessful. Likewise, there are/were some incredibly success people that had virtually no money. Many, if not most of your artists, missionaries and teachers fall into that category.
  • Money is not: A component of self-worth. Money is a tool, not something that defines who we are or our value to our families, communities and corporations.
  • Money is not: A reward for good living. Money doesn’t care if you are good or bad. Good living is a reward in itself. If you are a person of faith, you know that the true blessings are things such as peace, joy, love, grace and contentment.
  • Money is not: A guarantee of satisfaction. Money does not guarantee happiness or contentment. In fact, most people who look to money to be their source of satisfaction  never seem to have enough of it.

 

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Use It, Keep It, Take Care Of It But With The Proper Perspective

Money, when kept in the proper perspective (as a tool) and used correctly (as a medium of economic exchange and a tool to build wealth) can lead to financial freedom that includes peace, contentment, options and freedom from worry. But when used incorrectly, as a measure of success, self-worth or a guarantee of satisfaction, can lead to the opposite of freedom: Entrapment, discontentment, misery and, yes, pain, just like that mallet story I told earlier. Our lives change for the better (financial freedom being the main objective) when we view money as a tool and not as our goal.

Looking for more help with your finances? Try Dave Ramsey’s book: The Total Money Makeover. Order here and SAVE!
 
The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

And Then There Was One

 

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On The Path To Financial Freedom

To this point, the path toward financial freedom has been straight forward. The budget is in place. All consumer debt has been paid off, including cars, student loans and credit cards. Emergency fund is all set. Same is true with college savings for our last child in the house. We are saving and investing 15% toward retirement and tithing 10% to our church. And any left over money gets invested in a taxed account that will be used for future purchases.  Last, everything is automated so it “just happens”. Now, time and compound interest should produce results that lead toward freedom freedom. So far, so good. Now there’s only one debt left to deal with, the home mortgage, so the big question is: Do we pay off the mortgage, our last debt,  or do we invest that money to meet future needs?

Two Choices, Is One Better?

I think the choice between paying off an existing mortgage on a primary residence or investing that money to growth wealth is a matter of priority between financial freedom and financial independence. They are the same thing, you might say? I don’t think they are. Financial freedom puts peace of mind at a priority, including freedom from money worries and anxiety. So that would favor paying off the mortgage, because a debt, any debt, is an obligation that presumes we know and can control the future. Unknown-3It presumes we can make all the payments, but that is not a sure thing. Because in a 30 year mortgage, (15 year mortgage if you are really savvy), a number of things can go wrong that are out of your control and could prevent you, or hinder you greatly, from paying the mortgage like job loss, physical injury or other family health related issues. Yes, an emergency fund certainly helps in these circumstances, but if peace of mind and total freedom from money worry is the top priority, you probably would pay off the mortgage as soon as possible to ensure you always have a place to live.

Want financial freedom but don’t know where to start? Start with Dave Ramsey’s Total Money Makeover, click and enjoy!


The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

Financial independence, on the other hand, prioritizes choice over freedom. And it is quite possible that investing the money, instead of paying off the mortgage, can provide more choices. Choices like work (or not to work) choices, location choices and purchase choices. The assumption here is that the return on the money invested is greater than the savings in interest paid on the mortgage. And for the last ten years, including the financial recession of 2008-2009, that has clearly been the case. First, let’s look at the math.

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The Math – The Easy Part

Simply put, the cost savings by paying off the mortgage in the last ten years has been significantly less than the return on investment if that money was put into any S&P500 Index Fund for investment. This is how it works out for me: Mortgage interest rate of 3.875% minus the mortgage interest tax break (use a conservative tax rate of just 10%) gives you an effective cost of the mortgage money around 3.5%. Another way of saying this is that the financial benefit of paying off your mortgage is roughly a 3.5% return on your money. Compare that with investing that same money in a simple S&P500 Index Fund for the same time period, ten years, which according to Fidelity Investments, returned 7.5% annually, not including dividends. Minus out the taxes on that return and you have an after tax return of roughly 6.7%, or almost double the return when compared to paying off the mortgage!

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But There’s More

The math between our two choices is the easy part. Clearly, investing money instead of paying off the mortgage will generate more value. In my example, investing produces almost two times the return as paying off the mortgage. But there are several other factors to consider:

  • Peace of mind – Clearly paying off the mortgage will give you great peace of mind but it will cost you. In my ten year example, the investment difference of investing the money instead of paying down the mortgage is worth over $115,000! That is a high cost for peace of mind but for those that are truly risk adverse, it may be still worth it to pay off the mortgage.
  • Cost of the mortgage – If your mortgage interest rate is over 5%, the financial freedom of paying off the mortgage may be worth it, since the financial benefit of investing the money is much smaller. But, something else to consider, if your mortgage interest rate is that high, consider refinancing your mortgage. Today’s rates are much lower.

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It’s A Personal Decision, Possibly An Expensive One!

For me the decision is simple, because my investments actually did far better than average over the past ten years, (10% including reinvested dividends) and my mortgage rate is fixed at 3.875%, I choose to continue to invest our money instead of using that money to pay off the mortgage. Our six months of expenses emergency fund gives us peace of mind as far as making the mortgage payments, as does our long term disability insurance. Worst case, I can change my mind any time and pay off the mortgage with a portion of the investments. But the priority is to invest the money for a greater return. Assuming my wife and I live an average life span and we keep the money invested in the market, we can expect to earn about $400,000 more dollars by this decision than if we decided to pay off the mortgage. That certainly helps calm the nerves about having a mortgage!

What do you think? This is what I think: Financial freedom (or independence) is hard work, but it is worth it!

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The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

Kissing Frogs & The Pursuit Of Financial Freedom

 

It’s Been A Long Time

It seems like I have been really busy working on our family’s financial freedom since the start of the new year, but you can’t tell by the number of posts I have made (three). We have now officially completed one quarter of the new year and as I looked at my progress toward financial freedom, I see my blog post productivity going down, but seemingly my effort going up. What gives? So I took an inventory of what I have been doing. This is what I found: I made a lot of progress in finding side hustles and passive income. By that I mean I found what works and doesn’t work for me and my family for side hustles to help us meet my financial freedom goals. I want to share both our side hustle successes and failures to help others finds their path to financial freedom!

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Kissing Frogs

At the start of the new year I made it a goal to find side hustles that could grow our passive income or side income. I found some great ones that I can see my wife and I doing for the rest of our lives. But not before trying a whole bunch that just did not work out with our lifestyle and priorities! Like the fairy tale says: Sometimes you have to kiss a lot of frogs before you find your prince! We kissed a lot of frogs and found a couple princes.

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Before we take a look at what works for us, let’s review the side hustles that I pursued that did not meet our goals. Note: This is not to say these side hustles are bad and you should never try these. These all worked to some degree over a three month period but were not what we were looking for. Take a look at what didn’t work for us: Our Frogs

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First, I tried to make money with the apps Ebates and Ibotta, getting rebates on household purchases but I found that our frugal lifestyle doesn’t gain much in the way of rebates. In fact, I found the opposite, I found the temptation strong to buy stuff I didn’t need in order to get the rebate (That’s probably the point). So I stopped those.

Second, I tried the apps, Swaybacks and Receipt Hog, where you scan and track your receipts and earn money doing so. But after three months I only made $10 bucks, so the payback was not there. What did I expect on only grocery store and gas station receipts?

Then I tried flexjobs.com doing data transcription, but that was a lot of work for just pennies an hour, literally. Not right, so I stopped.

As a budding photographer, I wanted to see if selling stock photography on iStockphoto.com could earn us some good money, but after 3 months I learned that I can only make about $2/hour selling my stock photography online. So it is not a good source of side income.

I learned a lot by trying these forms of side hustle, but they weren’t for me. The payback was too low and the impact on our lifestyle was too great to keep pursuing them. So I looked for other sources of side income, and found a couple that really worked, sort of:

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Downsizing Pays Dividends

My family decided to downsize and de-clutter our home. We didn’t physically move, just simplified and changed our style to one of a clean, de-cluttered look. In the process of repainting, recarpeting and removing all the old knickknacks and decor, we developed a huge pile of stuff to get rid of! That pile was the “inventory” for a huge garage sale, quickly followed by online selling through Craigslist, Facebook and Ebay. The results were great! We sold almost everything, including old stereos, clothing, furniture, cameras, shoes, jewelry, toys, stuffed animals and anything else you can think of. It kind of stung at first, getting rid of all that stuff. Some of it sentimental. But once we got started we made over $1500! The good news is that we made good money for such a small amount of work. The bad news is, we ran out of stuff to sell! However, this selling spree did open the doors, and our eyes, for us to sell other stuff we find in our travels on Ebay and other online marketplaces. I would characterize this side hustle as a huge success but you need constant inventory to keep selling online. We would need to find a source if that were to become a regular part of our side hustle income stream.

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From Frogs To Princes

One of our 2017 side hustle goals was to generate $2,500 a month in side hustle income. The online efforts listed above weren’t going to get us there and the reselling of stuff on Ebay helped a lot but would not be consistent because we ran out of inventory to sell. So the next thing we tried was dividend investing and options trading. Now these forms of side hustles are not for everyone, but I’m pretty sure they are perfect for us!

First, dividend investing. I have been an investor in stocks for a long time, but only recently adjusted my investing strategy to dividend investing. For many years I was simply a growth investor, investing in growing companies who, for the most part, reinvest all their earnings into the business. This type of investing had done well for us but it was not generating any side income. And the vicissitudes of the stock market were not letting me experience financial freedom. I was not free of worry and until I sold the stocks, there was no real profit. But dividend investing seems to be my thing! In November and December I researched everything I could about dividend investing and made a plan which I executed in January. I reorganized my investments to include many dividend champions and aristocrats that started paying dividends right away. For each of the last three months, our dividends have increased and the payback on the time invested to research and buy stocks is exceptional. Far better than the $2/hour I was getting woking on selling stock photography! Our goal of averaging $1000/month in dividends is well within reach and something I really enjoy.

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The other side hustle I really enjoy and have had some success with is options trading. Again, option trading is not for everyone, but it is for me, because I love the research and technical analysis. And with the help of some really smart mentors, I have come up with a simple and easy way to generate income, leveraging my stock investments that are already in place. My process is really pretty simple: Each weekend, do my homework and make a plan that I then execute the following week. The time commitments are not very taxing and so far, for the first three months of 2017, have been quite fruitful. So much so that I believe our $2,500/month in passive income is doable and sustainable.

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Lessons Learned From Kissing Frogs And Finding Princes

As you can see, I was really busy pursuing side hustles for financial freedom these last few months, but you can’t tell by the few blog posts I made, (now four). But the lesson learned is that it takes a while to find your financial freedom voice and pursuit. For us, financial freedom is in the form of frugal living, ample savings and some extra income through two side hustles: Dividend investing and options trading. It took us a long time, and a lot of effort to sift through a number of side hustle opportunities to find what works for us. And we are not done yet by any means. We will keep trying new things to build our passive income in pursuit of financial freedom. I hope I get back to sharing more financial freedom via this blog over time too. In the meantime, keep on hustling and never stop pursuing your financial freedom. It’s hard work but worth it!

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The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

The Financial Freedom Letter I Want To Write To My 30 Year Younger Self

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Letter To Self

Dear Self,

Freedom is a big deal. Great people in our country have fought and died for it. And financial freedom is no exception. If you start early and 1) aggressively save,  2) use the power of compound interest and 3) exercise some budget restraint, you can achieve complete financial freedom and transition into retirement at an early age. What does this mean? You will have the freedom to choose if and where you work. You will have freedom from worry about money and the anxiety of debt. You will have freedom to chase your dreams and spend time in those things you are passionate about. Sound good? I think so too. If you are seriously interested in financial freedom, listen carefully. There are just a couple simple actions you need to take right away. They require immediate commitment and action. Still interested? Then read on…

Begin With The End In Mind

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The first step toward financial freedom is to know your “why”. Actually, it is to know your “what” and your “why”. The what we already discussed. The what is to retire from full time employment at an early age and to experience financial freedom. To go a little further, let’s be more specific. The what is to retire by age 55 and have the freedom to pursue the passions of your heart, namely: tropical beach centered living, travel and generously giving back in my community. That brings us to the why. The why is that financial freedom allows me to contribute the most to my family and to society in general. I am more valuable to my family, community and God if I am financially free to live and serve others without the constraints of a full time job or full time financial worries. Let’s get started.

Save And Invest From The Start

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You’re 22 years old and fresh out of college, making a good salary in a growing industry. Your first step is to save aggressively. You just came out of four years of living frugally on the college campus, so before you expand your cost of living with the new salary, dedicate yourself to save 30% of your salary from the first paycheck on. That’s right, 30% right off the top. Have the savings automatically deducted from your paycheck before you see it in your checking account. That way you don’t even miss it, because you never had it to spend in the first place. Where will the savings go? Three places to start: 1) 10% of your paycheck will go into an emergency fund until it gets up to one month’s of expenses. 2) 15% will go into your retirement account, offered by your employer, and includes a matching program. 3) The balance, 5%, goes into a new investment account. Once the emergency fund totals the equivalent of one month’s of expenses (enough for a single guy with a stable job, for now), that 10% of your paycheck will be added to the investment account (now totaling 15%). It’s that simple. Do this and your on your way to financial freedom…but not there yet.

Keep It Simple And Watch It Grow

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You were taught compound interest and investment principles in college, but go back and learn them again. What will you learn? That compound interest of savings that is invested in low cost, equity based investments develop rapid growth of wealth. Let’s go over the basics in some detail. The emergency fund goes into a checking or savings account and does not earn any investment return, but acts as self-insurance. This is called “sleep at night” money because it helps you sleep at night knowing that you can cover most of the unexpected little costs that come up in every day life. The emergency fund is the single biggest deterrent to mounting credit card debt. In turn, credit card debt is the single biggest threat against financial freedom, so we want to avoid consumer debt at all costs.

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The retirement account goes into the company 401K program as a pre-tax investment which lowers your taxable income and is eligible for the company matching program. That means the 15% of your income that you put aside from each paycheck automatically gets another 5% (50% match up to 10% of your income) added to it and then gets invested in low risk equity based mutual funds. This retirement savings, match and investment gets done automatically, each paycheck, before you see your paycheck.

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Last, your regular investment savings goes straight into a low cost equity index fund. Specifically, an S&P 500 Index Fund, which over the course of history has produced a 10% return annually. It’s that simple. Save money, invest money, let compound interest do it’s thing. What’s the key? Have the money automatically taken out of your paycheck so you don’t see it or be tempted to spend it before it goes to your investments.

Embrace The Budget

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To ensure you stay disciplined in your regular savings, embrace living on a budget. What does that mean? Develop a spending plan and learn to live (and spend) by it. Take the 70% of your paycheck that is left after savings is invested and allocate the money for living expenses. It’s pretty straight forward but you would be surprised how many people do not have a budget and lose track of their spending, only to end up broke or in debt. Here are the big budget items and targets for spending:

Housing (house payment/rent, utilities, insurance, taxes, HOA): 30% of net monthly pay

Auto (Car payments, gas, repairs, insurance, etc): 15% of net monthly pay

Food (Groceries, toiletries, eating out): 15% of net monthly pay

Debt Payment (No debt payment, no credit card balances, start off right!)

Generosity (Tithe, donations, etc): 10%

Entertainment (Fun, travel, vacations, pets, hobbies): 10%

Living Expenses (Clothes, gifts, household stuff, medical): 10%

Misc. 10%

Make a budget, live by that budget and get comfortable living well below your means by learning how to find low cost or free entertainment, food, transportation and household needs. You will not miss anything important by keeping your cost of living down. It’s that simple: Save, invest, live on a budget…and oh yeah, compound interest!

Enjoy The Ride

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I’ll say it again, it’s that simple: starting right out of college, save 30% of your paycheck, invest in an emergency fund, a retirement fund and low cost equity investments, and live below your means using a simple budget. Those are the primary vehicles to financial freedom. Because, over 33 years, from age 22 to 55, using the power of compound interest, those investments turn into something much bigger than the sum of the savings made over that time. Let’s take a look at the math with a couple assumptions:

Starting pay right out of college: $50,000 annually.

Assume 3% annual salary increases, pay by age 55 is $128,000 annually

Total savings over 33 years at 30% of income (Age 22 to age 55): $1,030,550 including company match

Investment value at age 55, given the following returns: emergency fund 0%, retirement fund 6.5%, investment account 10%: $2,991,000

That much money, almost $3M, produces $120,000 a year in annual income at age 55 (4% rule) or $10,000/month, which supports just about any lifestyle. More importantly, this income, allows for full financial freedom! And this does not include other income sources such as social security. In addition, by starting your saving and living on a budget early, and investing regularly, the process to achieve financial freedom was simple and easy. Compound interest does the heavy lifting. It turns your million dollars of savings over 30 years and into three million.

Start early, be disciplined, trust investments over time and the power of compound interest. It’s that easy!

Sincerely, The older you.

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Free Money! What Do I Do With It?

Free Money!

Maybe its money from a long lost relative. Maybe its a business deal or stock trade that went far better than planned, or maybe its a big tax return check or a bonus. We all LOVE getting money we weren’t expecting. I call that free money! Boy, the possibilities start to enter your mind on how to enjoy that money! I’m not talking about the dollar bill you found on the sidewalk or the five dollar bill folded up in a pocket. Those finds are sweet, don’t get me wrong, but I’m talking about some serious money that could afford something big, like a vacation, a new car or a whole lot of fun! If you’re like me, my head can get filled with ideas on how to use the money real quick. So years ago, when I was in one of these sweet situations, I had to stop for a moment and come up with an approach to dealing with large amounts of unexpected money so that I would make the best use of this new windfall. I call it the 30/50/10/10 plan. Here’s my approach:

Before We Get Started

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Before we get started let’s do two things: First, take a moment and list your overall financial goals and objectives. It helps to look at the big picture before we get into the details. For me that’s pretty simple: 1) Live in complete financial freedom, 2) Provide for my family, 3) Responsibly help in my community, 4) Pursue our passions. What does that look like practically?

  • No debt, no money worry or anxiety, no dependence on others for our needs
  • Ample savings for emergencies, retirement, family/house needs, and college expenses
  • Live on a balanced budget and teach our kids to do the same
  • Tithe to our local church plus support some local charities
  • Travel!

Second, before we use the free money, subtract an amount for taxes and (in our case) our tithe so that we know the real amount available for use. Typically, that totals about 30% of the free money. This is the 30 in the 30/50/10/10 plan, meaning the first 30% of the free money. In other words, if we received $10,000 of free money, we would put aside about $3,000 for taxes and tithe, ( giving thanks to God and giving Uncle Sam his portion), then plan to use the remaining $7,000. By doing this, we eliminate a nasty surprise come tax time at the next of the year when the money is all spent and we have nothing to pay the taxes with. Now we are ready to use the rest of the free money. But what do we do with it?

Step #1: Pay Yourself (The “50”)

Since financial freedom is our top priority, always, we need to pay ourselves first, in the form of eliminating debts and/or adding to our various savings and investments. At least half of all free money goes to paying ourselves first. This is the 50 (50% of the free money) in the 30/50/10/10 plan. First step: pay off any outstanding consumer debt. Is there a credit card with a balance still on it? Pay it off first. No questions asked. If there is no credit card balance but there is a car loan balance or a student loan balance, we make payments to pay down that debt. Next, if we paid down our debts and we still have some of that half left, we pay ourselves by adding to our savings and investments in this prioritized manner:

  • Top off our emergency fund, if it needs it, which when full, stands at three month’s worth of expenses
  • Extra savings for upcoming household needs: replacement used car, replacement washer and dryer, etc
  • Money towards the kid’s needs: College 529? Summer camp?
  • Add to long term investments
  • The retirement fund already gets maximum contributions from the budget so it gets a lower priority for any free money allocation.

Again, about half of the available free money goes to paying off any debts and/or savings, with the hope that we can achieve a milestone of some sort that we then can celebrate as a family.

Step #2: Celebrate!

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Celebrate! Take some of the free money and take time to celebrate 1) the free money and 2) the debt reduction and savings milestones you achieved in step #1. If the free money allows us to completely pay off credit card debt. Awesome! Let’s celebrate that. If the free money allows us to purchase, with cash, a good replacement washing machine because the old one died, great, let’s celebrate. If we can put some money away for that next vacation, celebrate! You get the idea. Most people don’t celebrate saving money or paying off debt, but most people will get excited about achieving a milestone. Take the family out to dinner, or go to a movie, or something that everyone gets excited about.

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Let your kids know what you are celebrating so they connect the fun with the milestone. The celebration doesn’t have to be big. Just big enough to make the point that the free money is an unexpected blessing that allows you to obtain or maintain your financial freedom as a family. The money to celebrate is a portion of the first 10 in the 30/50/10/10 free money distribution plan. In fact, step #2 and step #3 (explained next) combined make up the full 10%.

Step #3: Meet Family Needs

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Now’s a good time to put some money aside for upcoming family needs. These are things like kid’s school expenses, clothes, a delayed car repair or shoes. This money can also go toward a date night with your spouse or attending a special event. This money allows us to catch up on “want” expenses. Those purchases or experiences that make you feel special but don’t qualify as a “must have item”, like an emergency fund or putting money towards retirement. As mentioned in step #2, the combined total of money spent in steps #2 & #3 is not to exceed 10% of the free money.

Step #4: Be Prepared…And Generous (The Last 10)

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Want to really experience financial freedom? Try taking 10% of your free money, after you have tithed, paid Uncle Sam, saved, eliminated debt, celebrated and bought something special for that someone special, and set it aside…for what comes your way. That’s right, set aside money for living, and helping, in the moment. Do you have a friend that needs a little help? Maybe that friend just lost her job and you feel like you’d like to bring over some groceries. Use this money! Maybe you get an opportunity to help a local charity. Use this money. Maybe you’ve got wedding/birthday/Christmas presents you want to purchase, outside your regular budget. Use this money. Take 10% of your free money and set it aside as a contingency to help and/or bless others as you feel moved to do so. You may be surprised how freeing this money makes you feel, because it gives you the freedom to act in the moment. This is the final 10 in the 30/50/10/10 plan.

Financial Freedom Is Better

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Coming into free money, that is, a large amount of money that you did not expect to get, is wonderful in and of itself. But free money that is allocated in a way that supports your financial goals following financial freedom principles is even better. Why is that? Because the money is allocated consistent with your long term dreams and priorities. Let’s recap the free money allocation discussed here:

  • We gave thanks to God for the free money (Tithe)
  • We set aside a portion for taxes so that there would be no “gotcha” come tax time
  • We paid off debt
  • We saved and invested money for future needs, emergencies and dreams
  • We celebrated the blessing of the free money
  • We invested in some family  wants
  • We set aside money for opportunities that come our way

That is great use of money we never expected to get. It is invested in both our present and future needs that the whole family will benefit from. This distribution of free money is also generous, grateful and opportunistic, which goes a long way in our quest to live in financial freedom. What do you think of the 30/50/10/10 model? Let’s us know what you think! However you use your free money, I hope you achieve and maintain financial freedom.

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The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

How Much Should I Be Saving? a.k.a. Prior Planning Prevents Poor Performance

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Knowing What To Do, And Doing It, Are Two Different Things

In January of this year, Fidelity Investments published a report that said we need to be saving at least 16% of our net spendable income (total income minus taxes and charitable giving). It went on to say that we really need to be saving closer to 23% of net spendable income if we want to be sure to have enough money to fund most of our dreams and plans. Yet, in that same article, Fidelity reported that the actual American savings rate is actually in a range between 4.5% to 7% of net spendable income. That’s right, Americans are saving roughly one third of what we should be saving. So what does that mean? Does it mean we only have 4.5-7% of our money left after paying our bills to go towards savings? Or maybe it means that we aren’t serious about the American dream, including retirement, travel and helping our kids with college. In any case, let’s take a look at what we should be saving for, how much we should be saving, and why it matters.

Categories Of Savings

Before we discuss the categories of savings, we should determine WHY we need to save. We save money from each paycheck to 1) build wealth to fund our lifestyle, dreams and goals, 2)self-insure against disaster, 3)  raise our families and 4) to help others through generosity. When there is enough savings to cover all four of these areas, we are well on our way to financial freedom. If that is the case, then there are four types of saving we need to maintain:

  1. Emergency Fund
  2. Retirement
  3. Family/Kids Savings
  4. Future Needs Savings

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Emergency Fund

First and foremost is an emergency fund. This is money set aside for true emergencies so that we don’t rely on debt when an emergency strikes. In fact, the emergency fund is the number one way to keep out of debt, as it is the most cost-effective self-insurance. How much emergency fund is enough?  Most pundits agree that somewhere between three months and six months of expenses is the right range for an emergency fund, depending on your risk adverseness. Once the emergency fund is fully funded, we do not need to continue to fund it. But every time we dip into the fund, we need to re-fill it to prepare for the next emergency.

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Retirement Savings

The second reason to save is for retirement. Let me say it another way. Once we have funded an appropriate emergency fund, we need to start saving for retirement, and the earlier we start the better because of the power of compound interest. There are many theories about how much and where you should save for retirement but the fact remains that we must prepare for life after full time work and/or old age. It is not our children’s responsibility to take care of us when we are old but our own. How much do we save? As a general rule, target 25 times your annual expenses as the amount you want to have for retirement. And though this amount varies for each individual, there are some smart rules to follow:

  1. Start saving for retirement early, letting compound interest work over decades of savings.
  2. Take advantage of tax preferred accounts like 401K, Roth, SEP and IRA accounts to minimize taxes
  3. Take advantage of employer matching plans and/or other employer retirement benefits

How much should we be putting away for retirement each month? Experts suggest we save 15% towards retirement.

images-3Family/Kids Savings

For those raising families or expecting to raise families, we need to be saving for known children expenses, including school, marriage, cars and other events (think summer camp and travel) that are assumed to occur. For most of us, this can be done over many years so slow and steady savings can meet your needs. Why not start savings accounts for each child on the day they are born? Where should we save this money? 529 Plans come to mind for their education. Also trust accounts or ESA’s. But they should be separate from our day-to-day funds and take advantage of tax preferred accounts if we know the money will be used for higher education. How much should we be saving each month? Experts suggest  3-5% of our pay.

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Future Needs Savings

Life happens and it can be expensive. All of us have autos, homes, furniture, appliances and other items that wear out or need upgrading over time. We need to be saving for these eventualities. Since these savings are short term in nature, less than 10 years, the money needs to be invested in something that is safe but returns more than the cost of inflation. Maybe a safe low cost, low turnover mutual fund or an ETF. How much each month? Again, 3-5% of pay.

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Total It All Up

Savings must be a part of the monthly family budget. Savings is as important as the rent, food and clothing. Why? Because savings, when invested correctly, generates the wealth needed to fulfill goals and dreams. Want to retire some day? Invested savings is the answer. Want to send your kids to college? Savings is the key. Want to stay out of debt? Saving, in the way of an emergency fund, is the only way to prevent credit card debt when (not if) an emergency occurs.

What are we looking at when it comes to savings as a percentage of net income? When you add it all up, it really is between 16-23% of our net pay. Wow! Some people even suggest it should be 30% of our net pay. That’s a lot. But it pales in comparison to the financial and mental cost of debt, worry and anguish that comes when “life happens” and we don’t have funds set aside to deal with the emergencies. Or don’t have the money when a car of some other piece of equipment wears out and we can’t replace it. What is the alternative? Credit card debt? Student debt? Auto loans? Line of credit? All of these option are expensive and ultimately steal away financial freedom.

Here’s the mindset we must have as stated by Warren Buffett: “We must spend what’s left after saving, not save what’s left after spending.” Instead of trying to save what’s left after spending, we need to make savings a priority and right-size our lifestyle to live comfortably on what’s left after saving.

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Save And Invest Money Or Pay Off Debt?

The question of which is most important, saving and investing money, or, to pay off debt, is much like the age old question: Which came first, the chicken or the egg? Cases for both answers have been convincingly made. For some, this question is easy and they pick either saving or debt reduction as first priority and do it. But to others, the lack of clarity as to the priority has cause them to pause, or even worse, caused them to not act on either priority. So where do you start to answer the question? I think it starts with understanding why we save or eliminate debt. We save and/or eliminate debt to obtain financial freedom. Financial freedom defers for each person, but it is rooted in having the resources to pursue one’s goals and dreams. This financial freedom allows us to be free from worry and concern over money and be free to achieve our long term goals.

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Financial freedom, in most circles, is predicated on four main principles, which include saving and investing to build wealth and eliminating debt. The other two core principles are living within a balanced budget and insuring against disaster. It is the first two principles, building wealth and eliminating debt, that sometimes get at odds against each other. Because many times, debt reduction and savings for investment compete for the same dollar in our budget. It’s a common dilemma that goes something like this: If I only have limited money available to achieve financial freedom, is the priority to pay off my debts or should I save and invest the money to earn a decent return? On the one hand, we have debt, the wealth killer that is to be avoided or eliminated as a top priority. On the other hand we have the need to invest to build wealth to fund our goals and dreams. Both actions are paramount for financial freedom. But which action is the MOST important? Which action comes first?

The Case For Eliminating Debt First

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Debt is an obligation that assumes we know, and can control, the future, in that debt requires regular payments over time which we can’t 100% control. Job loss, natural disasters and health issues can interrupt future payments. Debt is also expensive. Here’s some examples: Home mortgages cost us 4% (Interest rate on the money borrowed) and it only gets more expensive from there: Car loans and student loans are between 3%-7%, and the worst, credit cards, cost anywhere from 10% to 25%. This means that the couch that we purchased on a credit card for $1,000 and made minimum payments on for many years ended up costing us about $2,400 in all. In essence, we had to pay a fee of $1,400 to borrow $1,000 for the couch. Ouch, that’s expensive. And in comparison to the return on money invested in most safe investments, like money market accounts, certificates of deposit or savings accounts, which only pay a percent point or two in interest at most, most debts are more costly than any safe investment return received. So one could argue that paying off our debts is the top priority.

The Case For Investing First

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Building wealth, another core principle in financial freedom, is about investing early and often and letting compound interest work over time. It is imperative to start as early as possible, so we should make saving a priority. In addition, the return on investment for  blue chip equity investments, like an S&P500 index fund, is higher (averaging over 10% per year including dividends over the past 75 years) than the cost of some debt that people carry, like student loans, home mortgages and car loans. So, it could be argued that it is better to invest the money than to use that same money to pay down debt which has a smaller return. In other words, if I can make 10% on my investment, why would I instead pay down debt that only costs me between 3% to 7%?

A trusted source for all things investing: The Street

 

What’s The Smart Decision For Financial Freedom?

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The answer to the question: Should I pay off my debt or save for investment to build wealth?, is rooted in the current condition of the four main principles of financial freedom mentioned previously:

  • Live within a balanced budget
  • Insure against disaster
  • Building wealth
  • Eliminating debt

If you’re reasonably insured against disaster (have an emergency fund) and you’re living within a balanced budget, then eliminating debt is the top priority. But if you don’t have both an emergency fund or a sustainable balanced budget, then the priority shifts to getting those right before attacking the debt.  Let me explain a good way to approach it.

Step #1: Start an emergency fund. Do you have an emergency fund? If you have no emergency fund, then the first priority is to save up at least $1,000 in an account for emergencies. Why is this the first priority? Because an emergency fund is savings to PREVENT further debt associated with any unexpected emergency. It is self-insurance, a key component of financial freedom. We’re not done with the emergency fund quite yet. More on this later. To recap, the first priority is to establish an emergency fund if you do not have one.   If you already have $1,000 saved in an emergency fund, or better yet, your emergency fund covers 3-6 months of expenses (discussed later) then skip this step and go straight to step #2.

Step #2: Eliminate debt. Within the confines of a balanced budget, treat consumer debt with extreme prejudice. What does that mean? It means after a minimal  emergency fund is established, the next priority is to eliminate the consumer debt (and a commitment to stay out of consumer debt).  How would I do it? I would list all my consumer debts (all but the mortgage for now) and rank them by the interest rate paid on each. Then I would pay the minimum amount on all debts except for the one that has the highest interest rate. That one I would pay as much as possible (while keeping a balanced budget). Personally, I would cut back on my lifestyle and use that saved money to make as big a payment as possible each month until it is eliminated, all the while staying within your budget. Here’s an example using the chart below:

This person has three debts, with amounts ranging from $1,000 to $5,000, and through squeezing his budget, can allocate $500/month towards paying down his debt. In the chart below you can also see interest rates and minimum payments. The first step it to prioritize the debt by interest rate. In this case, the first priority is the Visa card at 16%, then the MasterCard and last the Student Loan (See Priority Column). At this point, we pay the minimum payment to all debts except for the top priority. So we pay $125/month toward the MasterCard and $50/month toward the Student Loan. But the top priority, the Visa card, gets ALL of the remaining money available that month for debt reduction, the balance of the $500. In this case, that is $325 ($500 – $125 – $50 = $325). $325 is far more than the minimum payment requested, $60, so the pay off of this loan will be hastened. At this rate, the $1,000 Visa debt will be paid off in full in four months, at which time the payment amount of $325/month gets moved to the next highest priority, the MasterCard. That will make the MasterCard monthly payment $450, while keeping the Student Loan payment at $50/month. Once the MasterCard is paid off, about five months later, all the money will be put towards the Student Loan. In all, using this method called a Debt Avalanche, it will take 18 months to fully pay off all the consumer debt.

Debt Pay Off Plan Available to pay down debt: $500/month
Debt Name Amount Owed Interest Rate Minimum Payment Priority Suggested Payment
Visa Credit Card $1,000 16% $60 1 $325
Student Loan $5,000 6% $50 3 $50
MasterCard Credit Card $2,400 12% $125 2 $125

Step #3: Start serious saving! At this point, we have no consumer debt and $500/month which was used to pay off the debt available to save and invest. But invest in what? There is a priority in your savings and investment. If all you have is the initial emergency fund discussed in step #1, of $1,000, the top savings priority is to build up your emergency fund to self insure against disaster, which could return you to debt. How much is enough? The standard answer is somewhere between three and six months of household expenses, depending upon your risk tolerance. For instance, if your monthly household expenses total $5,000, then your emergency would need between $15,000 and $30,000.

Once your emergency fund is fully funded, it is time to start funding other priorities, starting with retirement. Why is retirement the second priority? Three reasons: first, a retirement account like a 401K, SEP or IRA requires a large amount of time to build up to meet your long term needs. Nothing like compound interest over time to build your nest egg. Second, a retirement account is tax preferred, meaning not only are you saving but you are paying less taxes all the while. Third, many retirement accounts offered by employers have a match program where the employer matches a portion of the savings you commit to your retirement account. In essence, this is free money given to you by your company which then will return interest in your account. How much is enough retirement savings? It is recommended that the full amount by law be saved and invested in a retirement account, roughly 15% of your net spendable income each month.

What’s next after the emergency fund is full and we are meeting our retirement savings needs? If you have children and plan to financially help them attend college, you need to set up and fund an education fund, like a 529 plan, and then contribute an amount that will meet your financial goals and timeframes. We are still not done saving yet. We need to save and invest for future needs too. Cars, homes, vacations and furniture are just some of the things we need to save for so that we don’t go back into debt when it is time to purchase them. In all, there are a lot of things to save for, but using a prioritized approach will ensure you don’t go (back) into debt when an emergency occurs or a large expense is required.

Some Sage Advice

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Warren Buffett is credited with some really sound advice on the topic of saving. To obtain and maintain financial freedom in our lives, he said we need to “spend what’s left after savings, not save what’s left after spending.” Here is where the balanced budget comes into play. It is crucial that we first factor savings into our budget to ensure our goals and dreams are being financed and to keep us from going into debt. Then, and only then, can we determine what we can afford in the way of monthly expenses. So often, people build up a lifestyle that is comfortable, only to find out they can not afford the savings needed to fulfill their dreams. They save money after they finish spending. Then find out there is not enough money left over to save! Make a budget, save first, then spend while not exceeding your income.

There you have it. The answer is quite straightforward, though it is not as easy as deciding between saving or paying down debt. The flow goes like this: Develop and maintain an emergency fund, then eliminate consumer debt, before saving and investing for your dreams and goals in life, including retirement, children’s education, homes, cars, vacations, etc. AND, all of this must fit into a balanced, sustainable budget in order to experience financial freedom. Financial freedom, it’s not easy, but it worth it!

Want more help with your personal finances? Start with Dave Ramsey’s Total Money Makeover. Click the image and SAVE!

The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness