- Personal Finance
How to Make Your Money Work for You
Before You Begin
Before you begin, you need to have some basics in place first.
You need to have a budget. This might be obvious, but how are you supposed to know what you have unless you know what is coming in and going out of your life? Remember, there are three elements to every budget:
What you earn
What you spend
What you save, the difference between earning and spending.
You need to have an emergency fund. Assess the risk that you might suddenly be without income for a while and how long it might take you to find a replacement. For most people, that means having enough to pay all your expenses for at least six months. A year would be better.
Get rid of all debt. All debt comes with interest payments and interest puts a drag on your ability to save. The only debt I want you to have is for the home you live in or if the interest you pay is equal to or less than the rate of inflation. If you have not bought a home yet, wait until your life situation is stable enough that you know you will live there for a while, at least four years. Moving is costly.
You need to have a plan for how to pay for significant events in your life, the birth of a child, college, daughter's wedding, new used car every 15 to 20 years, etc.
You have a plan for retirement. Try to predict the type of lifestyle you expect to have in retirement and how long it might last. Take into account that people live longer and longer lives and are more active longer than ever.
Road to Financial Independence
When you have all of these in place and your budget is in balance, only then should you begin to embark on a journey towards financial independence. Financial independence happens when the return on investments, royalties and other passive income covers all your living expenses and you no longer need to work for money. Your money will work for you so you can concentrate on the really important things in life.
We are going to look at some options for how to make your money work for you. We will look at them in the order of risk. Start with the least risky option. While you do this, continue to widen the gap between income and expenses maximizing your savings.
Transfer half of your emergency fund to a brokerage firm or another institution with interest bearing checking. Many brokerage firms offer checking accounts with no fees or limits, even free ATM access. The interest rate is often better than a savings account. The only thing you give up is the ability to walk into a branch and take cash out. Also, some of these options may not be FDIC insured. Check if this matters to you. Keep the other half in a local savings account so you have instant access.
Next, I want you to take a look at the money you have set aside for life events. Begin with an assessment when you need it and how much you need. For anything less than a year or so, stick with an interest bearing checking account at a brokerage firm or Internet bank. For funds you need in one to three years, CDs are a good choice. The return might be small, but guaranteed so you will know you have your funds when you need them. Learn how to create a ladder so that funds become available at predictable intervals either for spending or re-investment.
For funds you need in three to ten years and the amount is small, say, less than $10,000 , use a target date mutual fund. It is a really easy and hassle-free way to invest. If your amount is larger, most brokerage firms offer model portfolios to match most peoples' needs. They usually have names like aggressive, moderate, conservative or something in-between. Learn about how to pick the one that matches your particular situation. Use a moderate portfolio for funds you need soon and a more aggressive one for funds you need later. You'll be surprised how little you gain by being aggressive and how substantial the return on even a very conservative portfolio can be.
On the other hand, for funds you plan to hold for a really long time, even a small difference in return can make a big difference in how much you will have in the end. For funds you do not need for at least 15 years and you are comfortable with the sometimes wild gyrations of the stock market, use a low cost index fund tracking the broad market. Historically, even the worst 20-year period in the stock market has yielded a return of some sort. For shorter periods, negative returns have happened from time to time. The lesson is that you should not put all your money in the stock market unless you can leave it there for at least 15 to 20 years. For shorter time horizons, hedge your bets with bonds and other fixed income assets.
At this point I know you are asking why bother with this. After all, we are talking about relatively small amounts of money at low interest rates. You would be right, but you would be doing this for a really long time and that is my queue to talk about compound interest.
Julie Jason, in her book The AARP Retirement Survival Guide, gives us this example: What would you rather have, a million dollars or a penny? This is no ordinary penny, though. This one doubles daily. Take the penny. In 30 days, it will have turned into $10.7 million. Of course you are not going to achieve 100% a day return on your money, but the illustration is valid. Take any interest rate, take the number 72 and divide it by the interest rate. The result is the number of years it will take to double your money at that rate. Even at 2%, your money will have doubled twice in a lifetime, money you did not have to lift a finger to get. If you are 25 today, even a modest interest rate on a modest investment will provide significant work-free money for your old age. Use tax sheltered accounts like IRAs, 401ks and Roth IRAs to make it tax free and it will be even better.
Investing in mutual funds is something just about anyone can learn to do. Even discount brokerage firms give you enough guidance to go it alone.
Next, I want you to take a look at your retirement plan. I hope it includes a plan for acquiring, growing and spending. Take full advantage of company matches, investing in a Roth IRA particularly while you are still young, 401k plans and any other tax deferred options. Don't forget about the Health Saving Account (HSA) if it is available to you. It is the best deal around. You don't pay tax on funds you put into it, any earnings or funds you use to pay medical bills. It is triple tax free. Not even the Roth IRA beats that. You have to pay tax on money you put into a Roth IRA, so do it while you're young and your tax rate is low.
Other Options for Income
Now, if you are a more hands-on type person who would get bored easily if all your income came from managing an investment portfolio, here are some other options that might increase your return and have some fun doing it.
If you are a creative person, you are still young and you have some extra time on your hand, this is a good time to write some books or record some music. If your material is any good, the royalties could be a source of income for years to come. One-of-a-kind artwork does not have this potential for ongoing earnings.
Start or Buy a Business
That may not be an option for very many of us, but how about starting a business? Starting a business is a dream lots of people say they have. For some it is a necessity because they are unemployable for some reason. For others, it might be an escape from a boring or hostile work environment. Still others, simply like the excitement of making things happen. Before you embark on this strategy, take a good look at yourself. What is your motivation for doing it? Are you cut out for it? Ask some friends. They will tell you.
If your motivation is to have some flexibility in your life, not just another job, plan to learn how to manage people. If not, you will just be working seven days a week instead of five and for less pay. The goal should be to be able to take a day off any time and the business will still be running when you return. The ability to hire and manage the right people is key. If you cannot do that, choose another option.
Another key to success is research. Is there a market for the product or service you plan to provide. Buying an existing business or a franchise is safer than starting from scratch. Competition is a good thing. It means people are making money in whatever niche you have chosen.
Real Estate Investment Trust (REIT)
How about real estate? The really neat thing about real estate is mortgages. Mortgages allow you to control large amounts of money with a relatively small investment of your own. There are basically three ways to invest in real estate. The easiest way is through Real Estate Investment Trusts (REITs). REITs are a type of securities that invest in commercial real estate like shopping malls and apartment complexes. REITs can be purchased through a broker. They behave a lot like stocks so type A personalities might want to consider one of the other options.
The second way to invest in real estate is to purchase houses in need of repair at below market value, fix them up and sell them again. This option operates much like owning a business as mentioned above. Again, the key is to be able to lead and inspire a team of people to do all the work for you.
The third way to invest in real estate is to buy houses in decent to good condition and rent them. Done right, the rent becomes a constant stream of passive income. The most important skill to make this a success is the ability to read people, to choose good tenants. Bad tenants can become expensive really fast. It is a physically low impact option you can pursue well into retirement.
So there you have it, how to make your money work for you.