This post contains my personal notes about the big ideas in the book Securing your Financial Future- Complete Personal Finance for Beginners by Chris Smith.
This is a wonderful book and I think it should be made a part of high-school curriculum. I wish I had read it 20 years back. Although the book refers to U.S conditions, one can extrapolate the principles to almost any country. This is a big post. Read it slowly, grasp the essentials and you will never be the same again.
PART I: THE ESSENTIAL CONCEPTS
YOUR FINANCIAL LIFE
1. To achieve a strong financial position, you have to get an early start, and from that early start, do the right things, make the right financial decisions, over and over, right from the start. Doing this will give you confidence and assurance that you are on the path to financial independence.
2. Your financial life begins when you have a steady income and have become completely responsible for your own financial affairs. Your financial life ends when you are no longer responsible for your own financial condition. This can be divided into three parts: age 20-40, age 40-60, more than age 60.
3. The first part( age 20-40) is vitally important. The reason why it is important is because of two factors. One is habits. The financial habits you develop during your 20s and 30s will stay for the rest of your life: so it is vital to develop good financial habits. The second factor is time. The earlier you start, the greater the time you have for the power of compounding to work.
4. Money is not everything. Money however plays an important role in our lives. Learning how to manage your money is important for you to get fulfillment in other areas of your life. But remember, that money is not the be all and end all of everything in life.
THE TRULY AMAZING POWER OF COMPOUNDING
5. Compounding is the mightiest force in the personal finance universe!
6. The effect of compounding starts out small and slow, which is one reason why so many people fail to appreciate its power. But eventually it picks up steam, and then the growth really accelerates, and the numbers can get big very fast.
7. How much power compounding has depends on the amount you start with, how long the compounding goes on( the number of compounding periods) and the fixed-percentage increase that occurs after each period( the interest rate).
8. Compounding works for you when saving and investing, but against you when borrowing.
9. Interest rates when borrowing are usually higher than interest rates when saving and investing.
10. Compounding hugely rewards early investments, compared to later ones. The rewards for investing when young are disproportionately very high, and so are the penalties for waiting. It can’t be emphasised too much or too often – start saving as early as you possibly can.
11. Your long-term savings will grow the most the earlier you start, and the higher the average rate of compounding but don’t begin to invest before you know exactly what you are doing. Before learning how to invest, keep your money in a savings account, but not for ever.
YOUR FINANCIAL HEALTH
12. In any endeavour, it is critical to understand what the objective is and how to measure it. In personal financial management, the objective is a strong net worth. Rich, wealthy and high net worth all mean the same thing.
13. A bathtub can be used an analogy to understand the relationship among income, spending and wealth; income is water coming in through the faucet, expenses are represented by water leaving through the drain, and wealth is the resulting water level in the bathtub.
14. Net worth is calculated as assets( things of financial value that you own, measured at today’s fair market value) minus liabilities( debts that you owe to others).
15. Having a high income doesn’t necessarily ensure high net worth. Neither does a high level of spending. Yet these are often mistakenly assumed to be the objectives.
16. The key to increasing net worth is to ensure that spending( water leaving the bathtub through the drain) is consistently less than income( water coming in from the faucet).
17. According to the book The Millionaire Next Door, the most common profile of wealthy people in the United States comes as a surprise to most people; it is various levels of income paired with proportionally modest levels of spending. Evidently the relative unglamorous aspect of drain control is actually highly successful in achieving financial success.
18. The First Rule of personal financial management is this: Save at least 10% of everything you ever earn.
19. The 10% savings is 10% of gross income( before any withholding or deductions)
20. Following the First Rule automatically rules out borrowing of any kind, because borrowing is the opposite of saving.
21. The earlier in your financial life you can begin practising the First Rule, the better. Saving at least 10% becomes a near-automatic habit and therefore isn’t viewed as a sacrifice or an imposition.
THE BIG PICTURE
22. A high income level is helpful in building a high net worth, but it is not a requirement. And contrary to popular belief, a high income is no guarantee of building a high net worth; lots of high-income/high-spending households end up with a minimal, or even negative, net worth.
23. As long as you have a consistent income, even if it is modest, the most important factor in building a high net worth is how much you spend. The surest approach to building a high net worth, and the strategy that is available to virtually anyone, is to control spending consistently to a level that is less than income, year after year. The more of a positive difference you can maintain, the longer you can maintain it, and the earlier you can begin it, the bigger the accumulated net worth.
24. Spending is the real key. And you decide how much you spend – no one else. So no matter whether you call it wealthy, rich or high net worth, the person who is clearly in control of whether you attain that status is you!
25. To be successful in doing so, you have to make a fundamental lifestyle choice of delayed gratification and consistently stick to it. That’s how most wealthy Americans became wealthy.
26. The choice is yours because you are the one who determines how much you spend. That’s the big picture!
THE HUMAN FACTOR
27. Dead right means being technically or procedurally correct, but in a way that isn’t likely to do you much good. Personal finance is filled with potential dead-right hazards.
28. In the left brain-right brain model, the left brain is rational, quantitative and linear, while the right brain is more creative, intuitive and spontaneous. Most newcomers to personal financial management tend to see it as strictly a left-brain endeavour. But that is a mistake, because the right brain is capable of derailing any financial plan. The key is to understand ahead of time what some of the right brain’s most common tactics are and to guard against them.
29. Personal financial management is a very, very long-term endeavour, probably at least 50 to 60 years in length. Operating in this kind of time frame is probably very new to you but is an essential habit to get into. Patience and discipline are at an absolute premium. Be aware that your right brain does not like long-term plans requiring long-term commitment and delayed gratification at all and will try a variety of tactics to prevent you from starting( this will never work, 40 years is a long time, let us start next month, etc). Your right brain will object to your steady, methodical approach but begin anyway. Once you begin, your habits will become obstacles too formidable for the right brain’s objections to overcome, and it will turn its attention elsewhere. Eventually your right brain may even learn to like the feelings of certainty and security that your long-term financial outlook brings.
30. The right brain does not like the whole idea of making important financial decisions about unfamiliar topics and is fearful of making a wrong one. So it will try to convince you to let others take charge and make the decisions for you-the sooner the better. But remember that you are in charge of your financial destiny- and nobody else. Although others may be involved in various ways, you are the one who will ultimately feel the effects of your decisions. Understand, accept and fully embrace this essential fact of financial life.
31. Your right brain can come up with various sneaky ways of making unjustified spending decisions seem logical, but you can overcome these by remembering that all dollars are green, and they all count the same, no matter where they came from or what you compare them to. Adopt a windfall strategy of “100% of any windfall money will go straight into my savings account for a 6 month cooling-off period before I make any decisions about what to do with it.”
32. It is human nature( maybe more like “right-brain nature”) to seek the path of least resistance. This tendency can work against you financially by causing you to treat ongoing, automatic expenses like small expenses instead of realising that they add up to big ones, by inducing you to avoid the resistance required to follow through on rebate requirements, or by generally being lax about financial matters. Counter this by using a monthly budget and by resolving to complete all rebate requirements before using the purchased item.
33. A common challenge that households face is how to go about making, and carrying out, financial decisions; and specifically, who has responsibility for what, and with what limitations. There is no one right way to establish this, but the most common wrong way is to avoid the discussion altogether. Discuss the topic directly, early and often. Find common ground and build from there. Make it a priority to have a well understood and consistent approach to financial decision making in your household.
34. Many decisions have both financial and nonfinancial factors that are important to consider. The left and the right brains may both need to be involved, but make sure that both of them take turns, and the left brain gets to go first. Do this by following a methodical, structured decision process. A good approach is the tried and true pros-and-cons list. Quantify whatever you can and for the others indicate its importance on a 1 to 10 scale or even just an indication of major, minor or medium. This allows a decision to be reached based on a thorough consideration of all important factors. You will make better decisions this way and have more peace of mind afterward.
THE ULTIMATE ACCELERATION STRATEGY
35. Following the First Rule(saving at least 10% of everything that you earn) will result in an increasing net worth. To increase it at a faster rate, you can either increase your savings percentage or increase your income while maintaining the same savings percentage.
36. To increase net worth even faster, increase your income but keep your spending and lifestyle exactly the same. Then continue doing this each time your income increases. This is known as the Ultimate Acceleration Strategy and will get your financial river flowing in the right direction at tremendous speed.
37. The categories of income are active income from your primary job, supplemental active income from one or more part-time jobs, portfolio income( investment income), and passive income( rentals, royalties, dividends, interest on savings). Most people, especially early in their financial lives, tend to think of income as only first of these categories.
38. Active income is limited by available time. But passive income is limited only by how quickly you can establish it.
39. Relying on one primary source of income leaves you completely vulnerable to the potential loss of that income; if you lose you job, or your employer goes out of business, you lose 100% of your income. If you diversify your income sources by establishing supplemental and passive income, you are more protected from the possibility of interruption of any one of these sources.
40. The Ultimate Acceleration Strategy requires increasing your income; income can be increased through your primary job, through supplemental or passive income, or both.
41. The Ultimate Acceleration Strategy will result in very fast-growing savings(and therefore net worth). These savings can be grown further, via compounding. The combination of the Ultimate Acceleration Strategy plus compounding represents an extremely powerful means of building wealth. It is conceptually simple and requires no great sacrifice beyond simply maintaining a constant spending rate and lifestyle while increasing income.
42. The income milestones you will reach if you follow this strategy are:
- Primary income
- Supplemental active income
- Passive income
- Supplemental+ passive income exceeds annual income tax bill
- Passive income exceeds annual expenses
- Passive income exceeds active income( primary plus supplemental income)
- Passive and portfolio income high income to make primary income optional.
PART II: BUILDING YOUR FOUNDATION
43. The best way to control spending is through a monthly budgeting process. This process has four cyclical steps: budget( how much to spend and save in various categories), spend( use the budget to spend), compare( compare spending versus the budget) and learn(improve and correct your budget if necessary).
44. Consistently following this process allows you to continuously improve your skills in managing your spending.
45. One of the most powerful and effective tools in all of personal finance is called Pay Yourself First. To do this, you transfer your intended amount of monthly savings out of your checking account and into your savings account as soon as your paycheck is deposited, before you have a chance to do any other spending. This forces you to spend what is left after saving, instead of saving what is left after spending.
46. A key advantage of budgeting is that it enables you to compare various spending alternatives with one another on a side-by-side basis, in advance, rather than a series of independent yes/no decisions. This ensures a result that is much closer to your intended priorities.
47. Becoming a smart, well-informed consumer involves a commitment to do the required research before making spending decisions, but pays off in the form of much less wasted money and more satisfaction with your purchases.
48. Most of your expenses occur monthly, but some of them are non-recurring. Plan for these expenses in advance, before you need the money to pay for them, by including them in your budget in small, regular amounts. Not every month is the same financially, but the idea is to smooth your nonrecurring expenses out in order to make each month seem the same.
49. Anticipate that you will have some unplanned expenses; they are inevitable. Deal with them by including a contingency fund in each month’s budget. If needed, the money will be there; if not, this defaults to increased savings and net worth.
50. Avoid using currency( coins and bills) whenever possible; it leaves no trail and thus short-circuits the compare and learn parts of the budget cycle.
51. It is very easy to underestimate the true annual impact of small-dollar decisions repeated a large number of times throughout the year, especially when paid for in currency. Budgeting is the best means of detecting and accurately assessing these kinds of expenses.
52. The subscription effect refers to the practice of service providers collecting payment via automated monthly payments. This usually involves low initial rates to attract you to the seller, but these rates are then increased over time, sometimes gradually and sometimes abruptly. Again, the budgeting process is the best defense, providing full visibility to every increase.
53. A complete budgeting cycle is optional but highly recommended. A substitute way to bypass the budgeting process, but strictly commit to the First Rule, is to use the Pay Yourself First technique and the No Borrowing Ever rule.
THE DETAILS OF BUDGETING
54. The first thing to know is what your take-home monthly income is, as compared to your gross income.
55. The second thing is to spend not more than 5% of your gross annual income( if you have no debts) or not more than 4% of your gross annual income( if you have debts). Your budget should be within this limit.
56. Save at least 10% of your take home pay every month.
57. Research how you can cut your current spending smartly.
58. Remember that you have to be in charge and make all the decisions and then follow them. Remember that you are responsible for your financial position and you have to plan and carry out the plan.
59. Changing your smaller, everyday habits, like food, clothes and entertainment is very important.
60. When you really look at what is essential and what is not, it is a lot easier to change spending levels.
61. A good plan is the start, but it does not count for anything unless you follow it.
YOUR CASH BUCKET
62. Insurance cannot cover every possible financial emergency; that’s why you need emergency money, funded by your own savings, which we call your cash bucket.
63. Until your cash bucket is full, you should consider yourself on financial red alert, because you are exposed to financial emergencies. Financial red alert means that your highest financial priority is to fill your bucket, and you should say “no!” to any financial decision that is contrary to that priority. When you are in financial red alert your goal is to spend the absolute minimum amount that you possibly can, and therefore save the maximum amount. You are also in financial red alert if you have any debt apart from a mortgage. You can go into optional financial red alert when you are saving up for a house or when you are contributing to an employer match and your cash bucket is not full.
64. The size of your cash bucket depends on the degree of risk you are facing. The default-size cash bucket is 6 months’ average primary income. Those at higher-than-average risk should use 8 months; those with lower-than-average risk can use 4 months. Your risk level is determined by the likelihood of job loss( industry, skills, seniority, performance ranking), the difficulty that you would have finding another job, whether yours is the only( or predominant) income( more than 2/3rds of your household income) in the household, and the presence or absence of supplemental or passive income.
65. It may take you 5 or more years to fill up your cash bucket, but you can accelerate this by saving more than the 10% minimum, earning supplemental or passive income, putting any windfall or unscheduled gains directly into your cash bucket, and/or by taking steps to earn interest on the money in your cash bucket.
66. The required size of your cash bucket is likely to grow as your average primary income grows. A good practice is to review your cash-bucket requirements and status once a year; you’re likely to need to top off your cash bucket from time to time.
67. The length of time required to fill your cash bucket, as well as the discipline and sacrifice involved, makes some people hesitate to commit to fill it as soon as possible, starting now. But the high risk or ineffectiveness of any of the alternatives makes it filling ASAP your best choice.
68. Your cash bucket should be filled up with money that you can access without delay and without penalty. You would like to earn some interest on at least a part of your cash bucket, but because this money is for emergencies, you won’t risk any loss of principal. A typical breakdown would like this:
- a small amount of currency to serve as household cash( less than a few hundred dollars)
- a FDIC or other insured checking account( no more than 1 month of average primary income)
- a FDIC or other insured savings account( about 1 to 2 months average primary income)
- the balance in one or more certificates of deposit.
BORROWING, LENDING AND CREDIT
69. Don’t borrow any money. When you need or want something, pay in full at the time of the purchase, saving up in advance if necessary. The only possible exception is a mortgage on a house. Do not co-sign for a friend or relative ever. If you have student debt, you should pay it off last.
70. Don’t lend any money. Do not lend money to family or friends, especially more than 10% of your monthly budget. If you feel that you absolutely must, be careful about it, and draw up a formal agreement detailing your expectations. Then be prepared to lose what you have loaned, as that is what happens usually.
71. Always use a credit card to pay, but never use credit. The only way to use a credit card without using credit is to always pay your balance, in full, each and every month, without fail, automatically if possible. If you can’t qualify for a credit card yet, or you aren’t yet confident in your ability to consistently stay within your monthly budget, then use a debit card as an interim “training wheel” strategy until you can.
72. All credit cards are not the same; very good and very bad choices are available. Make your selection based on careful research of information provided by objective credible third parties. Do not make your selection based on advertising, promotions or preselection. Start with one primary card and one backup for emergencies
73. Your FICO credit score is a three-digit-number ranging from 300 to 850 that measures your creditworthiness. It is based on your debt-and-repayment history and nothing else. Three primary credit bureaus( Equifax, TransUnion, and Experian) collect your credit-related transactions, and these are run through software from FICO to generate your score. You can request a credit report from each of the credit bureaus once a year for free, to review the transactions for completeness and accuracy. But if you want to see your actual score, you will probably have to pay.
74. Credit scores are used by lenders of all kinds, including mortgage lenders. This will become important if and when you are ready to buy a house. But increasingly, FICO scores are also being used by a variety of other parties, including landlords, cell phone companies, credit card issuers, and even prospective employers. Therefore, it is in your interest to understand how the score is calculated and to take steps to increase it.
75. Follow the following seven point strategy to safely and easily earn a great FICO score. Since you aren’t going to be borrowing any money, the strategy is based on the responsible use of credit cards. Your goal isn’t a perfect score; it is a score at least high enough to qualify for a prime loan.
- Maintain a spotless payment record.
- Carefully select your credit cards, then stick with your choices; completely avoid all other forms of debt.
- Add new cards slowly, until your credit utilisation is 25% or lower. ( Credit utilisation is your average monthly balance, divided by the total of all your credit limits)
- Ask for credit limit increases.
- Keep your back up cards active.
- Review your credit report three times each year, using the 4-month stagger approach, and promptly request corrections of any inaccurate or incomplete information.
- Order your annual FICO score from each credit bureau after you have gone through the annual credit report review cycle once; and again about 6 months before you anticipate buying a house.
TAXES, RISK MANAGEMENT AND INSURANCE
76. The Eight Tax Rules are:
- Pay your taxes in full, on time, every time.
- Pay the minimum legal amount of taxes that you owe and not a penny more. Tax evasion is a criminal offense but tax avoidance is completely legal.
- Commit to understanding the basics of the income tax and to keeping your understanding current.
- Have an effective record-keeping process.
- Know your marginal tax rate( your tax bracket) and your average tax rate.
- Have a deduction strategy. Deductions are expenses that the tax code allows you to subtract from your income before your tax is figured. Know about standard deduction and itemized deduction.
- Have a tax withholding strategy.
- Know when to seek outside expertise, and what kind.( do it yourself, tax software, certified tax professional)
77. Your risk-management strategy is your means of guarding against financial risk, which is any situation that could result in direct financial harm. Your three lines of defense are (1) avoidance of unnecessary risk (2) insurance, and (3) your cash bucket.
78. Insurance is an arrangement whereby an insurer will assume financial risks on your behalf in exchange for a payment called a premium. It makes sense for you if the probability of the risk is high enough, if the amount at risk is large enough, and/or if the premium is low enough.
79. The coverage amount is the upper limit of what an insurer will pay for a claim, and the deductible is the lower limit. For exposure above the coverage limit or below the deductible, you are on your own. Raising coverage amounts and lowering deductibles increases premiums and vice versa. You have to remember that there is a possibility of financial loss but the premiums are certain.
80. The most common mistakes that people make in the area of insurance are not understanding their choices, buying either too much or too little, not adjusting coverage as life circumstances change, failing to notice and evaluate premium increases and falling into the subscription trap, and selecting an insurer who doesn’t pay claims reliably, fairly, and promptly.
81. A typical progression of insurance types for someone early in their financial life is health, renter’s and car insurance, followed by homeowner’s and life insurance.
82. With life insurance, use only term insurance, nothing else.
83. Private mortgage insurance is needed if you pay less than 20% down-payment on a house. But you should never buy a house unless you put down 20%. Hence you should never pay private mortgage insurance.
84. Long-term care insurance should be considered only if you are in your late 40s.
85. You don’t need a will if you have no dependents or if your net worth is less than $ 100,000. But as soon as you meet either of these conditions, you do need a will, no matter your age and health. It is a must.
86. Living trusts are important once your net worth becomes large(say over $1 million) or if there is something unusually complex about your assets or about the way you want to distribute them after your death.
87. A living will allows you to express your wishes in advance, in the event that you become incapacitated and unable to communicate them for yourself. You can advise health care professionals as to what they should do, if you become very unwell. It might be worthwhile considering this as well.
PART III: BIG TICKET ITEMS-CARS AND HOUSES
When you buy a big ticket item emotion can often overrule logic. The person who is selling the big ticket item probably has more experience and may try to take advantage of you by emotional tactics. When buying a big ticket item, remember that you have to sell it one day. Future resale potential needs to be your primary concern in any big-ticket item purchase.
88. When you buy a car use the Total Cost of Ownership model to select a a car, which will force you to consider net price( total cost to buy, minus the likely resale value). You want to select a car that will depreciate the least during the time you will own it. Getting the best net price means selecting a car you can resell in the future for only a little bit less than you paid for it.
89. Zero in on relatively older cars with relatively few miles.
90. Shoot for the makes and models with relatively higher MPG ratings. Apart from the net price there are costs to own and operate a car. These include gas, maintenance, insurance, parking, and regulatory fees( such as tab or tag renewals and emissions tests). The single biggest element of total cost is the cost of gas. Therefore buy cars with higher MPG ratings. The other costs are service and the number of miles you will drive.
91. Ask for help from others when you need it, remembering that automotive and scam- avoidance knowledge are necessary for a good financial outcome – not just financial knowledge. Know about vehicle identification numbers, title, registration and service schedule of a car.
92. Familiarize yourself with the Kelley Blue Book or NADA Guides websites to become knowledgeable about car prices and the factors that influence them. You should decide how long you are going to own it and how many miles you will put on it each year. Then use the above resources to calculate the private party value ,” x” number of years ahead. The cost of the car minus the private party value is the net price. The car with the lowest net price is what you should buy.
93. Shop carefully, considering the pros and cons of dealers as well as private individual sellers. Use websites and publications to guide you. Always negotiate. When you have made your final decision, pay in full at the time of purchase.
94. Follow the service schedule for your car and keep the records from each service.
95. If you are considering alternative technologies, be careful; the goal is to select the right alternative, the one most likely to survive. Don’t be an early adopter because you can be stuck with an orphan technology.
96. The best way to save money on owning and operating a car is to minimize the number of miles that you drive it.
97. Don’t buy until you have saved enough on top of your regular 10% minimum savings and outside of your cash bucket. You can fill your cash bucket first and then start saving for your car. You can save more than 10% of your income-put 10% in your cash bucket and anything more than that into car savings. You should not stop filling your cash bucket while saving for a car. You should not borrow money to buy a car.
98. Don’t buy a new car. Buying a new car is a net price loser every time. The two things that cause a car to decline in value are age and mileage. When it comes to age, cars begin to depreciate very quickly right away. Resale value takes a big hit the first few years as buyers move on to new styles. As car enters “middle age” age-related depreciation slows down. Mileage related depreciation is based on how long the engines in various types of cars will last before needing a major rebuild. It starts slowly and speeds up as the time goes by. Therefore cars that are older, but with relatively low mileage tend to be the biggest net price winners.
99. Don’t buy a car until you have verified that you can afford the new, ongoing costs within your monthly budget while still being able to maintain your savings rate. This means, even with the costs of owning and operating a car, you should still save 10% of everything you earn. Till then do something else: public transport, carpool, bicycle, move closer to work, car-sharing cooperative membership, informal short-term rental, get a job closer to home, or any other alternative.
100. Don’t try to save money by skipping or stretching out service intervals.
SHOULD YOU BUY A HOUSE?
101. Buying is almost always a better financial choice than renting because of the opportunity to recover a big portion of your expenses on resale and because of significant tax advantages.
102. A house means any structure that you legally own and live in most of the time – which allows you to designate it as your primary residence for tax purposes.
103. Even though buying a house is almost always the best financial choice, many risks are involved. One of the biggest risks is buying before you are completely prepared to do so. Completely prepared means passing the nine readiness tests shown below. You pass if you can answer with a clear yes to each of the nine questions.
The Nine-House Buying Readiness Tests
1. The 5-Year Test: Can I commit to staying in the house that I buy for at least 5 years or the break-even time, whichever is longer? Use a rent versus buy calculator to determine the break-even time, the time taken for buying to be a better option than renting. Use a break even time of 5 years or the result calculated by the rent versus buy calculator( according to your local circumstances), whichever is longer. If you can commit to staying for this time, you pass this test.
2. The Financial Priority Test: Am I ready to make the financial aspects of house buying my primary consideration? Do not buy a house based on emotional reasons. Buying a house is first and foremost, a financial decision. All decisions about house ownership have a very big impact on your financial future because you will be borrowing a lot of money. Therefore, you should decide whether you are ready to make the financial aspects the central consideration in any house-related decisions. If you can, you pass this test.
3. The Very Big Commitment Test: Am I ready to commit a great deal of money, time, and effort over a long period of time? The money part is obvious. You need to commit time and effort tor research and homework before buying, need to maintain your house after buying by developing DIY skills or paying for maintenance to protect your investment. If you can, you pass this test?
4. The Income Test: Is my income high enough for my local housing market? Find the price range of the bare-minimum acceptable houses to you. Find out what the interest rate levels are for a 30-year fixed-rate housing mortgage with 20% down. From this interest rate select a multiple from the house affordability table below. To determine the highest house price you are likely to comfortably qualify for, multiply your annual income by the appropriate multiple on the table.
30 year fixed rate mortgage with 20% down interest rate=7%
Maximum house price= annual income x multiple=$100000 x 3 = $300,000
You pass this test if you the house you want falls less than the maximum house price based on the above calculations.
5. The Cash-Bucket Test: Is my cash bucket full? Have you saved up 4,6 or 8 months of average primary income for emergencies. If your cash bucket is full, you pass. House buying is not a financial emergency, therefore fill your cash bucket before you buy a house.
6. The 27% Test: Have I saved up enough for down payment, closing costs and move-in costs? This is made up of 20% for a down payment, 5% for closing costs and 2% for the costs of physically moving in and other first time homeowner expenses.
7. The Credit Score Test: Is my credit score high enough to get a prime loan? You should not get a subprime loan under any circumstances. If you can get a prime loan, you pass this test.
8. The Mortgage Affordability Test: Can I afford the monthly payments in my budget and still continue to save? After you move in, you should be able to handle the monthly payments and other increased expenses and still be able to save at least 10% of everything that you earn. The monthly payments are usually these: your monthly mortgage payment(principal+interest payment), property taxes, homeowner’s insurance, utilities( power, water and garbage removal), house maintenance(0.5%-2% of the house’s value per year). The question is, can you afford the above payments and still mange to continue saving 10% of everything you earn? If not, can you cut something out from your monthly expenses, like vacations or entertainment. If you can afford the above payments and still save 10% of everything you earn, you pass this test.
9. The Market Conditions Test: Is it advisable to buy in my local market right now? Occasionally housing prices move in a downward trend. This is not typical seller’s market cycles or flat prices. It means you are in a sustained period where house prices are literally declining month by month. If you find yourself in such a market, then don’t buy, just save money. Sooner or later prices will hit bottom, stabilize and then start back upward. Once the prices are going up( and everybody says you have waited too long to get the best prices) buy. At any other time other than absolute price declines, though, give yourself a green light on this test.
104. You will need to continue renting until you pass the readiness tests. Your approach to renting should always be to rent just as cheaply as you safely can. Sometimes you may decide that buying is not for you and you prefer renting. Then rent as cheap and safe as possible and put your money into investing.
105. It is often very possible to buy a house without passing all of these tests, and you are likely to encounter some pressure to do so. But remember that you are in charge of your financial future; resist this pressure until you are completely prepared to buy.
BUYING A HOUSE: HOW THE MONEY WORKS
106. Let us define and discuss the following terms:
- Down payment: The amount of money( usually 3%-20%) of the price of the house that you pay upfront when buying a house.
- Mortgage: The amount of money(97%-80%) of the price of the house that you borrow.
- Term: The time within which you will pay off the mortgage.
- Closing: Finalising the mortgage agreement is called closing. After the closing is done, nothing is negotiable, everything is final.
- Buyer’s closing costs: Out of the pocket expenses like commissions, title searches and inspections(2%-5%) of the costs.
- Title: The legal proof that you are owner of the house is place on a certificate called the title, which is kept on file at a local government office.
- Collateral: In case you do not pay the mortgage, the ownership of the house reverts back to the lender. The term for this arrangement is that your house serves as collateral for the mortgage.
- Installments: Your monthly payments( principal+interest). This is called P&I for short
- Interest rates: Fixed( fixed for the whole term of the mortgage), Variable( can move up or down, formally tied to some specific measure of prevailing market interest rates)
- Property taxes: They are required by law. Cities, counties and school districts get funding from property taxes. This is usually 0.2%-2% of property value per year.
- Homeowner’s insurance: This is required by your lender. This is usually 0.3%-1.5% of the value of the house per year.
- PITI payment: Principal, Interest, Taxes(property), Insurance(homeowner’s insurance)
- PMI: Private mortgage insurance. This is required by the lender if you pay less than 20% down payment.
- Equity: House’s current selling price minus the balance remaining on your mortgage. In the early years, the principal declines very slowly. It only picks up a lot during the final years of the mortgage. This is very important to remember.
- Home equity loan: If your equity increases, many lenders will offer to loan you more money based on the ever-growing equity as collateral. This is called a home equity loan and you should not take this loan, no matter how eagerly the lender tries to entice you with the possibility.
- Upside down or underwater mortgage: A mortgage with negative equity can be called either upside down or underwater mortgage.
- Default: If you don’t make your monthly payments to the lender on time, or in full or you stop making payments altogether, you are contractually and legally considered to be in default on the mortgage, and the lender is entitled to assume full ownership of the house.
- Foreclosure: The lender assumes full ownership of the house, you forfeit the down-payment, all th payments you made before the default, and any claim whatsoever on the proceeds that the lender will receive from selling the house. You must leave the house and the lender has the right to engage local law enforcement to force you to leave, if necessary.
- Selling costs: They are out-of-pocket expenses required to close the transaction. They are usually 6-7% of the value of the house.
- Capital gain: The price you sell minus price you buy is the capital gain
- Basis: The price you originally paid for the house is given a special term, called your basis.
107. You should borrow money only for buying a house. The higher the down payment you make, the less the chance of the mortgage going underwater; therefore you should make a down payment of at least 20%. Interest rates are important, because, the higher the interest rate, the higher the total payment. If you default, your lender will foreclose the property. When you make monthly payments, your payments are mostly interest initially, only much later in the mortgage the rate of principal reduction takes stream. Apart from these, there are buying costs, property taxes and maintenance. There are also selling costs. Buying costs and selling costs are not tax deductible. This is the reason why it does not make sense to buy and sell a primary residence very often. Pick one that you can stay in for at least five years.
108. There are two very favourable tax advantages of home ownership. The first one allows you to deduct the interest portion of your mortgage payments each year. The deduction is done at your highest or marginal tax rate. The second one, called exclusion, allows you to pay no tax at all on the gain you make when you ultimately sell your house( unless the gain exceeds some very high limits). Right now, the limits are $250,000 for single people and $500,000 for couples. In both cases, these advantages apply only to your primary residence.
109. The negative financial effects of buying a house occur when you buy and as you own; the positive effects occur when you sell. Think of it as a very large purchase, followed by a stream of ongoing payments- but when you sell you are eligible for a potentially very large rebate.
110. How big the rebate is- and therefore how financially favourable the purchase of your house has turned out to be – depends on a very critical factor: price appreciation. Every percentage point of price appreciation that occurs while you own your house makes a huge difference in the final financial picture. When selecting a house, the goal is the one whose resale value will increase the fastest.
111. You should buy rather than rent, but only if – and not until – you meet all nine of the readiness tests. When you buy a house as a primary residence, you will make a down payment of at least 20%, which you will pay from money that you have saved, outside of your cash bucket. You will take out a 30 year fixed-rate mortgage for the remaining amount. In the first third of your financial life, a primary residence is the only kind of real estate that you will buy, and the mortgage that you take out to buy it will be the only money that you will borrow.
112. Financially, buying is way better than renting. It is best to start planning for it as early as possible. The rate of resale price appreciation is the single most important thing to pay attention to when you buy. Even a little bit of extra appreciation makes a huge difference in your financial outcome.
BUYING A HOUSE: LET’S DO IT
113. The six steps for finding the resale winners are as follows:
- Broaden your thinking: Do some homework on resale value before making a long-term decision about which region, city, and/or neighbourhood, or sometimes which country to buy in. Some parts of the market fare better than the average. Buy in such areas.
- The three L’s: Location is the single biggest factor in determining resale value. But location is also important, as is location. Houses in outstanding school districts; or with ready access to workplaces, retail centers, and/or public transportation; or with terrific views; or being surrounded by houses that are more valuable offer good resale value. Locations along airport flight paths, on busy streets, on in a neighbourhood where lots of new construction is planned; or the most expensive house on the block will hurt resale values.
- Find an agent with high local expertise: General tips only go so far; finding an expert with specific local knowledge( both area and type of housing) is imperative to finding resale winners.
- Avoid very new and very old: Brand new or relatively new houses often appreciate more slowly at first because of their proximity to lots of other new houses; very old houses appreciate more slowly because buyers suspect that heavy repair and maintenance are probable. Houses in areas that are scheduled for new development also don’t do so well. If you are a first time buyer, do not buy houses that are more than 50 years old. Some of them can be fixed up and sold for a profit, but leave that to experts.
- Think like the masses: Your goal is to select a house that will be of interest to the maximum number of buyers when you are ready to sell. That means that unique, different and stylish are not resale-enhancing qualities. Stick to types, styles and locations likely to be popular with ‘the masses’ in the future.
- Be wary of bargains: Bargains might be warning signs. Rely on your agent’s experience to help you find out what’s really behind an apparent bargain as it may be worth far more less because it has problems.
114. The ten steps to successfully buying and owning a house are:
- Make sure the time is right: Don’t start until your calendar and your emotions are ready for an intense, potentially stressful multiweek process. Avoid times of the year when other buyers are starting their searches.( like late spring and summer rush)
- Get prequalified: This means selecting a lender to supply you with documentation identifying you a having prequalified for a specific loan amount. Choose only a 30 year fixed-rate mortgage. Do not agree to bundling closing costs into your mortgage. If you are offered discount points, use a web calculator to see if it makes sense.
- Set a firm and final upper price limit: Decide on your absolute upper limit and set it in stone. It is certain that you will be tempted by yourself and others to stretch this upward – it is upto you, and you alone, to hold your ground.
- Do an intense Internet search within your price range. Your goal is to come up with a prioritized list of the house features that you want by familiarizing yourself with what is currently available in the market.
- Get a buyer’s real estate agent. Select someone with strong experience and credentials, who is willing to work with a first-time buyer, and with whom you feel a good personal chemistry.
- Search and select. Don’t select until you’ve done a thorough, methodical set of walk-throughs with your agent and you’re completely comfortable from all angles. Take pictures, extensive notes and lists of criteria to score each house against. Of course, your primary selection criterion is front and center- resale value!
- Offer and negotiate. Here is where a strong agent really pays off; when it come to how much to offer, whether or not to include contingencies, and all other aspects- listen to your agent and trust his or her advice.
- Close. On closing day, you will sign many documents and you will hand over a big check. Work with your lender and your agent in advance to fully understand everything that you’re going to be asked to sign, and don’t sign anything until you fully understand and agree to it.
- Protect and enhance your investment. Stay on top of all the required maintenance to keep your house in good working order; in addition you may or may not want to make a few selected enhancements that will increase the resale value by more than they will cost.
- Watch interest rates and refinance if appropriate. After you buy, if interest rates drop far enough, it may make sense for you to take out a new mortgage; use a web refinance calculator to help you do the math. if you want to enhance your house, compare the enhancement with the house’s resale value.
PART IV: LONG-TERM INVESTING
115. Providing for your own retirement is like inheriting money from yourself. Everything that we have covered so far can be thought of as setting the stage for investing, which is the primary means of building up your self-inheritance.
116. The era of retirement being completely paid for by employer pensions and/or public programs like Social Security is coming to a close. The only way to be truly assured of a financially healthy retirement is to assume full responsibility for it yourself.
117. The idea is for you to establish a long-term investment strategy and make a substantial start on it during the 1st third of your financial life, continue it nonstop throughout the 2nd third, and then not touch a penny of it until you arrive in your 3rd and final third.
117. Some selected long-term savings and investment milestones are as follows:
Milestone 1: Savings program begun- at least 10% of everything you ever earn, paying yourself first.
Milestone 2: Cash bucket filled and remains full( except in the case of a true financial emergency)
Milestone 3: House purchased( or decision made not to, at least for the foreseeable future)
Milestone 4: Long-term investment program begun
Milestone 5: Investment balance exceeds 1 year’s average income
Milestone 6: Investment balance becomes the single largest element of your net worth
Milestone 7: Investment balance reaches a point where it can be converted to portfolio income that can last for the rest of your life, but at a bare minimum lifestyle. You can stop earning active income at this point or continue earning and go on to…
Milestone 8: Investment balance reaches a point where it can be converted to portfolio income that can last for the rest of your life at a lifestyle level similar to your current one. You can stop earning active income at this point or continue earning and go on to…
Milestone 9: Investment balance reaches a point where it can be converted to portfolio income that can last for the rest of your life at a dream lifestyle level.
118. Investments can be structured for either growth or income. Yours should be structured for growth in the 1st and 2nd third of your financial life; in the 3rd third you can begin structuring some of your investment balance to fund your living expenses. The higher your investment balance, the higher the level of retirement lifestyle you can afford.
119. It is not necessary to have a highly specific retirement objective( dates, ages, or amounts) right away; instead it is best to simply begin investing as soon as you can, to allow yourself the maximum amount of choice and flexibility in defining your objectives later.
120. The real objective of investing is to achieve ‘enough’ investment income to support freedom from the requirement to work and ‘enough’ financial security to seek fulfillment and happiness in the other areas of your life.
121. Your decades-long investment horizon makes you a rarity in the market place; nearly all other investors are operating in the much more challenging and risky world of short- and midrange investment horizons. You ultra-long horizon allows you to take much deeper advantage of compounding’s later jaw-droppingly powerful stages.
122. Because of your unusually long investment horizon, most of the financial news and advice, advertising, and informal information that you have ever seen before, or will run across during your investing career, isn’t intended for you and probably doesn’t apply to you. To get the information that you really need, you’ll have to seek it.
123. The five major obstacles to long-term investment success are risk(chance that whatever you invest will go down in value), human nature( your own right-brain driven emotions and instincts which makes you buy high and sell low), inflation, taxes and frictional costs. Our recommended long-term investment strategy is designed to squarely address and overcome each of these.
124. Our recommended long-term investment strategy calls for you to
a. begin as soon as possible after you have met the basic requirements; i.e. you begin your long-term investment strategy as soon as you can after you have filled your cash bucket, have no debt and have a savings program where you save at least 10% of your income every month.
b. invest relatively constant investment amounts at regular intervals(payday) regardless of market conditions
c. buy the same broad mix of very low-cost equity index funds every time, again regardless of market conditions
d. hold these investments without selling any until the 3rd third of your financial life(b,c, and d together are often called dollar cost averaging)
e. buy from, and hold with, the fund seller who has the very lowest frictional cost available in a tax-sheltered account
f. get advice from a virtual team of people that will differ based on your own situation.( employer’s fund administrator, online broker, independent financial planner, tax professional or somebody whom you trust and is trustable)
SIMPLE BUT NOT EASY
125. The recommended investment strategy is simple to understand, but it will work only if you stick with it- which isn’t always easy. Your right brain can be counted on to generate all kinds of reasons to deviate from the plan.
126. If you have any preconceived ideas about the mindset required for successful long-term investing, throw them out. The mindset that you want to adopt is one of patience, consistency, rationality, and discipline. It is not the mindset of a hunter you want, you want the mindset of a tree planter or a farmer. You want to be a tortoise and not a hare. You want to be Mr. Spock and not Captain Kirk. Your strongest warriors when you have this mindset are Time and Patience.
127. Fear and greed are the most common emotions that cause major investment mistakes. Fear can compel you to lose sight of the long-term and sell at a loss when you could be buying for the best prices. Greed can compel you to over buy at the highest possible prices.
128. Occasionally some of these emotionally driven decisions pay off-temporarily. This is the worst thing that can possibly happen, because it encourages you to continue, or even accelerate, in the wrong direction. This is virtually guaranteed to end badly.
129. Following the never-ending ups and downs of the market through the financial media is not just irrelevant, it is potentially harmful. Therefore, you actively avoid regularly following the market and the associated media coverage. You get all the information you need from checking your investment account once a year or so. Some books that you can read are:
- The Little Book of Common Sense Investing by John C. Bogle
- The Elements of Investing by Malkiel and Ellis
- The Four Pillars of Investing by William J. Bernstein
- The Bogleheads’ Guide to Investing by Larimore, Lindauer, and LeBouef
- Stocks for the Long Run by Jeremy J. Siegel
130. Regardless of what the market does, every year is a good year for your investments. That is because you own more shares of your selected funds at the end of every year than you did at the beginning.
131. You may need expert help in designing and implementing your long-term investment strategy. We are calling such an expert a financial planner, but this is simply an arbitrary designation, because the actual titles used in the financial services industry vary widely.
132. The type of financial planner you should be looking for should be fee-based, independent, and credentialed(CFP or PFS). Once you have narrowed down the candidates using those criteria, make your final selection based on price, compatibility with your investment strategy, and personal chemistry.
133. Before you begin investing, identify a person to be your rescuer incase you get tempted by fear and/or greed to make any unplanned change to your investment strategy. If you’re tempted, contact this person right away to get straightened out.
134. Say out loud ‘The Disciplined Investor’s Pledge’:
“I am a disciplined, long-term investor. I have a proven plan and I am going to stick to it no matter what. My plan is based on very long-term trends and it is the safest and surest way to get strong long-term results. I have the discipline to stick to my plan even when popular opinion and my own emotions tell me not to. When the market is going up, I am going to resist the idea that I can increase my gains by changing my plan to take advantage. When the market is going down, I am going to resist the idea that I can cut my losses by abandoning my positions. Just to be safe, I have identified a trusted expert who fully understands and supports my investment strategy and whom I will contact immediately if I am ever tempted to deviate from my plan.”
135. Portfolio selection has a popular reputation as being the only thing that really matters when it comes to long-term investing. The truth is that it is one of several very important elements, but not the only one.
136. All financial investments involve a trade-off between probable or expected returns vs probable or expected risk. Simply put, the higher the average returns you want, the more risk you have to take on. Return is the gain or loss that you can earn from holding an investment, and investors usually annualize rates of return for easier comparability. Risk is measured by the range of variability of return, sometimes referred to as volatility.
137.The very lowest risks and returns are in the cash-equivalent investment category; the low risk is precisely why we choose this for our cash bucket. Bond funds entail low to moderate risk and return, while stock(or equity funds) are highest on the risk-and-return scale. There are many other kinds of investments beyond these three types(including individual stocks or bonds), which range widely in risk and return; but these are not recommended for beginning investors.
138. Three very powerful and well-known risk-protection tools make it safe for you to invest in equity funds, but only if you use all three tools, all the time. These are diversification, frequent and regularly timed entry and exit points, and holding each investment for a long period of time.
139. Because the equity market is so huge, investors use a variety of ways to break it into subcategories. Four of the most common ways to break down equities include by country(or groups of countries), by company size( as measured by market capitalisation or cap), by industry, and by growth vs. value.
140. An index is an analytical tool used to track the price performance of any particular group of stocks. A great many indices are available, but some are followed much more widely than others. The most popularly known index is the Dow Jones Industrial Average(DJIA); within the investment community, the Standard and Poor’s 500(S&P 500) which includes large-cap stocks representing over 70% of the U.S equity total, is favoured as a broad measure of market performance.
141. Investors cannot directly invest in indices, but they can invest in funds. Funds can be actively managed(which means that their goal is to beat a particular index) or passively managed( their goal is to match an index). These passively managed funds are called index funds. The actively managed funds don’t consistently beat their targeted index, but index funds virtually always match it. As a group actively managed funds underperform the index fund. Some active funds do beat the market, but it is very difficult, if not impossible to pick them in advance. Hence passive funds are the better bet.
142. Frictional costs associated with funds include loads(one-time sales commissions) and expense ratios( ongoing fees paid each year, charged as a percentage of the investment’s value). Index funds are usually no-load and have generally much lower expense ratios than comparable actively managed funds.
143. Over the past 100 years or so, equities( as measured by the S&P 500) have increased in value by about 10% per year and by about 6% per year after inflation. This performance may or may not hold true in the future, but even if the performance is less, equities are still the highest-probability choice to consistently outpace inflation.
144. An asset allocation refers to a list of fund categories held in a portfolio and the target percentages of each. Because of differing attitudes about risk, as well as potential choice limitations(in the case of employer-sponsored retirement savings programs), it is best to work out your own best asset allocation with the help of your financial planner or by yourself, if you are savvy enough.
145. General recommendations regarding asset allocation are
- use only broad categories
- include bonds( which you will gradually increase in proportion over time)
- include a healthy proportion of non-U.S. equity representation
- avoid overlap( the same underlying stocks within multiple selections)
- stay between three and seven funds
- rebalance your portfolio regularly( when proportions drift away from the original targets, take steps to reestablish them using the lowest-frictional cost means possible).
146. A target date fund is a special type of fund package that automatically rebalances, and gradually includes more bonds, as you get closer to your prespecified retirement date. As long as you are careful about selecting the right one, a target date fund can be an extremely simple, convenient, and very low-cost way to invest successfully.
PROTECTING YOUR INVESTMENTS FROM TAXES
147. The U.S. government wants you to save and invest for your retirement and offers you significant tax incentives for doing so. These tax incentives are a very big deal and can make an enormous difference in how much of your long-term investment gains you get to keep.
148. Whatever you do, never, ever begin a long-term investment program without first determining a tax strategy based on thorough, current and careful research.
149. Tax shields are accounts in which you hold your long-term investment portfolio, and the investment activity that happens inside a tax-shielded account is taxed very differently than if it had taken place in a normal account.
150. If you invest long-term without any tax shield, you’ll be subject to capital gains tax when you sell. If you invest in funds, you’ll be subject to tax leakage(more for actively managed funds) even if you don’t sell. Never invest unshielded if you can help it. But if you must, hold your investments long enough to qualify for capital gains treatment( i.e pay long-term capital gains tax rather than short-term capital gains tax), select relatively less leaky funds, and stick with whatever investments you initially select. Any early selling interrupts the compounding cycle.
151. The tax shields come in two varieties: you can either get your benefit early( as you invest) or later(as you withdraw). The early-benefit shields are called tax-deferred plans, and the later-benefit shields are called Roth plans.
152. Roth shields are very simple to understand and operate. You receive no deduction when you invest, but you pay no taxes on your gains when you withdraw- or ever.
153. Tax- deferred shields allow you to treat your investments as tax deductions; this generates tax savings each year that you invest. The tax savings must be reinvested back into the tax-shielded account for you to receive the benefit of this type of shield.
154. For both Roth and tax-deferred plans, there are rules covering the maximum amount per year you can contribute, the age you must reach before you can begin withdrawing, and the types of penalties you face if you are forced to withdraw early. These rules can be confusing and subject to frequent change, but the basic structure has remained fairly stable for several years
155. You can either participate in the plan that your employer offers or establish a tax shield on your own. Your tax professional and your financial planner are both indispensable members of your team in helping you establish, and fully understand, a tax shield.
156. For most investors just starting out, a Roth plan is recommended over a tax-deferred plan because of its simplicity, and the probability that your tax bracket is likely to be higher than your current one in your retirement years.
157. If your employer offers a match, this is the best long-term investment plan possible. Take advantage of it to the fullest extent that you possibly can- even if your cash bucket isn’t completely full. Use a 50-50 plan divided between cash bucket and retirement savings or double your savings rate.
LONG-TERM INVESTING: LET’S DO IT
158. The fourteen-step plan that summarises your long-term investment plan is as follows:
- Ensure you are financially ready: Have an income, First Rule plan in place, no debt apart from mortgage.
- Resolve your housing situation: Buy or Rent or Decide Later to Buy
- Hire a financial planner or make a financial plan yourself( if you are savvy enough)
- Choose a tax shield: Roth versus tax-deferred
- Choose a fund seller: lowest frictional cost seller
- Determine your asset allocation: Equity and Bonds
- Select the specific funds to invest in: Low cost passive funds
- Decide on the exact amount to invest: 10% of your income bare minimum
- Decide on how often to invest: Simple- every payday.
- Decide how to automate the process: Set up automatic payroll deduction, resulting in automatic purchase of your preselected funds
- Choose a 911 rescuer: Choose someone who understands and supports your investment strategy, whom you respect and will listen to, and who can be depended upon to respond.
- Make your first investment.
- Rebalance your portfolio as necessary.
SOME OTHER THINGS TO ROUND UP….
159. Your retirement savings come first. Once you have done that to the bare minimum(10%), you can also save and invest for your children’s college education.
160. The stock market is risky but over 30 to 40 years has given the best returns that beat inflation. All the other alternatives also involve the same or more risk.
161. Successfully starting your own business takes a tremendous amount of talent, hard work or luck – and usually plenty of all three. The above approach can be done by anyone. Many businesses fail. Starting a business also involves financial and non-financial decisions. Be aware of the risks, and if it seems right for you, go for it.
162. The principles for a secure financial future are outlined above. For specifics, always go to the Internet and research.