This is a long, informative, and potentially value add post, so buckle up and prepare to get learned. Your bank account will thank you.
I want to forewarn you, this is not a post about making more money. The content in this post is much more powerful and actionable than that. This is a post about structured frugality and financial self control. You’ll see what I mean throughout the post. I expect I will eventually write posts about different ways to make more money, but that won’t really help anyone unless they can answer the following questions.
There are two very important questions I ask friends of mine when they talk to me about personal finance and wealth building.
- How much money do you spend every month?
- How much money do you make every month?
Almost everyone can answer the second question, but very few can answer the first.
Now I will ask you a question.
How the hell do you expect to build wealth if you don’t know how much money you spend each month? The wealthy do not become wealthy because they earn more money. That is a common misunderstanding. The wealthy get that way by spending as little money as they can. They know how much they spend, and reduce it where they can. This allows them to earn more than they spend.
If I earn $10 every month and I spend $8, then I get to keep $2. After a year I have how much money? $24.
This is the very first lesson most wealthy people learn.
[themedy_alertbox icon=”ok” colour=”green” custom_colour=””]Know how much you spend each month.[/themedy_alertbox]
The great thing about being alive in 2014, is that tracking your finances is easier than ever.
That is what the next section is about.
Build Wealth Step 1: Organize your Finances
Know your expenses.
Know your expenses.
Know your expenses.
Mint.com is your promise land.
Go to it now, then tab back over to this article.
Welcome back friend.
Mint is the best tool I’ve found that aggregates all of your finances in one place, and displays fun graphs and dashboard information for you.
It can do a lot of things, but now all we care about is what?
Know your expenses
So, here is my quick and dirty guide to mint. Just tab through the steps:
[themedy_tabs][themedy_tab label=”Mint Step 1″]Only connect spending accounts. No loans, Mortgages, or Investments. We’ll get to that noise later. Only spending accounts for now[/themedy_tab][themedy_tab label=”Mint Step 2″]Go through your expenses and make sure they are properly categorized. Be sure to click on the rule check box so Mint doesn’t screw this up again[/themedy_tab][themedy_tab label=”Mint Step 3″]Leave everything else alone. We will get to that later.[/themedy_tab][/themedy_tabs]
You should now know how much you spend each month. If you still don’t, go reread this section.
You might be surprised with your expenses. I was very surprised. I used to eat out a lot, and was spending a lot of money at restaurants, bars, etc. I stopped doing that and put the leftover money towards savings.
I reduced part of my expenses, which brings me to the next step.
Build Wealth Step 2: Reduce Those Expenses
Chances are you spend too much money on things you don’t really need, like eating out, or cable tv.
This section is all about taking your expenses and reducing them where possible, without changing effecting your overall quality of life. The point here is to reduce your expenses to about 70% of your income for starters. As you get better at reducing your monthly expenses, they will take up even less of your total income.
Below I’ll outline some of the easiest ways I’ve found to reduce my monthly expenses.
Cooking instead of Eating Out
Eating Out might be one of the most common forms of over spending among Americans. We just don’t feel like we have the time to cook our own food.
Well this is one of those life choices you need to make. Do you value more money in your pocket, or having your food served to you at a restaurant? If you chose having food served at a restaurant instead of more money in your pocket, you should stop reading this post now and go pay Olive Garden or Chili’s a visit. The waiter or waitress will have no qualms about pocketing your money. Be sure to tip them well ;).
Now, if you’re like me and you’d rather pocket that money instead of spend it, then cooking your own food at home is the right course of action. There are other benefits of cooking at home too, like weight loss and better nutrition.
Since this is a post about building wealth, and not a post about cooking, nutrition, or meal prepping, I won’t go into any of the details here. Just know that if you plan out your weekly meals, and buy your groceries specifically for those meals, your food budget will plummet.
Instead of Buying Drinks, Bring a Flask
Going out with friends is inevitable, and sometimes you just need a night out. I bring a flask full of whatever liquor I prefer and only buy the mixer. Many bars don’t exactly allow this, so if you do bring your own flask, be discreet. You’ll save a TON of money. You do still have to incur the cost of buying the alcohol for home use, but you’ll make back that money in one night out.
Netflix Vs. Cable TV and Going To The Movies
Cable TV is expensive, and going out to the Movies is expensive.
Netflix, Hulu, and Amazon Prime, are (individually) not expensive.
If you must watch some sort of TV show, movie, or other video programming, don’t spend a premium to get it. There is literally nothing cable television has that I can’t get much cheaper elsewhere. Seriously consider cancelling your cable. Avoid going to the movies as much as possible, and put that saved money to something more important.
Find Your Own Ways to Cut Back
Each of us knows our lives better than anyone else, and each of us have unique ways we can reduce our expenses. Cooking, drinking from a flask, and cancelling cable were just three ways that I have managed to cut costs. There will be many ways in which you can lessen your own expenses. Analyze your spending on Mint, and see where you can avoid giving more of your dollars away.
Building wealth requires you to keep dollars, not spend dollars.
Build Wealth Step 3: Save Money, Automate Your Finances, and Invest
Use the cost cutting strategies in the section above to reduce your spending to at least 70% of your income. That leaves 30% of your monthly income. You will saving 10% of this income each month no matter what bills you have.
Always pay yourself first by saving 10% of your income. 5% of that should go towards some long-term investment fund like a 401k or a Roth IRA. This money will grow and compound over time and will be a nice cushion should you ever decide you want to do something foolish like retire one day.
For the other 5% I recommend putting it in an Ally Savings Account. Their savings account pay 0.9% interest compounded daily. This is the best interest rate on a savings account that I have been able to find.
This 5% being put in a savings account will grow over time and is used to finance whatever goals you may have for yourself.
- Emergency Fund: $3,000 is my recommended amount. This is used for any emergency expenses that pop up.
- Unemployment/Quit your Job fund: 6 months worth of expenses is recommended, which should give you time to find another job, or start your own business.
- Various investments: I wrote an entire blog article about investing
The point here is that every month no matter what happens, you are paying yourself 10% of your income that nothing else will touch. Having the self-control to do this every month may sound difficult, but the next section I’ll cover automation, which will set up your bank account to automatically save that money, removing some of the temptation.
Automate Your Finances
This topic deserves an entire article to itself, so I’ll just be covering the basics.
Humans by nature generally do not have a lot of self-control. Humans also love when tasks are done for them, especially by software. Automating your bill pay, savings, etc. will go a long way towards helping you stick to a savings plan or budget. It helps you to build wealth automatically.
The first step is to automate your savings. I said before you should always pay yourself first, and you should be allocating 10% of your income to savings. Set this up first so you’re not tempted to spend it later. All banks allow automatic transfers between accounts. Choose the day after your paycheck clears your account, and set your account to automatically transfer 10% of that money to your savings. If you have a Roth IRA or a 401k, then you can also set your bank account to automatically transfer 5% to those accounts.
The second step here is to go back to Mint, and look through your primary expenses every month, and make a note of their due dates.
- Living expense (Rent, Mortgage)
- Utilities (Water, Electricity, Gas)
- TV & Internet (Cancel TV, it is a waste of your time)
- Car Payment
- Phone Bill
All of these bills can be set to automatically withdraw from your account. This will only work if your bills are due on the same day. Most of our bills are spread out sporadically throughout the month, but the due dates can be changed online or over the phone. The one exception here is rent or mortgage. This bill is almost always due on the first of the month.
If you get paid once a month, change all of your bills to the day after you get paid, and automate them for that day.
If you get paid twice a month, say every two weeks, I’d recommend breaking your bills into two chunks, once after the first paycheck, and another after the second paycheck. Automate those bills on their new due dates.
In this step of the process your bills are synced for the same days, and they are all set to auto pay on that day. If you’ve reduced your expenses to 70% of your income, then these bills will leave you with plenty of money left in your account, amounting to over 20% of your income.
You may want to leave your automation at this step for a few pay cycles, to make sure that things are working properly and your bills are getting paid properly and on time, and your savings are being withdrawn properly.
Until I can write a full length post on this topic, here is an awesome post on Financial Automation
Make Your Money Work For You
If you follow this guide, you will eventually start to incrementally increase the amount of money in your savings, since you are putting 10% a month towards purely savings. This is a great start, but it is just a start. At some point (this point varies from person to person) you should start thinking of ways to make your saved money earn money.
This type of earning is generally referred to as passive income, horizontal income, automated income, etc. For the most part each of these phrases means generally the same thing. It is where you’ve put your money to work, and it has begun to earn money itself.
If you chose to get an Ally savings account, you can already begin earning some very small passive income at 0.9% APR.
I’m going to write a separate post dedicated specifically to discuss the various forms of passive income. If you’re interested in reading that post, please subscribe to email updates at the top of the page, and I will let you know when the article is published!
[The link to that article will be here when it is ready]
In the mean time, there is still one very important step to building wealth, and that is reducing your debt. Read on for the details.
Build Wealth Step 4: Pay off Debt
So for the math wizards out there, you will have noticed that there is still 20% of your income unaccounted for.
We’re using 70% of your income to pay expenses. We’re using 10% of your income to build your savings. The last 20% will dedicated to paying off any debt you might have.
If you don’t have any debt, congratulations! You’re blessed, and can use that 20% towards your savings or investments!
The rest of us however, will be using this 20% to pay off our debt. Every $ of principle we pay off, is another bit of wealth we will have next month.
Debt includes credit cards, student loans, car loans, money owed to friends, etc.
How should I go about paying off my debt?
There are a lot of strategies to paying down debt, and most of them are solid options.
The first thing we should do, is add our debts to Mint! So go there now, and add those loans, credit cards, etc.
Once they’re aggregated, you should know your debt payoff goal. All the debt is your payoff goal.
So what is the best way to pay it off?
My personal favorite is to simply pay off the debt with the highest interest rates. This will save me more money in the long run, and will allow me to become debt free sooner. So the strategy here is to pay the minimum on all of your monthly debt payments first (if you can). Then, spend whatever is left of that 20% on the debt that has highest interest rate. This will lower the interest that gets added to your total debt each month. If you are unable to cover the minimums on all of your debts, then you should focus as much as you can on the debt with the highest interest rates until you can cover all of your minimums with 20% of your income.
This method is sometimes hard to stick to, because it can sometimes seem that little progress being made. For those of us that would like to see more visual progress being made, they might prefer the snowball method. Keep in mind, the debt snowball method will only work if you can cover all of your minimum debt payments.
The debt snowball method works like this.
- Pay your minimums
- Put the rest of your 20% towards the smallest debt
- Once that smallest debt is paid off, put your 20% towards the next smallest
- And so on
- And so on
The progress here is much more visual since you will, over time, have less credit card/loan/car payments to make each month. This won’t save you the most money in the long run, but it will give you the drive to keep up your debt destroying life cycle.
If you have the discipline to do the four steps of wealth building below, you don’t need to earn more money to build wealth (although it does help, ha!).
- Organize Your Finances
- Reduce Your Expenses
- Save Your Money by Paying Yourself First
- Reduce Debt
The Books Below Inspired This Post
Hope this post added value to your finances!
Let me know what you thought of it.
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