By Rob Berger
My Personal Takeaways →This book reframes financial freedom as a math and behavior problem, not an income problem. Rob Berger dismantles common myths: you do not need a huge salary, investing does not need to be complicated, and freedom does not require waiting until old age. The core levers are simple but powerful: save consistently, keep spending intentional, start early, and let compounding do most of the heavy lifting.
The most practical takeaway is that your savings rate and lifestyle design matter more than appearances, because lower recurring expenses both increase what you can invest and lower the amount you need to be free. Read this if you want a clear, numbers-driven roadmap to optionality. Implement it by tracking real expenses, raising your savings rate over time, and aligning your investment plan to long-term consistency rather than short-term noise.
By Rob Berger
Lie #1: Financial Freedom Requires a BIG Salary
Lie #1 tells us we are destined to live paycheck-to-paycheck. This lie is easy for us to believe. Our minds play a trick on us. Let me explain. Imagine somebody making $50,000 a year their entire adult life. Even if they saved 10 percent a year ($5,000), how could they ever become a millionaire? If they worked for 45 years, they would have saved $225,000. Sure, they may have invested their money and made some interest, but it couldn’t possibly take them from $225,000 to $1 million. Or could it? Would you believe that it could take them to $3,421,620.11? That’s what our $50,000 a year earner would accumulate over their working years if they invested $5,000 a year (about $416 a month) and earned an average investment return.
Lie #2: Financial Freedom Takes 40 Years (or Longer) to Achieve
Lie #3: Happiness is Expensive
Lie #4: Investing is Complicated
Lie #5: Debt is a Fact of Life
Most people see each dollar that enters their lives and nothing more than that—a dollar. What they don’t see is the dollar’s potential.
We have a choice every time a dollar passes through our hands. We can either spend it or we can put it to work. Spending money is, of course, necessary. We spend money for true needs, like housing, food, and clothing. We also spend money on wants, like cable TV, expensive cars, and gym memberships. I’m not making a judgment here. I have cable TV, an expensive car, and a gym membership. But these are wants, not needs. As for those dollars we don’t spend, we can put them to work for us. We put our dollars to work when we deposit them in a savings account. We put them to work when we invest in a 401(k) or IRA. And we even put them to work when we pay down high-interest debt. Every dollar we put to work is like an employee. They are the best kind of employee. They never complain about the working conditions. They don’t ask for a raise. They never sleep or ask for time off. They work 24/7. And if we let them, they will keep working for us for the rest of our lives. Like the energizer bunny, they just keeping going, and going, and going.
The only change we are going to make is to invest your money. This change doesn’t require you to: Work overtime; Stay at the office on weekends to keep the boss happy; Get a second job; Cut out vacations; Eat rice and beans every day; Win the lottery; Or, as in our example, get a raise. Just invest your money.
Second, wealth comes from investment returns, not directly from saving money. We must save to get the ball rolling, of course. But the vast majority of wealth comes from investment returns. That’s true for you and me, and it’s true for the richest men and women in the world.
The Money Multiplier is a moving walkway for your money. And the longer you let your money ride, the faster the moving walkway goes.
The Money Multiplier consists of just three parts: Amount, Time, and Money.
If we assume a 9.3% return, guess how much one cent would be worth after 225 years. Result: $4,892,563.14 (compounded annually).
The compounding that helped us build an avalanche of wealth works to multiply the losses for those who delay. Let’s look at time from another perspective. Let’s compare one person who saves and invests for 10 years with another person who saves and invests for 35 years. Who ends up with more money? If that seems like a trick question, it is. We are going to let the 10-year investor, who we’ll call Samantha, start today. Imagine she’s graduated from college, started her first job, and signed up for her company’s 401(k) retirement account. The 35-year investor, who we’ll call William, doesn’t start investing until the first 10 years are up. William waits for 10 years for no good reason. Investing just didn’t seem important to William when he started his job. During this entire time, Samantha keeps her money invested. After year 10, however, she can’t add any additional savings to her account. Given that they both earn our average return rate of 9.3%, who ends up with more money?
Samantha ends up with $40,940.80 after 10 years. Remember that she invested $208 a month for 10 years, earning a 9.3% annual return. Here’s where things get crazy. She stopped saving additional money and just let her investments continue to compound. Thirty-five years later she was a millionaire. Her nest egg was worth $1,047,937.16. What about William, our 35-year investor who has to wait 10 years before he can get started? He didn’t do as well. His wealth added up to $660,135.60.
The best time to start saving and investing is today. Delaying even one year can cost you thousands of dollars over the long run. Delay for five, 10, or 15 years and the losses really add up. If you are late to the game, there is still hope.
One thing he shared with me during the interview was the Rule of 752. Here’s how it works. Take any recurring weekly expense that you have and multiply it by 752. The result is how much you would have if, instead of spending the money, you invested it for 10 years earning a 7% return. There’s no magic here in the number 752. It’s the result of the Money Multiplier applied to a weekly expense and assuming a 7% return.
These numbers get crazy big when you think about a 45-year time period. Over 45 years we need to use the Rule of 36,036. Latte 3 times a week at $4 is equal to $432,432. Cable TV at $25 per week is equal to $900,900. Eating out 2 times per week is equal to $1,081,080.
The “so what” is that small amounts of money, invested over time, turn into large piles of cash that can change your life. The “so what” is that you can build wealth over time if you choose to make some very simple choices.
Seemingly insignificant changes in how you spend money on a weekly basis can go a long way to helping you achieve Financial Freedom. You don’t need a lot of money to start investing. As you’ll learn, even $25 a month will get you started.
Over a 40-year period, for example, an initial investment will double four times at a 7% rate of return (once every 10 years), while it will double five times with a 9% return (once every eight years).
Instead of accumulating a Freedom Fund of more than $1.7 million, that “small” 1% difference lowered our Freedom Fund to $1,213,503.86. We lost $494,568.90. The rate of return on our investments matters. A lot. And seemingly small changes, multiplied over time, will have a huge, life-changing effect on our Freedom Fund.
Ultimate Financial Freedom comes when you can live off of your savings and investments without the need to work. It’s as simple as that.
We are conditioned to define financial success based on a fat paycheck. Yet Financial Freedom hinges on how much you spend, not how much you make.
Level 5: 5 Years of Expenses Saved
At Level 5, you’ve already exceeded the savings that most will achieve in a lifetime. Assuming $50,000 in annual expenses (the round number makes the math easier), for example, you’ve amassed $250,000 in savings and investments.
Level 5 also represents a danger point. It’s here that some may become complacent. With so much money saved, it’s easy to return to old habits or to lose focus.
While my wife and I hadn’t reached Level 7 at that time, we were right around Level 5. I knew I could walk out of that job if I needed to and we’d be fine financially. I wasn’t stuck. And it was a great feeling.
Level 6: 10 Years of Expenses Saved
Level 7: 25 Years of Expenses Saved
Level 7 is the Ultimate Financial Freedom. It’s here that you can completely retire from work if you so choose. Or, if you’re like me, you can work on projects you love while still earning an income. The choice is yours.
When you reach Level 7, you can pursue your passions. That may mean keeping your job. There’s nothing wrong with that if that’s what you love. It may mean starting a business. Here’s the point—you decide for yourself what you’ll do when you reach Level 7.
Known as The Progress Principle, which we will examine later, it tells us that making progress toward any goal gives us the grit to keep going. The 7 Levels give us a concrete way to measure that progress.
Financial Freedom is first and foremost about our expenses, not our income. That explains the all too common stories we hear about celebrities, athletes, and lottery winners going broke. They had huge incomes, yet they failed to achieve lasting Financial Freedom. Why? Their expenses consumed all of their income and then some.
Developed by financial planner William Bengen in the early 1990s, the 4% rule is a guideline on how much of our Freedom Fund we can spend each year without running out of money. It was developed with retirees in mind, but we can use it here as well. If you spend $50,000 a year, you’ll reach Level 7 when you have saved $1,250,000. Four percent of $1,250,000 just happens to equal – you guessed it – $50,000.
Determine your current level of Financial Freedom. This will require you to know, or to find out, how much you spend each month. Be sure to include periodic expenses, such as gifts and vacations. For your savings, do not include short-term savings you plan to spend on a specific goal, such as buying a home or a car. In this video, I show you a free calculator that I created to help you examine and understand the 7 Levels of Financial Freedom.
Saving 10% was popularized by the book, The Richest Man in Babylon, by George S. Clason. Originally published in 1926, it shows that by saving 10% of every dollar that comes into your life, you’ll do just fine. It was true in 1926. It’s still true today. Not to be outdone, the popular Dave Ramsey espouses saving 15% of your income. Remember, he does everything with gazelle-like intensity. In one podcast, Dave stressed that there is nothing magical about 15%. The key is to get serious about saving for retirement. Before Senator Warren was a senator, she wrote a book about personal finance. In her book, All Your Worth: The Ultimate Lifetime Money Plan, she talks about the 50/20/30 budget—50% of our income should go to needs, 30% to wants, and 20% to savings.
Save even ten percent and you are doing better than the vast majority of people. (The average saving rate in the U.S. is around 6%, according to the Fed).
There are many reasonable rules of thumb when it comes to how much you should save. Rules of thumb can be a good starting point. We should always think for ourselves, making informed decisions about our finances.
“There is only one kind of shock worse than the totally unexpected: the expected for which one has refused to prepare.”
When our Saving Rate goes to 20%, our Spending Rate goes down to 80%. Not only are we saving more but we need to save less money to equal one month of expenses.
Every dollar we don’t spend increases our savings. But just as importantly, it decreases how much we need in our Freedom Fund to reach each level of Financial Freedom. The Slingshot Effect. The effect of spending less as our Saving Rate rises can be seen even more clearly the more we save.
The more you save, the less you spend. The less you spend, the faster you can achieve each level of Financial Freedom, thanks to the Slingshot Effect. Your Saving Rate, and by extension your Spending Rate, is the key to unlocking a lifetime of Financial Freedom, as we will explore in more detail in the next chapter.
Over the past 100 years or so, inflation has averaged just under 3%. Therefore, we will reduce our assumed 9.3% return (called a nominal return because it’s not adjusted for inflation) by 3%. The resulting 6.3% is referred to as the “real” rate of return because it is adjusted for inflation.
Going forward I’ll still use the nominal return, 9.3%, for some purposes in this book. But when it comes to estimating the time it takes to reach Level 7 Financial Freedom, I’ll always use 6.3%, the real rate of return.
As the name of the rule suggests, in year one you can spend 4% of your investments. In each year following, you adjust the amount you spent the previous year by the rate of inflation.
Think of it more as the 4% Guideline than the 4% Rule. But it’s considered a reasonably safe approach to retirement spending. To put it bluntly, the 4% Rule gives us a reasonable chance of dying before our money runs out.
At first glance, 4% might seem low. We are assuming a nominal rate of return of 9.3%. If that’s a reasonable assumption, what happens to the other 5.3%? Good question. Keep in mind three things: We must account for inflation. By earning more than we spend with our investments, we can reinvest the difference to help our portfolio keep pace with rising prices. We must account for stock market declines. While we are assuming a nominal 9.3% average annual return, actual stock market returns are lumpy. Some years you might earn 25%, but in others you might lose 25%. Our portfolio must have the ability to withstand extreme bear markets. Finally, we must account for a more conservative portfolio. We are assuming a stock to bond allocation of 70/30. Once you retire, however, it’s common for some to increase their allocation to bonds to make their portfolio less volatile. If we move to a 60/40 or even 50/50 portfolio, our expected nominal return falls below 9.3%.
Let’s use the 4% Rule in our Level 7 Financial Freedom calculation. Take the amount of money you need to live on each year and divide it by 4%. The result is how much you need in your Freedom Fund to reach Level 7 Financial Freedom.
By the way, you get the same result by multiplying your expenses by 25.
For example, if your goal is to retire at 30 and never earn another dime doing anything the rest of your life, 3 or 3.5% is a better assumption. Why? Because your money needs to support you for upwards of 60 years or more. If your goal is to work until you are 80, you could probably assume a 5% withdrawal rate or even much higher. After all, even if you live to 100, you’ve only got 20 years in retirement. Again, these are extreme cases. Also, we haven’t accounted for other sources of income, such as social security or a pension. For our purposes, we’ll stick with 4%.
Once we know our Freedom Fund goal, we can estimate how long it will take to reach that goal based on our Saving Rate, rate of return, and current savings. The math here is easy, but to make it even easier, I’ve created a spreadsheet that does the work for you. It’s a Google Docs spreadsheet that you can view here: https://www.retirebeforemomanddad.com/FFCalc. I walk through the spreadsheet in the video that accompanies this chapter. Note too that the spreadsheet allows you to account for your current savings and any matching contributions your employer makes to your 401(k) or other workplace retirement account.
How much you make doesn’t change the results. The length of time it takes to achieve Level 7 Financial Freedom is a function of the percentage of income you save, the rate of return, and the withdrawal rate. If two people each save 10% of their income and earn the same rate of return, it will take them the same length of time to reach Level 7, even if one makes $50,000 a year and the other $500,000. If this seems impossible, remember that the person making $500,000 and saving 10% is spending $450,000 a year. Yes, they are saving a lot more than the person earning $50,000 a year. But they need a Freedom Fund of $11,250,000.
A one percent difference in investment returns can add five years or more to the time it will take you to reach Level 7.
Some folks, when presented with this data, still want guidance on how much to save. If pushed, my answer is always “at least 20%.” In the next section of the book, we’ll look at concrete ways you can make this a reality.
To determine how long it will take us to reach Level 7, all we need are our Saving Rate, Investment Return, and Withdrawal Rate. Our time to Level 7 is very sensitive to changes in our Investment Returns and Withdrawal Rate assumption.
The Latte Factor assumes that we forego our daily latte. Assuming our beverage of choice costs $5, that frees up about $150 a month to save and invest. If we earned a 9.3% nominal return over 45 years, we’d accumulate… $1,231,783.24.
Every dollar we save has a Slingshot Effect—it increases our savings and it decreases our Freedom Fund goal.
What makes you happy? It’s a simple question. It’s also one of the hardest questions in life to answer. In fact, many live their entire lives without ever answering this question. Before reading any further, answer this question for yourself. What makes you happy? List the top 10 things in your life that make you the happiest.
We shouldn’t be asking how much we need to make to be happy. We should be asking how much we need to spend to be happy.
“Do not save what is left after spending, but spend what is left after saving.” – Warren Buffett
I’ve learned one very important lesson about money over the past three decades. Relying on willpower alone to save money rarely works. Willpower may get the job done for a time, but eventually we let our guard down. It’s just like dieting. By sheer force of will, we may be able to lose a few pounds. But as the pounds come off, our willpower subsides. And eventually it’s all ice cream and fries. They call it a yo-yo diet, and you can end up weighing more than when you started. The same thing can happen with money.
Before you allocate a nickel of your income to expenses, decide first how much you’ll save. This process may require a glimpse into your expense categories, particularly those expenses that are true necessities. But arrive at your Saving Rate first, and then spend the rest.
Once you decide on your Saving Rate, automate the process. You want the money you’ll save to be removed automatically from your checking account as soon as you get paid.
If your employer doesn’t offer direct deposit, set up the automatic transfers with your bank. You can have a set amount transferred to a savings account and a set amount transferred to an investment account.
We want to make the money we save as difficult as possible to access. For this reason, set up a savings account at an online bank that is not the one where you keep your checking account.
You have to initiate an online transfer, which takes several days. Think of this as keeping the junk food out of your house.
If you use transfers, schedule them to occur as soon as you get paid.
Write down every monthly bill you have, including the amount. So much of our money is spent without thought. This is particularly true for those who automate their finances. Everything from the mortgage to utilities to cable is paid automatically from our bank account or charged to a credit card. The goal of this first step is to make a complete list of all of these monthly expenses. Here is a list of common monthly bills: Rent or mortgage, Credit card debt, Car loans, School loans. All other debt Utilities (electric, gas, water, trash service), Internet, cable, home phone, and cell phone Netflix, YouTube TV, Hulu, Amazon Prime, and other subscription-based services. Insurance (car, life, health, homeowners).
Creating a complete list is critical. Miss an item and you may miss an opportunity to save. To make sure you haven’t missed anything, check your credit card and bank statements. Trust me, it’s likely that you forgot something. Remember: out of sight, out of mind.
While every situation is different, here are some common ways that many of us can save money in Step #2 of The Money Audit: Increase insurance deductibles. Decrease the amount of life insurance (if you are over insured, as many are). Move to a lower-cost cell phone provider (e.g., Cricket or Republic Wireless). Move to a lower-tier cable package. Reduce your internet speed. Refinance debt to a lower interest rate. Get a roommate. Pay your car insurance premium for six months instead of one month at a time.
Switched cell phone providers to Mint. Saves us $500 a year.
Negotiated internet price every year. Saving $30 a month over regular pricing.
LED light bulbs lowered monthly usage.
Shopping at Aldi’s saves us easily $30 a trip.
Moved into a studio instead of a high-rise two-bed, saved $150/mo.
Bike to work/around town as much as possible rather than using the paid off car: hard to quantify but in terms of gas and maintenance $40/mo.
I’ve cancelled my gym membership and bought multiple sets of dumbbells, an exercise ball, resistance bands, a medicine ball, etc., and I do everything on my own at home. It saves me $65 a month.
Bought a French press and make my coffee at home, and I buy bulk coffee at BJs/Sams Club ($70-80 savings/month)
We got SimpliSafe, and it costs us $180/year ($15/month). It saves us $270/year on our homeowner’s insurance.
Shopped our house and auto insurance, which resulted in savings of $3000 a year. Included in new rates was umbrella insurance.
If your employer matches retirement contributions: Take. Advantage. Of. The. Match.
The best ways to save money are painless and require action just once.
Conduct a Money Audit at least once a year. Be sure to automate any money saved so that it goes toward your Financial Freedom.
Now let’s turn to what I call Lifestyle Expenses.
“The Latte Factor is a METAPHOR for how we waste small amounts of money on small things. It’s a teaching method to get people to “rethink” how they spend money and realize they have more than enough to start saving.
It was painful at first. I couldn’t get mocha lattes out of my mind. It was all I thought about. And talk about sacrifice. It hurt. But then it didn’t. It took a couple of weeks to adjust. And then I didn’t miss the mocha. I didn’t even want one. I haven’t had a mocha in years. And it’s no sacrifice at all. In fact, I’m happier today without my daily mocha than I was when I thought I needed it to make life worth living. Funny how our minds play tricks on us.
In the end, the Latte Factor isn’t about avoiding things that bring us pleasure. It’s about making sure that how we spend our money truly brings us the joy in life that we desire. In many cases, we spend money out of habit, and the happiness is fleeting.
Small wins fuel transformative changes by leveraging tiny advantages into patterns that convince people that bigger achievements are within reach.”
Step #1: Identify Your Financial Habits
Step #2: Pick One Spending Habit to Change
Step #3: Replace the Habit with a better habit.
Once you identify the habit or routine you want to change, replace it with something positive. Rather than just cancelling your weekly night out on the town that would cost you a lot of money, replace it with something fun to do that costs less. Rather than just cutting back on eating out, replace it with an extra special meal at home. Rather than just shopping until you drop when you are feeling depressed, ride your bike or go for a walk with a friend.
As an example, you may eat out at lunchtime every day. For you, the Cue may be time. You go to lunch every day at noon. The Routine may be that you leave your office building and go to a nearby restaurant or food court. Now what’s the Reward? The obvious answer is food, of course. However, perhaps the real reward is getting out of the office. Here we want to replace the routine itself. Rather than going out to lunch, you bring your lunch but still leave the office to eat it. Perhaps you go to a nearby park or coffee shop. The key is to replace a current routine you want to change with a new, more positive one.
Step #4: Automate Your Savings
“All life is an experiment. The more experiments you make the better.” –-Ralph Waldo Emerson
—What if I skipped my daily latte? —What if I took my lunch to work? —What if I ate out less? As you ponder these things, you ratchet up the boldness in your “What if” questions: —What if I scaled back my vacations? —What if I got rid of cable TV? —What if I biked to work a few times a week? But even these questions are minor league. Here are the big-league questions: —What if I got rid of one of my cars? —What if I got rid of all of my cars? —What if I downsized my home? —What if I moved close enough to my job so that I could walk to work? —If walking to work is impossible, what if I got a new job? —What if I moved to a less expensive area of the country? Some of these questions may raise an immediate objection. You think: I can’t get rid of my car; that’s impossible. Take some time with these questions. Seriously. What would you do without a car? I’m guessing you’d survive. Your daily routine might change dramatically, but you’d survive. The point of this exercise is not to convince you to sell your car. I have one. Maybe you should have one too, or maybe not. The point is to invoke our imagination. To think beyond our current situation. To consider what at first seems impossible.
With these assumptions, here’s how much faster we will achieve Level 7 Financial Freedom based on changes we might make in our lives following a 21-day experiment. (Also, an estimate of the monthly savings is in parentheses.) —Get rid of cable TV ($100): three years faster. —Eating out less ($200): six years faster. —Going without a car ($300): eight years faster. And if you made all three changes, thus saving an extra $600 a month, you’d achieve Level 7 Financial Freedom more than a decade sooner. You’d reach Level 7 in about 30 years (at a 6.3% real return), rather than after nearly 43 years.
Running 21-day experiments is a simple way to test not only whether we can put more money toward our Freedom Fund, but also whether the way we are living today really makes us happy.
In the last chapter we imagined life without a car. I chose cars because they are the #1 Freedom Fund killer. My good friend Jeff Rose of GoodFinancialCents.com describes car payments as the #1 thing that’s killing our wealth. In this chapter I’m going to show you why.
According to the personal finance site, Nerd Wallet, here’s a breakdown of the average cost of owning a new car: $523 Car Payment, $98 Insurance, $146 Gas, $99 Maintenance & Repairs, $12 Registration, Fees & Taxes = $878 Total. At this point, there can be no doubt about the kind of wealth we could build on $878 a month. Let’s look at the numbers, again assuming a 9.3% annual return. 10 years = $172,817.43. 20 years = $609,257.26. 30 years = $1,711,459.25. 40 years = $4,495,002.73. Now, before you send me hate mail, let me address some obvious issues: First, not everybody can or wants to go without a car. I get it. Second, even if you did go without a car, you wouldn’t save $878 a month. You’d have to spend some amount of money on transportation. Third, not everybody buys a new car. You may decide to buy a used car that costs a lot less than $523 a month. Fourth, you may pay cash for a car. It’s still money out the door that can’t be invested but at least you’re not paying interest. Finally, the $523 average car payment doesn’t last forever. Eventually you pay off the car and continue to drive it for some period of time. All true.
Buying a car every five years under the assumptions outlined above will cost over $3.7 million in missed opportunities to build wealth over a lifetime.
By driving the car longer, we add hundreds of thousands of dollars to our wealth. Of course, this assumes you invest what you aren’t spending on the car.
Cars are expensive. Any way you can reduce your car expense can go a long way to supercharging your journey to Level 7. Freedom first, cars second.
At first glance, lending the money seems safer than buying part of the company. In the world of investing, he would buy a Bond that represents the money he is lending to the dry cleaners. He would have a contract that requires the company to pay him interest and to return the money lent to the company when the bond Matures, that is, when the term of the bond comes to an end. If the company fails to pay the interest when due, or the principal when the bond matures, we can file a lawsuit to recoup our money. Depending on the terms of the bond, we can even lay claim to the company’s assets (remember all that equipment a dry cleaners needs in order to operate) to recover our money. Bonds are not without risk. We’ve already identified one risk—the company fails to pay us. Yes, we can sue, but if things go really bad for the dry cleaners, they may not have the assets to pay us even if we win the lawsuit. This risk of not getting paid on our bond is called Credit Risk. There’s another risk more serious than the first. It’s called Interest Rate Risk. Let’s assume we agree to lend $100,000 to the dry cleaners for 10 years in exchange for annual interest payments of 7%. The dry cleaners makes interest payments every year and repays the principal of the loan after 10 years when the bond matures. At the time we made this deal, 7% was a competitive interest rate for similar bonds. Now fast forward two years. Let’s imagine interest rates have gone up. On a similar bond, investors are now getting 10% interest. Ouch. We are stuck with eight years left before the bond matures, and we are earning 3% less than the going rate for similar bonds.
As with bonds, there are pros and cons to owning stock in the dry cleaners. The potential negatives are easy to see: We don’t receive guaranteed interest payments. We don’t have a contractual right to the return of our investment. Profits may not materialize as we expect. The business could go under if things got really bad.
Profits returned to the company’s owners are called Dividends. A dividend paid to owners is similar to interest paid to bondholders. There are, however, two big differences. First, unlike interest payments on a bond, a company is usually not contractually obligated to pay dividends. Second, interest payments on a bond typically are fixed for the life of the bond. That’s why rising interest rates hurt the value of existing bonds.
When the management of a company like Apple decides to distribute some of the company’s profits to its owners, it declares a dividend. That dividend gets paid out to you in proportion to your percentage of ownership. No different than our little dry cleaners. A bond is a fancy word for debt. When the government issues a bond, it is borrowing money from investors who purchase the bond. Bonds are sometimes referred to as Fixed Income. Most bonds have a fixed interest rate paid out over a predictable schedule. Savings accounts and CDs are also fixed income investments.
If we look at how each of these Asset Classes (a term that refers to different categories of investments) has performed over the last 100 years or so, we learn two very important things: First, stocks have performed better than bonds. Let’s imagine that in 1928 we had $300 to invest.
Any guess on how our investments performed? By the end of 2017, our investments would have grown to: 3-Month Treasury Bills: $2,105.63. 10-Year Treasury Bonds: $7,309.87. S&P 500 Stock Index: $399,885.98
Looking at the source noted above, for example, we can see that since 1928, three-month Treasury Bills have never gone down in value from one year to the next. They came close in 2011, earning just 0.03%. The T-bill’s best year is one that I remember. In 1981 they earned 14.30%. Of course, unemployment was high and inflation was in the double-digits, giving birth to the term stagflation, but T-bills had a banner year.
Seventeen years have seen negative returns since 1928. The worst year was 2009, when the 10-year bond lost 11.12%. Stocks have had more bad years than bonds. The S&P 500 index has lost value in 25 years since 1928, and some of those years were ugly. The index lost 43.84% in 1931. More recently, in 2008, it lost 36.55%.
In the long run, stocks perform better than bonds. In the short term, stocks are more volatile than bonds.
Broadly speaking, there are two types of mutual funds: Actively Managed Mutual Funds and Index Mutual Funds.
There are many indexes that track both stocks and bonds. Here are a few of the more popular ones: Russell 3000: Tracks 3,000 of the largest companies incorporated in the U.S.. Wilshire 5000: Tracks all stocks currently trading in the U.S.. S&P Midcap 400: Tracks U.S. companies with a market cap ranging from $1.4 to $4,900,000,000. FTSE All World Index: Tracks over 3,000 companies in nearly 50 countries. FTSE stands for the Financial Times and London Stock Exchange, a joint venture that developed the index.
Over long periods of time, index funds outperform most actively managed funds on an after-fee and after-tax basis.
In 2016, two-thirds of actively managed mutual funds investing in large U.S. companies underperformed the S&P 500 Index. In the same year, 85% of actively managed mutual funds investing in small U.S. companies underperformed the S&P Small Cap Index. Over longer periods of 15 years, 90% of actively managed mutual funds underperform their respective indexes. Since 2001, 89% of actively managed international funds underperformed their respective indexes.
Index funds are like having your cake and eating it too. They are cheap, simple, and most outperform actively managed funds over the long run. Index mutual funds come in different shapes and sizes, and that’s true for both stock index funds and bond index funds.
Generally, small-cap stocks have a higher return than large-cap stocks over a long period of time. That’s the good news. They also have greater volatility. Think of small-cap stocks as a wild roller coaster ride. That’s the bad news.
Mutual funds can also focus on either Growth or Value stocks. Growth stocks are those of companies whose revenue is growing rapidly. Here a company like Amazon comes to mind. In contrast, value stocks are those of companies whose stock price is considered undervalued. Here a company like Ford comes to mind. Growth stocks are the high flyers. They are the companies in the news and discussed at water coolers everywhere. In addition to Amazon, Tesla and Netflix are examples of growth stocks. They are also very expensive compared to the profits, if any, that they generate. Value stocks are often the older companies.
A REIT, or Real Estate Investment Trust, is a mutual fund that invests in real estate. REIT funds can focus on apartment buildings, retail space, shopping malls, commercial property, and even mortgages. Tax Alert: An important detail to remember is that REIT funds are not tax efficient. They pay out a substantial portion of their profits each year, and these distributions are taxed as ordinary income. As a result, if you invest in a REIT fund, you should do so inside a retirement account. Commodity funds invest in commodities. Here think of oil, corn, gold, and so on. Some funds invest directly in the commodity, while others invest in companies whose performance depends in large measure on the price of commodities (like an oil or mining company).
In fact, mutual funds that invest in corporate bonds issued by companies with shaky financials are called High Yield bond funds. High yield bonds are also called Junk Bonds. To be clear, junk bonds are not junk. They have more risk, but they also have potentially more reward.
A Short Term bond fund is one with a duration of less than three years. A short term bond fund’s interest rate risk would be considered low. An Intermediate Term bond fund is one with an average duration of about three to 10 years. And a Long Term bond fund has an average duration of more than 10 years.
“Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees.” – Warren Buffet
In fact, history tells us the lower the cost of investment, the better it will perform in the long run. It’s counterintuitive because we are conditioned to believe that we get what we pay for. But this is not true when it comes to investing.
Expense Ratios are often expressed in Basis Points or Bips for short. One hundred basis points equals 1%. Fifty basis points equal 0.50%. Expense Ratios range from just a few Bips (like 0.05%) to well over 200 (2%).
Here’s the dirty little secret few people know. The transaction costs that mutual funds pay do not come out of the Expense Ratio we just looked at. They are a separate fee. What’s more, we don’t know ahead of time what those fees will be. Why? Because not even the mutual funds know what their transaction costs will be until they actually decide to buy or sell something. We can, if we want, see what a mutual fund company paid in the past for transaction costs. We’d do that by digging into what is called a Statement of Additional Information
Here’s what you need to know. Index funds tend to have far fewer transaction costs than actively managed funds.
Some, but not all, mutual funds charge what are called Load Fees. These are fees you pay when you either buy shares of the fund or sell shares of the fund. Front-End Load Fees apply when you buy shares of a mutual fund. Back End Load Fees apply when you sell shares of a mutual fund. A typical Front-End Load Fee is 5.75% of the amount you invest. Funds with Load Fees also charge higher Expense Ratios than most index funds. These Load Fees and higher Expense Ratios go, in part, to pay the investment advisors who sell these funds to investors.
For actively managed funds, we want the Expense Ratio to be below 75 basis points (that’s 0.75%). As you know, I recommend index funds. For me, even 75 basis points is just too expensive. But if you plan to invest in actively managed funds, don’t pay more than 75 basis points. And expense ratios closer to 50 basis points are even better. For index funds, we want the Expense Ratio to be below 25 basis points (that’s 0.25%), and preferably below 10 basis points. The best index funds from the likes of Vanguard and Fidelity cost less than five basis points. And Fidelity has recently started offering index funds for free.
Fees are critical. We need to keep them as low as possible so that our money can work for us, not for a mutual fund company or investment advisor.
High fees can add years, even a decade, to the time it takes you to reach Level 7 Financial Freedom. Index funds offer both low fees and better performance.
We have just four goals to keep in mind as we decide how to invest. Diversification: We don’t want to put all of our eggs in one basket. We have no idea whether U.S. stocks or foreign stocks will do better over the next few decades. The same is true for big or small companies. How will REITs perform? I have no idea. Because we don’t know the future, we want to cover all of our bases. We do that by investing in different asset classes. As you’ll see, that’s very easy to do. Equities: History tells us that stocks outperform bonds over the long term. We already know how this difference would affect our journey to Level 7 Financial Freedom. The point is this: we want more of our money invested in stocks than we have invested in bonds. Low Cost: We want to keep our costs as low as possible. It’s one of the reasons we favor index funds over actively managed funds. Simplicity: Finally, we want to keep it simple. There are really complicated ways to invest, just like there are complicated ways to do just about anything. We value simplicity. It’s easier to understand and manage. And besides, life is complicated enough.
Mutual fund companies had a bright idea several years ago. They decided to create mutual funds that made investing incredibly simple. By investing in just one mutual fund, you can get great diversification, a portfolio with plenty of exposure to stocks, and low costs. To show you how they work, I’m going to use Vanguard’s Target-Date Retirement Funds (TDR) as an example. Let’s assume you are 25 and plan to work for 40 years until you are 65. In 2019, that means you’ll retire in 2059. Vanguard offers target date retirement funds by year.
Rebalancing simply means buying and selling investments to bring your portfolio back to your planned allocation. With a Target Date Retirement Fund, you don’t have to worry about rebalancing. The fund does it for you.
Target Date Retirement Funds shift your portfolio more toward bonds and away from stocks as you near retirement. To be clear, you will still be invested in stocks. Even in retirement, your portfolio will be heavily invested in equities. You need the returns they provide so you don’t run out of money, even following the 4% Rule. But the portfolio moves more into bonds as you near and enter retirement. Here’s an example. The 2060 fund today invests about 90% of every dollar in stock funds and 10% in bond funds. Let’s compare that to the 2020 fund, which is designed for people about to retire. The 2020 fund invests 53% in stocks and 47% in bonds. Still a lot invested in stocks, but a big shift toward bonds compared to the 2060 fund. The point is that TDR funds do this for you as you age. They truly are “set it and forget it” mutual funds. They are by far the easiest way to invest.
Target Date Retirement funds have a drawback in taxable accounts. As you saw above, they include bond mutual funds, which generally should be kept in retirement accounts for tax reasons (bond funds pay interest which is taxable if held outside a retirement fund). Finally, TDR funds do come at a cost. While the good ones, like those offered by Vanguard, are relatively inexpensive, they are more expensive than investing directly in other index funds. And the bad TDR funds can get really expensive.
If you want to add a bit of flexibility to your investments but keep the simplicity of a TDR, the TDR + 1 strategy may do the trick. It’s simple. You invest in a TDR plus one additional fund that covers an investing style that’s important to you. As an example, investor Paul Merriman recommends a portfolio consisting of a TDR + a small cap value mutual fund. A good example of such a fund is the Vanguard Small-Cap Value Index Fund (VISVX). I’ve owned this fund in the past. With this approach, you might invest 90% of your money in the Vanguard 2060 fund and 10% in the Vanguard small cap fund.
The 3-Fund Portfolio requires three types of index mutual funds: U.S. Stocks, Foreign Stocks, U.S. Bonds.
In my opinion, an 80/20 portfolio is ideal for long-term investors (those who don’t need the money for at least 10 years). As such, I believe the following portfolio of Vanguard funds is an excellent 3-Fund Portfolio: 50%: Vanguard Total Stock Market Index Fund (VTSAX) 30%: Vanguard Total International Stock Index Fund (VTIAX) 20%: Vanguard Total Bond Index Fund (VBTLX).
I’ll mention one more option for those with an adventurous spirit. This is the portfolio I’ve used for years. Here are the investment types with the percentages of assets that I invested in each: U.S. Large Cap Stocks (30%) U.S. Small Cap Value Stocks (10%) U.S. Bonds (20%) Foreign Developed Country Stocks (20%) Emerging Market Stocks (10%) REITs (10%). Here are the specific funds I used to create my 6-Fund Portfolio: Vanguard 500 Index Fund Admiral Shares (FVIAX) Vanguard Emerging Markets Stock Index Fund Admiral Shares (VEMAX) Vanguard Developed Markets Index Fund Admiral Shares (VTMGX) Vanguard Intermediate-Term Bond Index Fund Admiral Shares (VBILX) Vanguard Real Estate Index Fund Admiral Shares (VGSLX) Vanguard Small Cap Value Index Fund Admiral Shares (VSIAX). This approach does take more work. Remember, as market values change, you need to rebalance your portfolio from time to time. Once a year is more than enough. It’s not a lot of work, but it’s work. A TDR Fund is easier. So which one should you pick? There is no “right” answer. For those starting out, I think a TDR Fund inside a retirement account is a great solution. Ultimately, you want to go with a portfolio that you’ll stick to no matter how the market performs.
“Don’t simply retire from something; have something to retire to.” – Harry Emerson Fosdick
Retirement accounts fall into three primary categories: Workplace Retirement Accounts: These are accounts offered by your employer. Individual Retirement Accounts: These are accounts you can open on your own. Health Savings Accounts: These are accounts you can open if you have a High Deductible Health Plan.
As the name suggests, these are retirement accounts offered by your employer. The two most common are 401(k) and 403(b) accounts. Ever wonder why these accounts have such arcane names?
There is an annual limit to how much you can contribute to a 401(k). In 2019 that limit is $19,000. The limit is indexed to inflation, so it can go up from year to year. In addition, those 50 or older by the end of the year can also make what is called a catch-up contribution. In 2019 the catch-up contribution limit is $6,000.
Finally, some employers contribute to their employees’ retirement accounts, typically matching a percentage of an employee’s contributions.
The 401(k) accounts come in two flavors—a 401(k), sometimes called a Traditional 401(k), and a Roth 401(k). While the contribution limits are the same, the tax benefits are vastly different. With a Traditional 401(k), the amount of your contribution is deducted from your taxable income for both state and federal income taxes. For example, let’s assume you contribute $10,000 to a 401(k) this year. Let’s also assume your combined state and federal marginal tax rate is 25%. Your $10,000 contribution will reduce your tax bill by $2,500. There is no free lunch, however. When you take the money out of the account, the amount of the distribution is taxed as ordinary income.
In effect, a 401(k) enables you to defer paying the income tax until you take a distribution from the account, which can be decades later.
But here’s the benefit. Not only are your contributions tax free when you later take them out in retirement, but so are your investment earnings generated from your contributions. Imagine making a $10,000 investment at age 25. Forty years later, assuming a 9.3% return, that 10 grand is now worth $406,768.46. And it’s all tax free. So after all this, you may be asking which is better – a Traditional 401(k) or a Roth 401(k)? In short, for most people, the answer is a Roth 401(k).
The contribution limits for an IRA are lower than they are for a 401(k).
Recall that contributions to a 401(k) are deductible, period. In fact, 401(k) contributions don’t even show up as taxable income on your W-2. Your employer deducts them for you. Not so with an IRA. Because there is no employer involved, your W-2 won’t reflect any contributions you make to an IRA. Instead, you have to deduct them yourself on your tax return. But you can only do this if you qualify for the deduction. In 2019, if your filing status is single or head of household, you can deduct your IRA contributions from your taxable income if, and only if: You are not covered by a workplace retirement plan, OR You are covered by a workplace retirement plan, but your modified adjusted gross income (MAGI) is less than $64,000.
Roth IRA contributions, like Roth 401(k) contributions, are not deductible. That means we don’t need to wade through all the crazy rules for deductibility like we do with a Traditional IRA. And like a Roth 401(k), you don’t pay taxes on qualified distributions in retirement, and you can always take out your contributions tax and penalty free. But if you withdraw earnings before you turn 59.5 years old, you’ll pay the 10% penalty tax AND income tax (with some exceptions). There is one catch. It’s possible for you to make too much money to qualify for a Roth IRA. In 2019, for singles and heads of household, the phase-out range is $122,000 to $137,000. If you are married and filing jointly, the phase-out range is $193,000 to $203,000. If these incomes disqualify you, there is another way to fund a Roth IRA, and it’s sometimes called a Backdoor Roth IRA. Here’s how it works. First you contribute to a Traditional IRA. Then you transfer the money from your Traditional IRA to a Roth IRA. This is called a Roth IRA conversion. Because you didn’t take a tax deduction on your initial contribution to your Traditional IRA, the conversion does not trigger any tax liability. (If your contribution grew in value from the time of your contribution to the time of the Roth IRA conversion, the increase in value would be taxed as ordinary income. If the conversion happens soon after the IRA contribution, however, this amount should be minimal.)
To learn more about a Backdoor Roth IRA and the 5-year rule, I recommend this article from Michael Kitces, CFP: “Understanding the Two 5-Year Rules for Roth IRA Contributions and Conversions.” Always keep in mind, however, that tax laws are tricky and can change. So consult a tax advisor. Before we leave Backdoor Roth IRAs, we need to drag one more complication out of the dark closet. You may have several Traditional IRA accounts. The IRS treats them as one for many purposes. For example, you may have an IRA for which you’ve taken tax deductions on your contributions over the years. Now as your income has gone up, you no longer qualify for the deduction on new contributions and cannot contribute directly to a Roth IRA, either. So you decide to open a new IRA, contribute to it, and then execute the Backdoor Roth IRA strategy. Wait a minute—not so fast. While you never touched the old deductible IRA, the IRS will nevertheless combine it with your new IRA to determine how much of the conversion came from your old deductible IRA contributions and how much came from your new nondeductible contributions. Let’s assume you have $5,000 in a deductible IRA and you contribute $5,000 to a new nondeductible IRA. When you convert this new IRA to a Roth IRA, the IRS will treat it as $2,500 having come from your deductible IRA, and $2,500 from your new nondeductible IRA. The $2,500 from your old deductible IRA will be treated as taxable income.
The tax advantages of an HSA are without equal. Imagine taking the tax deductibility of a Traditional 401(k) and combining it with the tax-free withdrawals of a Roth 401(k). With an HSA, you get three tax advantages: Contributions are tax deductible, regardless of your income; The account grows tax-deferred; and Distributions from the account are tax-free, so long as they are used for qualified medical expenses. This is true regardless of when you use the money. You don’t have to wait until you are a certain age. HSAs are a beautiful thing.
There’s an added benefit. You can use HSA funds for nonmedical expenses. If you do, you lose the third tax advantage. The distribution is treated as ordinary income for taxes purposes. And, if you have not reached age 65, the distribution is subject to a 20% penalty tax. Once you reach 65, however, the 20% penalty goes away.
What follows is the order of account types in which I believe most people should invest their money. There are exceptions, of course, which we’ll cover shortly. Step #1 Contribute enough to your Roth 401(k) to get the company match. Step #2 Max out your Roth IRA. Step #3 Max out an HSA (Health Savings Account) if you have a qualifying HDHP. Step #4 Finish contributing the maximum to your Roth 401(k). Step #5 Invest the remainder in a taxable account.
First, if your employer matches your contributions, it’s critical you take full advantage of the match. Failing to do so is like having a winning lottery ticket and setting it on fire.
All employer matching contributions are made to a Traditional 401(k), not a Roth 401(k). This is true even if your contributions are to a Roth 401(k). The reason is that employer matching contributions are not added to your taxable income. Thus, if you contribute to a Roth 401(k) and have employer matching contributions, you’ll in effect have two 401(k) accounts—one a Roth and one a Traditional 401(k).
Here I should say that some would argue you should fund an HSA before a Roth IRA. Frankly, it’s a close call. I prefer funding a Roth IRA first for two reasons: (1) Contributions can be withdrawn at any time without tax or penalty, and (2) distributions from an HSA incur a 20% penalty if they are not for qualified medical expenses and occur before the age of 65.
Once you’ve maxed out all of your available tax advantage accounts, a taxable account is last in line.
Those in the top tax brackets may be better off avoiding Roth retirement accounts. The reason is that the higher your tax bracket, the more valuable the tax deductions from making contributions to traditional retirement accounts. Here it’s important to consider both state and federal taxes.
The above plan assumes that HSA contributions will be saved for retirement, and not to pay your current medical bills. Health issues, however, may necessitate that you prioritize HSA contributions. If you know you’re going to have significant medical bills and you can’t max out all of your retirement accounts, funding an HSA should be a priority. It’s still important to contribute enough to a 401(k) to get the match, if you can. But you may need to make HSA contributions your top financial priority.
Until the age of 65, you can’t take money out of an HSA for nonmedical reasons without paying taxes and a 20% penalty. In many cases this isn’t much of an issue, as the money in your retirement and taxable accounts can fund your living expenses. Still, you may need to curtail HSA contributions if your other accounts can’t handle your early retirement needs until you turn 65. Second, extreme early retirement may influence your decision between Roth and traditional retirement accounts. One approach is to contribute to traditional retirement accounts during your working years even if you are in a lower income tax bracket. Once you retire and your taxable income goes to near $0, you can start converting your traditional retirement accounts to a Roth IRA. These conversions will be treated as taxable income in the year you execute the conversion. So long as you don’t convert too much in one year, however, you can keep your taxable income very low. This strategy is called a Roth IRA Conversion Ladder. Roth conversions come with their own set of unique rules and considerations. If this is of interest to you, here are some excellent resources for additional reading: How to Create a Roth IRA Conversion Ladder (MoneyUnder30), How to Access Retirement Funds Early (MadFientist), Roth IRA Conversion Calculator (Schwab), Tax-Savvy Roth IRA Conversions (Fidelity).
Save one month of expenses before anything else. This takes priority over retirement savings. Keep your emergency fund in a high yield online savings account. They pay the best rates and separating your emergency fund from your checking account protects it from moments where you may be tempted to spend it.
The only tool we’ll be using is Morningstar.com.
Returning to my 401(k) and its list of funds, we can see an “FID 500 Index (FXAIX)” fund.
From Morningstar we learn the following: The fund’s full name is the Fidelity 500 Index Fund. It charges no Load Fees. Its Expense Ratio is just 0.02%. It tracks the S&P 500 index. In short, FXAIX is perfect for the U.S. stock fund component of a 3-Fund Portfolio. Next we need a bond fund. Here the “FID US BOND IDX (FXNAX)” fund jumps out at us.
It charges just 3 basis points in fees, no load fee, and invests in intermediate-term mostly U.S. bonds. A quick visit to the “Portfolio” link reveals that more than 90% of the fund is invested in U.S. bonds. Perfect. Let’s add it to our 3-Fund Portfolio. Now all we need is a total international stock fund. A quick scan of our available funds reveals the “FID INTL INDEX (FSPSX)” fund. Morningstar tells us this fund charges just five basis points in fees and invests in a blend (both growth and value) of large foreign based companies. We can jump to the “Portfolio” tab to learn more about the fund’s investments. Here we learn, for example, how much of the fund is invested in the Americas, Europe, and Asia. And there you have it. A perfect 3-Fund Portfolio based on low cost Fidelity funds. And you can follow the same process to find emerging market funds, small cap funds, REITs, or anything else your 401(k) may offer.
“The best time to plant a tree is twenty years ago. The second best time is now.”
If the cost of a TDR is above 25 basis points (0.25%), it’s too expensive. I’d prefer to see the Expense Ratio below 15 basis points. Anything above 100 basis points (1%) is highway robbery. If your company doesn’t offer TDR fund options for 25 basis points or less, you should do two things. First, evaluate the other fund options for lower cost index funds. You can build the 3-Fund Portfolio very easily, as we walked through in the last chapter. You may find a U.S. stock index fund, international stock index fund, and U.S. bond index fund for considerably less cost than the TDR options in your 401(k).
Fidelity offers several index funds at very low cost. And recently it introduced some index funds that have no costs. Its TDR funds are on the expensive side, so I’d avoid them. If you want a TDR fund, Fidelity is not your best choice. There is no minimum investment required to open an IRA at Fidelity, but some mutual funds do have minimum investment requirements.
“It’s one thing to shoot yourself in the foot. Just don’t reload the gun.” – Senator Lindsey Graham
Investor Returns represents Morningstar’s analysis of the average return earned by investors in the mutual fund. Why would it be different than Total Returns? Total Returns represents the return earned by the fund assuming we invest a lump sum at the beginning of the time period and leave it there untouched, in this case for 10 years. The Total Return assumes that no additional funds are invested during the time period and that no funds are withdrawn. In real life, however, things aren’t so simple. Investors tend to get excited when the market is up and scared when it’s down. They invest more when they are excited and take money out when they are nervous. The result is almost always the same—investors underperform the fund’s Total Return because they are terrible at timing the market. Welcome to the biggest threat to your journey to Financial Freedom—you.
The hard part isn’t coming up with a plan. The hard part is sticking to it. As boxing champ Mike Tyson says, “Everybody has a plan until they get punched in the mouth.” As investors, we get punched in the mouth. A lot.
Yet as bad as things were, let’s put 2007-2009 into perspective. The stock market has seen some really tough times: The stock market crash of 1929, The Great Depression, WWII, The Korean War, The Bay of Pigs and the Cuban Missile Crisis, The Vietnam War, The Oil Embargo, Interest rates near 20% (1980-1982), Black Monday (1987—market crashes 22.6% in one day), Dot-Com Bubble, and 9/11. Here’s the point. We don’t know what the next crisis will be. We also don’t know when it will occur. But we know one thing for sure. There will be a next one. And a next one. And a next one.
Remember the more than 50% drop in the market from 2007 to 2009? I’ve talked to many people who, in fear, sold some or even all of their investments during that time. They tell me their stories today with profound regret. Why? Because the dark days of 2007-2009 were followed by a lot of sunshine. By 2012, the stock market losses had been erased. The market had fully recovered. And if you had continued to invest during those dark days, you did even better. You were buying while the prices were low, and then reaping the benefits as the market recovered.
And here’s the thing: The above returns are “normal.” What I mean is that good years often follow bad years. And bad years often follow good years.
First, avoid lifestyle debt like the plague. This is debt we incur, usually on a credit card, to fund our living expenses. Often credit cards fund spending we could avoid, like eating out, vacations, and so on. Sometimes credit cards fund necessities, particularly if you experience a prolonged job loss. I don’t pretend it’s always easy. But do everything in your power to avoid paying for living expenses on credit. It’s the worst possible debt because you have nothing of lasting value to show for the debt you’ve incurred. (You can’t return the vacation you just took or the meal you just ate). Second, work hard to avoid car loans. We’ve already discussed how the cost of a car, even if we pay cash, affects our journey to Level 7. Add in debt with interest, and the problem gets worse. If you do decide to finance a car purchase, get the least expensive car possible. Remember, we buy our Financial Freedom first. Then you can get a nice car if that’s what you choose. Third, be smart about your student debt. There are ways to keep your debt burden to a minimum, including loan forgiveness programs, various debt repayment plans, and even refinancing student loans to a lower interest rate. By keeping your monthly obligations to a reasonable amount given your income, you take pressure off your monthly budget. This in turn enables you to save more, and it gives you some breathing room during bad financial times. Finally, don’t be house poor. Buying a home is one of the few instances when taking on some debt is a reasonable choice. But too much of a good thing becomes a really bad thing. It’s kind of like the third piece of chocolate cake. The first one? Maybe. The third one? I don’t think so. Here, a good rule of thumb is to spend no more than 20% of your monthly gross income on housing expenses. I understand that in some areas of the country this may be unrealistic. But I’ve found that as you spend more than that, your housing costs start to cause you problems in other areas of your financial life.
Last, never stop learning about investing and finances. I’ve been at this for 30+ years and I learn new things all the time. Read the Wall Street Journal, even once a week. Read a good book on investing, even just one a year. You don’t have to be a money geek like I am. But don’t stick your head in the sand either.
Some investment professionals earn fees through commissions paid to them from the investments they sell you. That’s the purpose of the Load Fee that some mutual fund companies charge, and a portion of it goes to the investment broker. The same is true for expensive insurance products, like indexed annuities, that many commissioned brokers try to push on unsuspecting victims (I guess you know where I stand on indexed annuities). One criticism of this fee structure is the potential for conflicts of interest. By earning their fee through commissions, these investment professionals have a powerful incentive to sell you only investments that pay them a fee. They will almost never recommend, for example, a low-cost index fund. Why? They can’t earn a fee from the sale. The solution, in theory, is to hire an investment professional who charges you directly for their services. Enter the fee-only investment advisor.
The best option is to handle your own investments. If you want help, however, you must consider the cost. Traditional commissioned and even fee-only advisors are just too expensive for Freedom Fighters.
“Of all the things that can boost emotions, motivation, and perceptions during a workday, the single most important is making progress in meaningful work. And the more frequently people experience that sense of progress, the more likely they are to be creatively productive in the long run. Whether they are trying to solve a major scientific mystery or simply produce a high-quality product or service, everyday progress—even a small win—can make all the difference in how they feel and perform.”
If you are working hard to save 5% of your income, focusing on a goal of a 30% Saving Rate is not helpful. It may even be frustrating and discouraging. Every step will feel like a failure because it doesn’t appear to get you closer to your goal. That’s the last thing we want. So rather than focusing exclusively on your big goal, create smaller, intermediate goals to achieve. Perhaps for you it means increasing your Saving Rate from 5% to 7% within 12 months.
Here are some ideas to consider as you think about your small wins and next steps: Set your 401(k) to automatically increase your contributions by 1% a year (some 401(k) accounts offer this feature). Use one-half of your raise to increase your Saving Rate. Use one-half of your tax refund to increase your Saving Rate.
Called The Progress Principle, seeing regular improvements, however small, builds our confidence and encourages us to keep moving toward bigger goals. Think outside the box when it comes to small wins, such as saving one-half of your next raise.
“Every time you borrow money, you’re robbing your future self.”
The first problem with debt is that financing a purchase often lulls us into spending more than we should. This is particularly true with cars and homes. That’s not to say you shouldn’t finance the purchase of a home. You should, however, be acutely aware of how financing the purchase is affecting your buying decision.
A home mortgage is generally considered “good” debt. The reason is simple—homes tend to increase in value over the long term. This “good” debt, however, can quickly turn bad under several circumstances: You pay more than the value of the home (something that happened frequently just before the housing crash of 2007). You spend more on a home than you can truly afford. You finance almost all of the purchase price, leaving yourself few options should the value of the home drop and you need to sell. You buy in an area where renting is far more affordable.
As a rule of thumb, we should not borrow more than one to one-and-a-half times our expected first year income. Consider that before you sign the loan documents.
Getting out of debt is simple. Note that I didn’t say it was easy. But it is simple. Here are the four steps: Stop going into more debt. Get rid of debt. Refinance debt. Pay down debt.
Many people are familiar with refinancing a mortgage for a lower rate. But you can refinance any debt. Look at each debt you have and evaluate whether you can refinance at a lower rate. Here are some ideas and resources to consider: Mortgage/HELOC: For a mortgage or home equity line of credit (HELOC), LendingTree is a great way to compare multiple financing options in one place. You can also ask your current mortgage company what rates they offer. Car Loans: If you decide to keep your car, see if you can get a lower rate on the loan. Once again, LendingTree is a good option for comparing rates. Credit Card Debt: If you have high interest credit card debt, consider transferring it to a card that offers a 0% APR introductory rate. Today’s 0% offers last for up to 21 months. Keep in mind that you’ll pay a balance transfer fee of 3% in most cases. This is well worth it if you are transferring debt that currently costs you 15% or more.
Student loans come in two varieties—federal loans and private loans. In both cases, if you want to refinance the debt to a lower interest rate, the resulting loan will be a private loan. Federal loans cannot be refinanced to a lower rate with another federal loan. (Federal loans can be consolidated, but the interest rate of the new loan is an average of the federal loans you consolidated.)
With that said, here are some excellent sources for refinancing student loans: SoFi, CommonBond, and Laurel Road
Generally speaking, you should consider the following factors when setting your financial priorities: The interest rate on your debt. The higher the rate, the more paying down that debt becomes a financial priority. Anything above 10% should be a priority.
Many employers match 401(k) contributions. If you’re lucky enough to have this benefit, contributing enough to your 401(k) to take full advantage of the match should be a financial priority. Emergency fund. Saving one month of expenses, at a minimum, should be a financial priority. We need this breathing room to handle emergencies or a loss of income.
Assuming you can pay more than the minimum payment on your debts, you now need to decide which debt to apply the extra payment to. There are two schools of thought on this question. One is called the debt snowball. The other is called the debt avalanche. Debt Snowball: The first school of thought recommends applying extra payments to the debt with the smallest balance, regardless of the interest rate. The argument goes that paying off a debt completely will help motivate us to continue paying down our debt. By focusing on the debt with the smallest balance, you’ll pay it off faster than you would debts with larger balances. Recall The Progress Principle.
The second school of thought recommends focusing on the debt with the highest interest rate. By paying down high interest rate debt first, you get out of debt faster and cheaper than with the debt snowball approach. So who is right? Well, there is research that supports the Debt Snowball approach. According to one study described in Harvard Business Review, “‘Pay the smallest debt first’ is a straightforward strategy that can be easily communicated and easily applied—and that’s sorely needed by millions of American credit card users.” At the same time, math doesn’t lie. Depending on your interest rates, the Debt Snowball method could cost you thousands in extra interest payments and significantly lengthen the time it takes you to pay off your debts.
I recommend that you calculate the difference between these two approaches. It’s easy to do with this free Debt Snowball Calculator.
In most cases, investing should not take a backseat to paying off debt. That’s not to say you shouldn’t make more than the minimum payments on your debt. Generally, however, tackling your debt shouldn’t come at the expense of saving and investing.
The key is to see yourself as an investor, regardless of your age. Investing isn’t for old people. Investing is for anybody, at any age, who wants to take control of their money and achieve Financial Freedom. The sooner you start, the easier it is.
What if I could be just as happy with less stuff? What if I could have complete control over what made me happy and what didn’t make me happy? What if the things I thought were making me happy really weren’t? Even worse, what if they made life less joyful?
1Check out my resources page: www.retirebeforemomanddad.com resources. Here I list books, software, and apps I recommend for everything from budgeting to investing to improving your credit. And I keep this page updated as new tools and books come out.