Step #1 – Spend less than you earn
1) The single most important rule to becoming wealthy is this: Spend less than you earn. However, that’s a little like saying the way to health is to eat right and exercise. Everyone knows this, and yet it’s difficult for some to do consistently.
The trick to growing rich is not to deny yourself the things you love in life, but to take a step back and try to prioritize your spending by what matters most. First, estimate your monthly expenditures. The easiest way to do this is to take last month’s credit card & bank statements and add up the numbers in each spending category. If you track your expenses on Mint.com or Quicken Online, then you should already have a lot of this data. Then, add in irregular expenses that aren’t reflected like gifts, tuition and car repairs. What did you spend most on? Where can you cut back?
Pursue free or lower cost substitutes that allow you to enjoy similar things at a cheaper price. Think borrowing instead of buying, generic versus name brand, or jogging outside and cancelling gym membership you rarely use anyway. Use Ebay and Amazon.com and shop for deals. Go to cheaper grocery stores like Costco or Safeway (or anyplace where the majority of shoppers are Asian) as opposed to QFC or Whole Foods (yes, Safeway sells organic too.) Avoid temptations by staying away from the mall or online shopping sites.
Remember to focus on your biggest spending areas like repeat purchases (clothes, eating out, subscriptions) or large purchases (cars, housing.) Cutting a $50 monthly bill savings you $600 a year with the same amount of effort as saving $4 by skipping one latte and making your coffee at home.
Step #2 – Pay off high-interest debt ASAP
Many credit cards have Annual Percentage Rates (APRs) anywhere from 11 to 20-something percent. By reducing and eventually eliminating your high-interest debt, you’re giving yourself an instant and guaranteed return on your money. Carrying around a $4000 balance at 20% means you’re paying $800 per year in interest.
Pick the lowest rate card you have and plan to use it only for emergencies until you’re credit card debt-free. Make your other cards unavailable. (One personal finance blogger recommends freezing them in water.) If you know you’ll still abuse that one card, switch to cash-only. Put a budgeted amount of money into an envelope each pay period and use only that amount for discretionary spending. You could have an envelope each for groceries, eating/going out, clothes, etc.
To pay down your debt, pay down the card with the highest rate aggressively until it reaches zero (then cancel that card, you really only need one or two at the most.) Repeat with the next card. If you have any non-retirement savings you can get at (including ‘emergency funds’), use these to pay off your debt. This is because your credit card APR is probably higher than anything you could hope to consistently earn through investing.
Once you’re out of debt, stay that way! Always pay your credit card balance off at the end of the month. If you don’t have the money for something in a checking or savings account, don’t buy it.
Step #3 – Don’t lose out on free money, and automate your savings
Learn to love free money. If your employer offers a match on retirement contributions, max it out before you spend/invest anywhere else (even before paying off your credit card debt.) Use an IRA or 401(k) to instantly earn 33-39%[1] more on every dollar you contribute by eliminating Uncle Sam’s take.
Use paycheck deductions to automatically save for your future. Once you set up that 10% 401(k) deduction, you’ll never even miss the money. Set up multiple INGDirect.com high-interest savings subaccounts with monthly automatic deductions from your checking account to save for big purchases like vacations, a wedding, or a house down payment.
Step #4 – Smart & easy investing: long-term savings in low-fee stock index funds
In most long (10+ year) time periods, stocks absolutely destroy every other asset class (like bonds, treasuries & real estate.) In rolling 30 year periods, stocks outperformed bonds 99.4% of the time over a period of 200 years, according to Jeremy Siegel’s ‘Stocks for the Long Run.’ Any money you don’t need in the next 5-10+ years should probably be entirely in stocks. Don’t let the poor stock market returns of recent years bias you against what has been the greatest wealth creation instrument of the last 200 years.
Look for a low-fee broad market index fund to invest your long-term savings in; something like Vanguard’s Total Stock Market Index (VTSMX). Roughly 70-80% of actively managed mutual funds underperform the market, in large part due to their high fees of 1-2% per year. A good index fund will often have an expense ratio of less than one fifth of that amount. The graph below shows how a 1% difference in expenses makes a huge difference in returns if you start with $10,000 invested at a 7% real return. In 30 years, you’d have over $17,000 more in the lower-fee index fund, a 32% difference!
To summarize…
Cut your savings & grow your earnings to spend less than you make. Pay off your high-interest debt if you have any. Automate a tax-deferred or employer-matched savings plan. For short-term (0-5 years) goals, use a high-interest savings account or a bond index fund like Vanguard’s VBMFX. For long-term goals, invest in low-fee stock index funds. There are a few other financial considerations I didn’t cover, including having proper insurance levels to protect yourself, but these 4 steps form the majority of what you need to know to guarantee yourself a rich life.
[1] If you’re in the 25% or 28% tax bracket, you get $1 of pretax contributions to a 401(k) for what would’ve only been $0.75 or $0.72 in after-tax income. 0.25/0.75 = 33% more money working for you.
It sounds so simple, but in practice it seems so difficult to get to step four!
@ Dustin – If you have credit card debt, I would agree getting to step 4 can be difficult (search online for some tips on getting out of debt. Hint: record your spending for a week or two and see where you can cut; you’ll be amazed at where your money is going.)
If you don’t have high-interest debt to pay off, it’s actually really easy to start investing. If you have at least $3000 saved up, I recommend going to Vanguard.com and opening a retirement account (IRA or Roth IRA) and plunking it down into a broad stock market index like VTSMX.
OR, if you have access to an employer retirement plan like a 401k, sign up online for automatic contributions of, say, 10% per pay period (this is better than the above because 1) you might get matching and 2) it’s automatic.) The money will come out tax-free and you’ll hardly miss it after a few weeks.
OR, if you don’t have a lump sum to invest AND don’t have an employer retirement plan, you can open an IRA/Roth IRA with as little as $50 at T. Rowe Price (see my article HERE.)
So there you go, if you have $50 per month (pretty much everyone living in America reading this blog does), you can start saving for retirement by spending about 10 minutes on http://www.troweprice.com.
Good luck!