For most of us, some phase of growth is the stage we’re in. Growth is the phase of accumulation, positioning, cash flow, savings, making short & long-term decisions. This is where your financial model is used the most. Each decision you make has a ripple effect in this phase, so it helps to have some rules to use as guidelines.
Ideally, achieving financial balance should be your first goal. This can be done by adhering to simple rules that ready you for growth:
- Annual Savings (15-20% of gross income)
- Short-term Liquidity (3-6 months of cash, 6-12 months of near-liquid assets)
- Short-term Debt (ZERO)
The Rules
RULE: Become a first class saver by saving 15%-20% of your income annually. This is one of the most important ingredients to reaching your full financial potential. If you can’t do this, then everything else has to work that much harder. It puts additional pressure on all other aspects of your financial life, including a greater likelihood of failure! What is standing in the way of your saving this amount? Write it down. Figure out how to overcome these obstacles so you can reach your full financial potential. Hint: Remember, your financial model can help you find lost opportunity. You can recapture those dollars, and add that to your savings.
RULE: You should always have at 3-6 months of cold hard cash on hand. It would even be wise to have 6-12 months of near-cash (i.e. short-term bonds) that are easily accessible as well. A cash cushion provides multiple benefits, such as giving you the ability to increase your insurance deductibles and lower your premium payments. It gives you peace of mind knowing that whatever short-term obstacle (accident, fire, job loss, illness) may pop up that you can easily handle it without having to go into debt. Plus, you have the ability to capitalize on an opportunity that may present itself, take a trip, make a substantial purchase (whether it be something you need or simply want) and more.
Cash can also make you a happier person in general. In Jonathan Clements’ book, How to Think About Money, his research found that those with cash on hand – and in the bank – were much happier than those without any or with small amounts.
HELPFUL TIP: Opt out of your 401(k) until you have built up your short-term liquidity! Take care of today first and you will be better equipped to take care of tomorrow. Statistics show that 28% of all 401ks have loans against them, and it’s because this liquidity bucket is neglected or never filled to being with.
Understanding the 401(k)
401(k) Traps:
- 10% penalty if you withdraw before 59 ½
- Taxed as ordinary income
- Limited investment options
- Must withdraw a portion at 70 ½ or suffer a penalty
- Match can go away
- Can create double taxation
- Can’t use it to pay for other life events
- Typically use more expensive mutual funds
Are all 401(k)s bad? NO! If your company has one and they provide a company match, you should at least participate to the point of the match. But not until after you have sufficient liquidity. Discuss this with your personal advisor.
RULE: Short-term debt should be zero. Period. Liabilities are what hold most people back. Short-term debt negates any future profits on your balance sheet. For example, $19,200 debt x 5% interest (lost opportunity) = $253,570 in 10 years. In 20 years, it’s upwards of $666,000.
Two of the most common short-term expenses among our clients are automobiles and credit cards. Cars depreciate 50% after the first three years on average. Look for used cars with low mileage that you can drive for a long time. You can often find a used car that is 25% cheaper than a new car. So if you must carry auto debt, then do it smarter.
Credit card debt can wreak havoc on your financial life. Interest rates average around 15%. That’s extremely high! This is exactly why Rule 3 is so important. If you have adequate liquidity not only can you pay off your credit cards every month, but you can limit what you charge on them since you have the ability to pay for things in cash. Think of it this way – if you have credit card debt carrying 15% interest, every dollar you don’t completely pay off costs you $0.15 each year. While there are always special circumstances, a good general rule of thumb to live by is if you can’t pay for it in cash, you probably can’t afford it.
You may need to slow down short-term debt payments in order to build liquidity and get protection in place first. You may even need to restructure your debt. But it is critical that you follow this order to provide relief, reduce stress, and build the foundation for growth.
LIFE HACK: if you are saving 15-20% of your gross income then short-term debt may just become part of your lifestyle burn rate.
While we’re on the subject of debt, we need to briefly discuss mortgages. Even though a mortgage isn’t considered short-term debt, it is a guaranteed debt that almost everyone will have to experience. Your mortgage payment should not exceed 15% of your gross income. My father used to tell me to buy as much house as you can afford. Back in the day, and still, people saw their house as an investment. However, what we do know is that real estate can and does decline in value. We also know that you can’t eat your house, it doesn’t produce income, and has multiple expenses (maintenance, taxes, updates, etc.). Any equity in your home is semi-restricted and you may not be able to access it when you need it most. Therefore, your mortgage payment should be part of your lifestyle burn rate, not your savings.
What do you do if your payment exceeds this number? First, ask yourself if the payment is preventing you from saving 15-20% of your gross income. If not, then consider it part of your lifestyle and know you may have to limit yourself in other areas. If so, then you could consider refinancing, selling, or maybe you just have to stay put.
