Financial stability is achieved through good saving habits. Tips on how to save money often talk about ways to save little amounts here and there. However, achieving true financial stability requires rigorous discipline that includes:
Saving before spending
Budgeting and sticking to your plan
Practicing delayed gratification
Learning to trade-off and make smart purchases
Making smart investments
Financial stability means that in the events like COVID-19, you have enough funds to pay your bills for a foreseeable future, even if you lost your job and most of your investments experienced a temporary dip. It would be perfect if in this situation you also had some extra money to invest in the stock market (for example). Unfortunately, not many of us are truly financially stable. Most people experienced significant financial struggle during COVID-19, while the rich kept buying discounted stocks and properties. And COVID-19 is just one of the many examples.
To achieve financial stability, you need to regularly save significant amounts. A general guideline is to save 20% of your income. The 50/20/30 budgeting rule has originally been popularized by Senator Elizabeth Warren. According to this rule, you should divide your income into three categories:
Essential Needs
Savings and paying down debt
Wants
50% of your salary can be spent on the essential needs, like paying rent or mortgage, hydro, groceries, car lease, etc. 20% or more of your salary should be saved and used to pay off debt. And, finally, 30% or less of your salary should be spent on your wants, like going out with friends, travel, tech gadgets, etc.
Why 20%? In short, because on average, it will allow you to achieve financial independence before you are too old to enjoy it.
Unfortunately, most people do not follow the 50/20/30 rule either because they do not have the discipline or because they have to spend most of their paycheck on the “Essential Needs”. As stated in the CBC article, “According to a new analysis of numbers from the Organisation for Economic Co-operation and Development from personal finance comparison website Finder.com, Canadians are forecasted to save just 3.21 percent of their disposable income in 2020, or about $1,277 on average per household.” A 2019 survey from GOBankingRates found that nearly 70 percent of Americans have less than $1,000 in their savings accounts, as per the Business Insider.
Let’s be honest, saving $1,000, or even $5,000 a year will likely not get you to your financial goals. For example, with an average studio/one-bedroom condo price in Toronto slightly below $500,000, it will take you at least 20 years to save for a 20% down-payment, assuming you save $5,000 a month. In 20 years, many people decide to have a family, and a one-bedroom condo is no longer enough. It is a never-ending race that you will never win.
So how do you save enough to get to your financial goals faster? There is no magic formula for that. Everyone who is financially well-off, worked hard to get there (unless you were born into a wealthy family or won a lottery, in which case, you are probably not reading this blog). It will require the following:
Tip #1: Understanding what your financial goals are.
Tip #2: Understanding your financial situation.
Tip #3: Religiously adhering to the set budget.
Tip #4: Compromising on spending for something non-essential today to achieve financial well-being tomorrow.
Tip #5: Potentially, taking side jobs if your income is currently insufficient to save fast enough.
Tip #6: Saving in a smart way.
Tip #7: Educate yourself about financial basics.
Tip #1: Understanding what your financial goals are.
Your ultimate financial goal should be to achieve financial independence, which would mean that your lifestyle can be sustained entirely with your investments. Of course, you will likely have to make many small steps before you get to financial independence. Here is a good list of steps to review and decide which ones make sense to you. The steps below are in order, and you should probably not attempt the next step before completing the previous one:
1. Paying off your debt (credit cards, student loans, bank loans).
2. Building an emergency fund.
This will require you to have at least six months of your salary put aside on your Savings account, without you planning to touch it, unless in extreme situations, which is what you will be putting this money aside for. The money has to be kept in a Savings account so you can access it quickly if needed. It also should be essentially risk-free. Putting your emergency fund money in a mutual fund or investing it in stocks will put a lot of risk on them and reduce your liquidity (ability to access them quickly). Investing them in a property will also add risk (think the 2008 crisis) and reduce your liquidity even further (if you need the money tomorrow, you won’t be able to access it if it is invested in a property). Keeping emergency fund money in cash at home simply does not make sense economically, as you are foregoing earning any interest on it, albeit small (savings accounts don’t pay high interest, as your deposits are risk-free; the riskier your investment, the higher return (or potential loss!) you should expect).
3. Purchasing a property to live in.
Consider the fact that when you live in a rental, you are paying off someone else’s mortgage, while their property is also appreciating in value. The money you pay is lost forever. You would want to live in your own property and make payments towards your own mortgage. Even though the property you live in is never considered an investment, it is still often a wise financial decision to purchase your home as opposed to renting.
4. Investing money in mutual funds, stocks, and other investment vehicles. Your choice of investments will depend on your level of comfort and knowledge of each of them. Mutual funds are probably the best option for a financially non-savvy investor. You will need to understand the level of risk you can take on and invest accordingly.
5. Potentially purchasing an investment property. Real estate can provide very good returns through rent and property value appreciation. Please note that the property you live in is never considered an investment. That is the misconception we find many people have.
6. Ultimately, achieving financial independence. This means that your lifestyle can be sustained entirely with your investments. The common rule here is a “4% rule” that states that you should withdraw 4% of your principal balance each year to live on it indefinitely. That means that you would need to save approximately 25x your annual expected expense. So, if you are comfortable living on $60,000/year, you would need to have 25x $60,000 = $1,500,000 set aside. Is that even possible, you might ask? Yes. Because the more you save, the more you can invest, and the more you invest, the more your money will grow. In hindsight, for example, if you bought a pre-construction studio in the downtown Toronto in 2012, putting only 10% down (or about $25,000), you would have now made about $200,000 (minus sale fees and taxes), if you were to sell the condo right after closing on it (5-7 years after). If you were to invest in a decent mutual fund portfolio, you could have made about 5-6% over the past 12 months (as of mid-2020).
Whatever steps you will create for yourself, celebrate every step you complete. You deserve it and it feels good to know that your hard work brought you a step closer to not worrying about money, ever.
Tip #2: Understanding your financial situation.
You will not be able to effectively save and follow through with your plan (or even develop a budget plan, for that matter), without fully understanding your financial situation now and having a good idea of what it is going to be in the near future.
Depending on your financial situation, goals, age, and personal/family circumstances, among others, you might or might not be able to follow the 50/20/30 rule. Of course, saving 20% of your paycheck or more and spending 30% or less should be your ultimate goals, but it is quite possible that you won’t be able to do so when you are just starting out. To understand your financial situation, you would need to know exactly how much you are:
1. Earning
2. Spending on the essential needs (rent, lease, utilities, Internet, etc.)
If spending on the essential needs is above 50% of your earnings, you should consider:
1. Cutting down your “wants” budget (30%) until your earnings increase, and/or
2. Finding additional ways to earn money (evening job, freelance projects, etc.)
Tip #3: Religiously adhering to the set budget.
Budgeting is an extremely important topic that deserves its own blog post, so we will leave it until then.
Tip #4: Compromising on spending for something non-essential today to achieve financial well-being tomorrow.
The more you save at the beginning, the faster your money will start working for you (through trading, real estate, and other investments). Consider cutting back on eating out, going to the bars with friends multiple times a week, buying excessive clothes, tech gadgets, fancy cars, big TVs, and on other non-essential purchases in favor for saving more at the beginning until at least you complete goals 1-3 above (paying off your debt, purchasing a property to live in, and building an emergency fund).
Tip #5: Potentially, taking side jobs if your income is currently insufficient to save faster.
Unfortunately, there is no magic formula for financial stability and wealth. If you cannot save 20% of your paycheck, even after eliminating non-essential expenses, you may need to find an additional source of income.
Tip #6: Saving in a smart way.
The smarter you save, the faster you will achieve your financial goals. The saving strategy will depend on your particular goal at the moment.
1. Paying off your debt Credit cards typically charge interest rates in excess of 20%. This is an enormous interest rate that is likely significantly hurting your budget. Take an example:
Your unpaid credit card bill: $1,000
Interest you pay over the next year (not considering monthly compounding): $1,000*20% = $200
If instead of paying the interest of $200 that will be gone forever, you could take those $200 and invest under 5% annual, you would have had: $200 + $200*5% = $210
That is a difference of $200 (that you paid in credit card interest) + $210 (that you would have saved instead) = $410! That is 41% of that $1,000!
Bank and student loans charge high rates as well (7%+, usually), which is in excess of what you likely would have been making have you invested your money in the market (5% on average is a reasonable expectation).
Therefore, if you have debt, the best saving strategy is paying off the debt as fast as possible: put all your cash (i.e., that 20% of your paycheck) towards paying off your debt, until it is paid off completely.
You might also consider taking advantage of the nowadays frequent credit balance transfer promotions by the banks that will allow you to move all credit card debt on your line of credit or another credit card under 0% for the next six months or so. Be sure, however, to read and fully understand all terms and conditions. For example, understand what happens when the six months’ promotion period expires.
2. Building an emergency fund.
Since you want the money in your emergency fund to be easily accessible and safe, the best way is to put money aside on a Savings account. Keep in mind that often Savings accounts pay a very low-interest rate, as low as 0.01%, so be sure to shop around for the highest interest rate available to you. Typically, you will find higher interest rate Savings accounts with smaller/newer banks. For example, EQ Bank offers an interest of 2.00% on their Savings Plus Account. Consider also the newly emerging neo banks or companies like Wealthsimple* (in Canada) that offer cash accounts (kind of a Chequing and Savings accounts combined) and pay higher interest rates on them, sometimes as high as 2.4% (vs. the 0.01% offered by the banks). Keep in mind, however, that those rates might fluctuate with the market, unlike the typical Savings account rates that typically stay fixed. Additionally, consider Tax-Free Savings Accounts (TFSAs). While most TFSAs pay a lower interest rate, their no-tax benefits might over-weigh the higher interest rate in some cases.
3. Purchasing a property to live in.
Saving for a property purchase is likely going to be your medium-term goal (three years+). In this case, you would want to invest your money in the market with low risk. Low-risk market investments will likely yield higher interest than a Savings account but be sufficiently safe at the same time (you will likely invest in a portfolio primarily comprised of bonds, cash, and a very small percentage of stocks).
Another great strategy, in this case, is to set an automatic deposit into your account. The automatic deposits can be set weekly, bi-weekly, or monthly (other frequencies might be available too). The automatic deposits should be calculated in your budget: it should be the maximum guaranteed money you feel comfortable regularly putting aside. Every month, make an additional manual deposit if you have extra funds remaining that you can save.
Moreover, be wary of investments with high fees. Most mutual funds will charge a management fee to compensate the fund managers for their work. However, often mutual funds offered by the banks and traditional investment firms carry a very high management fee (set as a percent of your investments), that will likely impact your returns. Do your research to identify providers with lower management fees.
Again, companies like Wealthsimple*, provide a great tool for such investments. There, you can select your risk level and set up automatic deposits. Wealthsimple also has rather low fees and a great referral program.
4. Investing money in mutual funds, stocks, and other investment vehicles. Once you have achieved goals 1-3 and you feel more comfortable with your financial situation, you can start investing in higher-risk mutual funds and individual stocks. Investing in individual stocks deserves its own blog post, so we will leave it until then.
Tip #7: Educate yourself about financial basics.
The modern financial world is hard to navigate. The more you know about finance, the easier it will be to make educated decisions on spending and investing and plan your financial future. A good approach is to make it a rule to read one financial blog or listen to one podcast per week. If you have more time, read books on how to manage your finance.
Achieving financial stability requires rigorous discipline. It is very important to develop budgeting skills and saving habits from an early age. Parents have the ability to help their children achieve a great financial future by teaching them to save and budget, among other skills. While there are limited resources available to help parents, some great fin-tech family solutions are starting to emerge. Apps like Pennygem are designed to help parents do that.
See you in our later posts!