Now that you’ve decided to become wealthy, you must ask yourself: what do I consider wealthy? Your financial Enough is a personal search for balance between income and spending. Early in life, your spending will include spending to live this month, and saving money to spend later in your life. During retirement, your only spending includes your living costs, which you will pay for with the money you saved earlier in life.
Your monthly expenses in the here and now that you will need to add up are housing, groceries, dining out, insurances, utilities, subscriptions, transportation, childcare, travel, health care, pet care, hobbies and probably some more. You can be meticulous about your expense budget, or roughly take the biggest expenses and add a reasonable ‘Other’ category to get a solid estimate.
With your monthly spending known, we can calculate the total sum of money you need in investments to live off indefinitely. The goal here is to find an amount that will grow yearly with the exact amount that you spend each year. At the end of the year, you end up with the same amount of money, but you’re now a year older. If you keep doing this until you die, you’ve succeeded financially.
The expected interest rate varies with experts and users, usually between 3-6%. Let’s take 4% as an example (also called the 4% rule). As your investment grows yearly with 4%, this is the amount of money you can safely take out of your investments and use for your living costs. As the 4% amounts to your yearly expenses, the 100% that you need to invest amounts to 25 times your yearly expenses. If you spend €50.000 a year, you will need 25 × €50.000 = €1.250.000 in investments. This can then grow by 4% or €50.000 per year, which you can then spend and end up with the same €1.250.000.
With the end goal in sight, we can work backwards to calculate our monthly deposit to our retirement savings. There are several compound interest calculators available that help you out determining your savings rate. Factors you include in the calculation are the final amount of money needed, your starting amount of money (which can be €0), the projected annual interest rate and the amount of years remaining until your retirement.
The 4% rule has been applied to your spending only (or maybe that of your family’s), but doesn’t take into account any money you might want to leave to your children, other inheritors or good causes. You do have the investments left over from which you paid your expenses, which might be sufficient as an inheritance. Any surplus money has to be gathered separately.
The inheritance relies on you dying before any heirs will spend their part, but chances are that some expenses of your children happen (hopefully) before your death. This is the case with educational expenses which you will have to account for separately.
Work towards rapidly moving out of living salary-to-salary and start building net worth. Every month, put some amount of money apart for later. This can be a percentage like 10% or an amount like €200. You should have estimated your financial Enough and work from there. How you divide your money can be done with a personal finance flowchart. Automate as much as the cash flow as possible so you don’t have to (re)think about it.
Your finances are water buckets. Buckets because they have a fixed size and can overflow when reaching the rim. Water because your money will flow abundantly when you follow this system. We will define financial buckets and their size, and see how they will overflow into the next. Some situations might become more complex, as a bucket might not overflow into one next bucket, but split up into multiple targets with differing contributions.
Your financial buckets are the emergency funds, employer retirement match, high interest debt, bridge funds, low interest debt, retirement contributions, large purchases funds and investments.
Figure 1. The payment buckets flow illustrates which funds should be filled first before continuing to the next one.
The emergency funds are used for unforeseen costs that should be dealt with rapidly. Your car broke down and you need to get it fixed to get to work. Your washing machine broke down. You got a fine. Around €1.000 should be sufficient, but decide what you’re comfortable with. It’s fine to cover just 1-2 emergencies, as this fund is the first to be topped up with your next monthly income anyways. You want to access this money quickly in case of need, so use a savings account for this.
The employer retirement match is a no-scam, no-risk 100% return on investment scheme. Always be careful when you hear such potentially fraudulent claims, so hear me out. Your employer might offer you a retirement match which means that for every €1 you contribute to your retirement out of your own pocket, your employer will also contribute €1 to your retirement out of its pockets. This is in addition to your existing retirement scheme. The only drawback is that there is often a limit per month or year. Pay exactly this maximum match to optimally benefit from this double-your-money-guaranteed deal.
High interest debt is debt with an interest rate of about 10% or higher. This might vary, but in general it is an interest rate higher than you would get by investing. It makes more sense to pay off the debt, than to invest your money in this case.
Paying off debt can be done via the Snowball method or the Avalanche method. With the Avalanche method, you pay off the highest interest debt first, which is the financially better option, but might also be the most demotivating option when the highest interest debt principal is large and paying it off takes a long time. With the Snowball method, you pay off the smallest principal debt first and continue with increasing size. This can soothe the mind and evoke a sense of progress, but is financially inferior. Don’t underestimate the human psyche in dealing with money, personal finance is both about the person and the finances.
The bridge funds consist of 3-6 months of total expenses. When you lose your monthly income for whatever reason, be it being fired or resigning yourself, you have some leeway to find a new monthly income source without stressing out. I think this is one of the first feelings of freedom I experienced by becoming less attached and dependent on an income source. You have to decide your level of security and take your situation into consideration. If you’re a sought after employee and can easily get a new job in this market, you can have less months of expenses saved. If you are self-employed and have highly varying income, you want more months of expenses. Store these funds in a savings account and you’re set.
Low interest debt has an interest rate of around 5%. It is less pressing than the high interest debt, as some other buckets will bring in more return on investment than this debt will cost. At some point you want to get rid of the debt. This might also make you feel psychologically better about the situation.
Retirement contributions differ in countries and continents, but are all based on some kind of tax relief or other financial attractive benefit. These are paid for by you and are different from retirement schemes and employer retirement matches which we’ve dealt with earlier. Like the employer retirement matches there is a cap. Your retirement contributions will be eligible for benefits up until a certain amount per year, and everything above will be considered regular wealth with the normal taxation. This basically makes everything above the limit a regular investment as we’ll see in the last bucket.
Large purchases funds include home renovations, college and other education investments, car purchase, etc. that you foresee in the next 3-5 years. You don’t want a loan for these purchases and the timespan is too short to safely store the money in investments in the meantime. Investments have enough time to average out and grow over 40 years, but over 4 years you could very well have entered a downturn of the market and lose a big portion of your large purchases funds. You can either store this in a savings account or a deposit, which gives a higher interest for a locked amount of time. Come up with an estimate of your costs and make this your savings goal. You don’t have to fill this bucket before continuing to the next one. You can split contributions for example 50% between large purchases and investments.
Investments are for the cool boys, but are also last on this list. It’s the hot talk in town, but the least financially attractive until you’ve filled the earlier buckets. Actually, we’ve indirectly been involved in investments with everything related to retirement as those are investments too. These investments have the benefit of being available before your retirement, so they can be used to retire early. You can also fund purchases during your lifetime. Keep in mind that the longer you let your money grow, the more money it will get you. Don’t spend too much early profit to ensure long term abundance.
Apart from genuinely making barely enough to survive, there is no excuse not to pay yourself first. Chances are your Enough is set too high and if you realistically look at your situation you would agree. You can’t see yourself living with one less car, in a smaller apartment and having to move and going out for dinner less, but you’ll manage when you try. Just admit the mistake of setting your Enough too high and now having to deal with the consequences. Also be glad that you’ve realised now and are still being able to fix the situation, instead of further spiralling downwards.
Time is your power, especially while you’re young. Recall compound growth as a driving force for ever-increasing gains. Adding more growth cycles before you quit is not just adding more growth on what you already invested, but also more growth on the growth you got. Let’s apply this concept to your financial situation.
Starting at the end, ‘I quit’ is equal to ‘I retire and I need my investments to live off now’ and we assume this to be at 65 years old. A growth cycle will be a year in our case. We’ll assume an annual 6% return on investment for every scenario. We disregard inflation for proving this concept, consider it somewhat included in the annual return rate if you’d like. We consider different scenarios for three people with a different background: Privileged Peter has the knowledge of investing early, Unprivileged Uma got to know investing later in life and Stubborn Sebastian refuses to invest. Peter is 20 years old, Uma is 40 and Sebastian is also 20. Let’s compare their final results and process to get there. Hopefully, these scenarios will convince you to start investing early, no excuses.
Scenario 1. Peter, Uma and Sebastian all inherit €10.000 from their grandparents. With 45 years to grow, Peter will own €137.646. With 25 years to grow, Uma will own €42.919. Peter could even consider investing only €3.250 and still end up owning little more than Uma, while having €6.750 to feast however he likes. Sebastian ends up at the bottom. With 45 years of non-growth, he still owns €10.000.
Scenario 2. Peter, Uma and Sebastian all have €0 to their name. They all want to own €1.000.000 by retirement. How much do they need to start investing monthly to reach their goal? With 45 years to contribute and grow, Peter will need to contribute €400 monthly until retirement. Peter has contributed €216.000 himself and the other €784.000 is capital growth. With 25 years to contribute and grow, Uma will need to contribute €1600 monthly until retirement. Uma has contributed €480.000 herself and the other €520.000 is capital growth. Not only does Peter have to contribute a total that is half of Uma’s, he’s also making it easier on himself by making the monthly payments rather low throughout his life. The only downside is that Uma has 20 years more to spend an extra €200 per month, but that comes with a cost. If Peter matches Uma’s madman contribution, he would end up with €4.000.000. With 45 years to contribute, Sebastian will need to contribute €1.850 monthly to his savings until retirement. If he contributes only €400 monthly like Peter, he ends up with €216.000. All of his worth is contributed by himself, none of it through capital growth.
These scenarios are just here to show you that investing early is worth it. It is worth it in the sense that you get more bang or growth for your individual buck. It is worth it in the sense that it puts less pressure on you and your finances later in life. You’re just chilling on your stable well-being train while others are desperately running besides it trying to catch up and hop on. They could’ve simply entered while the train was standing still at the station. The thing with investing is that the best station to hop in was always yesterday, the second-best is right now.
Strive to be a Peter and happily continue your pace, don’t stress out if you’re an Uma but start now, and work on yourself if you’re a Sebastian. Don’t take these scenarios as literal examples of what you should do. You should plug in your own numbers for expected interest rate, preferred retirement age, preferred retirement amount and other factors. You can find a ‘compound interest calculator’ that helps you out with the numbers, there are many of them.
A conveniently low effort and effective way to grow your money is by investing in index funds. A type of index funds you should consider are exchange-traded funds (ETFs). The funds consist of shares weighted in proportion to their market size. You reduce risk by investing in a lot of stocks instead of putting all eggs in one basket. Surely, you’ll miss out on huge multiplications, but you’ll also avoid huge losses.
Buy and hold is the strategy you want to use in purchasing index funds. It is as simple as it sounds: buy the funds monthly, and keep holding onto it until you need it (at retirement, for example). Don’t try to time the market, just mark a monthly task in your calendar to buy the stocks, or even automate this process. A common saying in investing is ‘time in the market beats timing the market’. Sometimes you buy on a high price, sometimes you buy on a low price, and eventually this price will average out.
An individual has to invest an unreasonable amount of time in stock selection to have a chance of profit. A smart individual applies an exaggerated Pareto principle here by recognising index funds as a less than 1% of time investment for a more than 80% results strategy. After an initial investment of your time where you educate yourself on using index funds and set up an investment account, the strategy takes a negligible amount of your time. Buying 1-3 index funds each month is a matter of minutes (on the conservative, slow side).
Avoid actively managed funds as you’ll basically pay the funds managers to wager your money for you. The managers charge a fee for constructing and maintaining a portfolio of stocks. Index funds automate this process by simply tracking the current market and buying or selling shares according to the publicly available state of the market. Management costs for index funds are much lower than those of actively managed funds. Even a 0.5% difference in management costs can eat away a sizable portion of your 6% interest.
Some people like to actively manage their holdings and pick individual stocks. Gambling is fun to some folks, but it should be seen as just that: a pastime for your amusement. Expect to lose all your money with your hobby and be fine with it. If you’d like to gamble with stocks, keep it under a preset boundary such as a few thousands euros or a low percentage of your total money invested.
Have dedicated bank accounts for specific expenses and saving goals to increase your money management satisfaction. Staying true to the Lazy Programmer principle, why spend time and effort mentally dividing your budget and deciding whether you can spend within a category or you’ve already reached your monthly limit. Create boxes for each expense category, set up an automatic monthly contribution to each of your boxes, and live a happy life splurging on whatever you’d like until you’re broke.
Within that category, that is. You still have money in another category, but you’re not allowed to use that for other purposes than is written on the box. Whether you like to buy clothes piece by piece as you go, or in a big bulk once a year, feel free to empty your Clothing box. You now still have money for your holidays in your Holiday box and for eating out in your Dining box. I love this strategy for allowing myself to be impulsive, but without the destructive results.
Not all boxes are of equal size. It’s realistic to cap your Holiday savings at €2.000, while your Clothing savings only need €500. Fill each box up until your predetermined cap and have your overflow contribute to either more payment towards your ‘Pay yourself first’ goals or use it as a one-time bonus on whatever you like. You’re doing a good job and are right on schedule anyways. Or do a combination of both options.
While setting up such a system, you want to start out by finding a bank that allows for two bank accounts (your main and daily shopping accounts) and several (free) bank/savings accounts.
Your main bank account is your workhorse and the foundation of all your automations, and also the one you’re least looking at eventually. All income of any sort should arrive at this account. From here, you contribute to your ‘Pay yourself first’ steps, pay monthly recurring costs such as housing, electrical, phone bills, etc., wire your monthly contribution to your daily shopping account and divide the rest under your boxes.
Your daily shopping account is the account you use to pay with daily. Its card is the one that will get the most usage. This account serves two main purposes. First, it protects you against theft and loss. There’s only a few hundred euros on this account, not thousands or more, so damage is limited. Second, it frees your mind to completely spend it on groceries and a new bike light, as you’ve covered your other expenses elsewhere. When needed, with the magic of fast internet and banking, you can transfer money from your dedicated box to your daily shopping account to pay for a specific expense in a physical location.
The dedicated accounts that make sense in your life have to be the result of your own analyses. I can give pointers and my preference as an inspiration, but we probably have different needs. Even you might change your needs and thus needed accounts over time. It’s a fluid process. If you own a car, I would add a Car account for depreciation, maintenance and repairs where you monthly add an estimate of the costs divided by the amount of months you guess you have left until that repair is necessary. If you own a house, add a House account for similar reasons. My dedicated accounts now include in no particular order: emergency funds, bridge funds, large purchases, holidays, clothing, sports, dining, education, business startup capital and pets.
Housing will be a major and constant expense in your life. You have two flavours in getting a roof above your head, each with their own pros and cons: buying and renting. A house you buy becomes your property. It is yours to keep, but also yours to maintain. A house you rent is someone else’s property that they are willing to let you use for a price. It is not yours to keep, but also not yours to maintain (up to a degree).
Rather than listening to commonly spread advice such as “renting is throwing money away”, learn about the pros and cons of buying versus renting and come to a decision that fits your life at the moment. There is no clear option that is always better than the other, and there is no option that is always better for you in every stage of life.
The “don’t throw money away” statement you often hear has to do with the rent disappearing from your bank account never to be seen again, and with buying a house, at least you pay off the mortgage and get to keep that amount in the value of your house. What is forgotten are the costs of owning a house. These are the unrecoverable costs of home ownership. That same mortgage you pay off also includes interest on the loan, which is also money disappearing never to be seen again.
Further, you buy a house in a certain state at 100% value. Over time without maintenance, your house will wear down. The paintwork will deteriorate and decrease the value of your home to, say, 95% of the original bought value. To bring your house up to 100% value again, you have to spend money on the paintwork, which is also throwing money away. You do not gain any money in the grand scheme of things, you simply bring the value of your house back to your bought price.
A forgotten cost is missing the growth of investment capital of your additional savings. The money you save by not having to own and maintain a house can be invested and make a profit. This difference can be invested by the renter, while the owner cannot. Sure, the owner can invest additional money above his monthly housing costs, but so can the renter invest the extra money as well. The owner is throwing away potential profit here.
So, yes, you do throw money away while renting. You also throw money away while buying. In return, you get a place to live, so maybe call the beast by its correct name: spending on housing. Throw away the “throwing money away” feeling. By calling it spending, you can now optimise for it. What is the best option in your case: renting or buying?
Here it gets interesting, as there will be many factors that eventually decide the financially best option. There are calculators available that ask you for your situation would you rent and similarly your input parameters would you buy. Numbers you should prepare are monthly rent, rent increase per year, security deposit, investment growth rate, expected years of stay, house price, down payment, mortgage interest rate, loan term, buying closing costs, maintenance costs, home value appreciation, home insurance, property tax, and some more.
A quick rule of thumb can be used before employing the whole calculator circus to decide whether it’s better to buy or rent. You have to know the price-to-rent ratio. To get this number, divide the price of the house by the annual rent. This ratio also works on median house values and median rent prices of comparable houses to check the general area that you’re interested in living in. Usually a price-to-rent ratio of 15 or less favours the buyer, while a ratio of 21 or more favours the renter1. The range in between is a grey area that requires further calculation. The in-depth calculation is always a good idea before making the final decision, but as a preliminary research the price-to-rent ratio is a fine tool.
While this is a chapter about financial health and decisions, and this focuses completely on the financial best decision, this is not the whole picture. There are valid non-monetary reasons for buying and renting. Renting can be more flexible, you can often cancel monthly and move somewhere else. With buying, you’ll have to sell your house first, which can take months, or choose to pay double for your new and old house. A bought house is yours to do with as you please, you can drill holes in the wall and have a place to live as you’d like with no fear of getting evicted. Consider both the monetary and non-monetary reasons to make a final decision on whether to buy or to rent.
A low price-to-rent ratio suggests a cheap house compared to the high rent. Conversely, a high price-to-rent ratio tells you that you’re renting the house cheaply, as the house is worth way more than you’re renting it for. Disregarding other costs, which are crucial in the whole calculation, the price-to-rent ratio essentially gives you the amount of years after which buying becomes a better option than renting. ↩︎
