Let’s face it, sometimes it feels so hard to get ahead financially.
Whether it is paying off all your debt, saving for something special, or just building net worth, sometimes it just feels like you take one step forward, then two steps back.
When I feel this way, I remind myself of one thing: Slow and steady will win the race.
Even though progress might feel molasses slow sometimes, so long as you stick to the #1 secret to wealth building, you will get there.
In this post I’ll outline the simple but powerful step you need to take to maintain healthy finances and build wealth.
Contents and Quick Links
- 1 The #1 Secret to Wealth Building – Pay Yourself First
- 2 What does it mean to pay yourself first?
- 3 How to pay yourself first
- 4 The Power of compounding interest
- 5 The power of investing
- 6 Pay yourself first – with a plan
- 7 Don’t feel like you can afford to save 10%? Here are some tips to increase your savings rate
- 8 Recap
- 9 Action Steps
- 10 Related Reading
The #1 Secret to Wealth Building – Pay Yourself First
A part of all you earn is yours to keep.
Let it be not less than one-tenth and lay it by.
Make it your slave. Make its children and its children’s children work for you.George S. Clason – The Richest Man in Babylon
What does it mean to pay yourself first?
Paying yourself first is more than just saving money. It’s about having a lifelong saving mentality.
When you pay yourself first, you save money for a secure future. You take the money that you earn and prioritize a percentage of that income just for you and your family. This ensures that you have money to invest to grow, a comfortable retirement and potentially even generational wealth to hand down to your children.
Action step: Download the checklist to Financial Independence to follow the personal finance steps you can take to save money and achieve FI.
How to pay yourself first
Thankfully, paying yourself first is easy and can be done on autopilot without you even noticing it’s happening.
First, set a percentage of each paycheck to automatically transfer into your employer-sponsored retirement account. Aim to save 10%, up to the maximum contribution of $18,500 for 2018.
Why so much? Because saving 10% of your income saves you money in taxes, accelerates retirement savings (meaning you can retire earlier), and takes advantage of employer matching contributions (free money which raises your total savings rate). Regardless of income level, you can find a way to live on 90% of your income.
Let’s look at a couple examples to demonstrate the value of a high savings rate. I’ll use Joe and Rebecca.
Joe is 30 years old and earns $60,000 annually. His new employer offers 401(k) contribution matching up to 4%. In order to take advantage of this, he automatically deducts 4% of each paycheck, pre-tax, into his 401(k) account and his employer matches an additional 4%. Each month, $200 is transferred over and his employer contributes an additional $200.
Each year, Joe contributes $4,800. Assuming a salary increase of 3% annually and an average 8% rate of return, in 35 years, Joe will have $1,275,000.
Now let’s look at Rebecca. She earns the same as Joe and works for the same employer. However, she saves 10% of her income. Each year, she contributes $8,400. In 35 years, Rebecca will have $2,231,000. If she only needs $1.2 million to retire, she could actually stop working 6 years earlier than Joe.
The Power of compounding interest
Rebecca was able to retire so much earlier than Joe because of the power of compounding interest. Over the course of 35 years, Joe earned $985,000 in interest, while Rebecca earned $1,723,000. That’s a significant increase in free money, and exactly describes the meaning of having your money work for you.
But let’s look at another example, which compares Adam, Beth and Charles.
Adam didn’t start saving until he was 38. He accumulated over $100,000 in student loans, purchased a sporty new car when he graduated and then bought a beautiful home after his first significant pay raise. It took him a long time to pay off debt and develop and saving mindset.
Luckily, he realizes the importance of saving and begins to diligently deposit 10% of his earnings each year, a total of $6,000. By the age of 65, Adam has $755,000. Unfortunately, this isn’t enough to cover all his expenses in retirement so he has to work a few more years.
Beth starts saving at a young age. She saves the same amount as Adam, but started 10 years earlier. By the age of 65 she has $1.9 million saved in her retirement account.
Now let’s look at Charles. He starts saving even earlier. But then life gets in the way. He also buys the fancy car and big house and just doesn’t have the money left over each month to contribute to his retirement plan. He saved more aggressively when he started, putting away $10,000 a year between the ages of 25-35. He doesn’t contribute anything else. At the age of 65, Charles will have $1.68 million.
Which would you rather be, Adam, Beth or Charles?
Action Step: For more real-life examples of compounding interest, visit The Power of Compound Interest – Real World Examples.
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The power of investing
If you do nothing else besides save 10% of your income in a retirement account, you will enjoy the benefits of compounding interest and, assuming you start early enough, enjoy a comfortable retirement.
But what if you want to retire earlier? Or build wealth to pass down to your children?
Here’s where it’s important to make your money work for you. And here is where investing comes in.
The most common example is home ownership. Assuming your home appreciates over the years, and the 30-year mortgage is paid off, you have built a strong asset which can contribute to your net worth. You could sell that home when you retire and downsize, keeping the remaining difference in profit. Or, you could buy a smaller home and rent the original home for passive income to use in your retirement. As another option, you could pass the home down to your children as an inheritance.
But there are many other forms of investing. Since I like real estate investing, I’ll use that as an example.
Real Estate Investing Example
Remember Rebecca? In addition to contributing 10% of her income to her retirement account, she scrapes together $5,000. She uses this as a downpayment for a duplex. She lives in one unit and rents out the second, which covers most of her mortgage. Since she plans to live there for 2 years, she qualifies for a FHA loan, meaning she only had to put 3% down, which is how she was able to afford it.
Since most of her mortgage is covered, she is able to save an additional $10,000 over two years. She buys another duplex and moves into one unit and rents out her old unit. She now has passive income every month and in 2 more years, she is able to buy a 4-plex. She is now renting both duplexes and 3 units from the new 4-plex. Her passive income is up to $1,500 a month.
In two more years, she sells all three properties and upgrades to an apartment building. This provides $3,000 a month in passive income. Over the years, the mortgage is paid down, rents go up and the property appreciates.
Within 10 years of buying her first duplex, Rebecca’s net worth is 2.5 million and she could retire early with the passive income alone.
Action Step: Step through the real numbers that demonstrate exactly how you can achieve financial independence through real estate investing at The Simple Math Behind How You Can Retire Early With Real Estate Investing.
Pay yourself first – with a plan
It isn’t easy to build and maintain the habit of paying yourself first over the long term. This is why it is so important that you have a plan. A long-term goal that will keep you motivated and consistent.
Money is not incentive enough. It doesn’t buy happiness. Furthermore, saving for the long term doesn’t provide instant rewards. What is to keep you from indulging in overspending for instant gratification?
Determine what really make you happy. What do you envision as an ideal future? What provides purpose and fulfillment?
Remember that you are saving for a purpose. There is an end goal in sight, it just might take a long time to enjoy the rewards. Since it takes so long, it is vitally important to remember why you are paying yourself first. What is your long-term financial goal and what does it mean to you? How will your life be different once you achieve it?
Your long-term goal will guide you and help you plan in the short-term. It will provide you with the reason to continue paying yourself first and the motivation to grow your wealth.
Don’t feel like you can afford to save 10%? Here are some tips to increase your savings rate
Track all of your income and expenses for three months. If you need a little help making this happen, visit How To: Track Your Personal Finances and download the Expense Tracking workbook and worksheet from my free Resource Library.
Identify areas of overspending. As you review your monthly expenses, take a look at your different spending categories and find areas where you are overspending, or you can cut back on. You can read about various ways to cut back on your spending, and the difference those little savings can make, at The True Cost of Your Morning Latte.
Create a budget. Budget your savings in by including 10% of everything your income as one of your spending categories. You can read more about creating your budget at The Beginner’s Guide to Creating a Budget You Can Stick To. Be sure to download a free monthly budget PDF worksheet from the Resource Library.
Prioritize your savings. This is your future. Your savings is your retirement, financial peace of mind, and how you can reliably take care of your family. It is important to make it your priority.
Set a financial goal and make it matter. Remember your why. How will your life be different once you achieve your goal? For further reading on how to define your short and long-term goals, visit 10-Year Goals: Why You Need Them Today and download the 10-Year Goals workbook from the Resource Library.
To quote the Richest Man In Babylon again:
That what each of us calls our “necessary expenses” will always grow to equal our incomes unless we protest to the contrary.
The purpose of a budget is to help thy purse to fattenThe Richest Man in Babylon
It may feel like saving 10% of your income (or more!) is unachievable. Perhaps you can barely makes ends meet as it is. The problem is, this will never change. Regardless of how much you earn.
It really doesn’t matter what you earn. If you live off of $30,000 a year, your monthly expenses are low. This means that you require less in retirement than someone that is accustomed to earning $100,000. The numbers themselves don’t matter. Your savings rate does.
In saving 10% of your income, you have the power to control your finances and save and invest for your future. Part of everything you earn is yours to keep. You just need to make sure you keep it.
- If you aren’t already saving 10% of your income, investigate how you can work your way up to a higher savings rate. You can do this by tracking your expenses and creating a budget. Find ways to cut back on your spending and then immediately transfer those savings to a separate account.
- Once you established, continue to live within your budget. Beware of lifestyle inflation. Instead, try to save bonuses and salary increases by automatically transferring the amount directly into your savings. This way, you won’t ever notice that it was there.
- Calculate your net worth and track it regularly. This will motivate you to keep making progress.
- Budget in additional savings for rewards, like travel or big ticket purchases. This prevents feeling financially deprived.
- Come up with a long term goal and work your way backwards to determine how long it will take to reach achieve it. For example, if you wish to retire in 10 years, determine how much you will need in total and how much you need to save each year in order to meet that goal. Track your progress and celebrate your milestones.
Pick up your copy of my favorite personal finance book. This is a great (and short!) book that is perfect for setting a savings mentality for the long term and spells out exactly what you need to do if you want to build wealth.
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