How to start wealth building?
What is financial wealth to you? For some, it’s an expensive house, expensive car, and luxury travel. while for others, it’s the ability to put kids through college, save for retirement, and have a paid home. No matter what financial wealth means to you, financial education, planning, and good investment decisions are essential in building wealth.
As with any education, you have to start with the basics. The most basic equation to remember in building wealth is:
Net Worth = Assets – Liabilities
In general, assets generates income and/or appreciates over time while liabilities are money owned (debt). Let’s see examples of each.
Assets: generates income and/or appreciates over time.
- Bank account (savings, checking)
- Investment in Stocks, bond, Mutual Funds, Exchange-Traded Funds (ETFs)
- Home ownership
Liabilities: This is debt (money owed).
- Student Loan
- Car Loan
- Home Mortgage
- Credit Card Balance
The first step in building wealth is to manage your assets and liabilities such that you end up with a positive net worth. This process starts with having a realistic budget, followed by setting realistic short-term goals (1 year to 5 years) and long-term goals (10+ years).
The goals should be S.M.A.R.T. – Specific, Measurable, Achievable, Realistic, and Timely.
Let’s look at examples.
Short-term goal examples:
- Build emergency fund of at least ten thousand dollars in one year
- Save at least $5,000 per year for three years for a car purchase
- Save at at least $20,000 dollars per year for five years for a down payment on a house
Long-term goal examples:
- Invest at least $2,000 per year in college 529 plan from birth to high school
- Fully fund 401k (retirement plan) for at least 25 years
Be flexible, track your goals, and make necessary changes to your spending in order to achieve the set goals.
Minimize Debt (Liabilities) to accelerate wealth building.
Debt reduces net worth; therefore, focus on reducing or eliminating debt. Debt takes away your ability to invest in incoming generating assets.
Debt takes away your ability to invest in incoming generating assets.Tweet
Let’s look at a few examples.
Large Screen TV:
You want to buy a large screen TV for $2,000 but you don’t have the money in the bank so you use a credit card with an annual interest rate of 20 percent to purchase a TV; therefore, increasing debt. It will take you approximately 66 months to pay off the loan amount and the accrued interest while making $50 monthly payments. The estimated interest on a $2,000 loan is $1,300!!! That is a whopping 65% of the initial purchase price of $2,000!!! Certainly. this is a bad financial decision. On the other hand, If you invested $1,300 at a 6% compounding interest, after 20 years that money would be worth $4,169 based on the future value of money equation.
FV = Future Value
PV = Present Value (1300 in example above)
I = Interest Rate; 0.06 (6%) in example above
T = Time in year(s); 20 in example above
The right decision to set a short-term goal and save enough money and pay cash for TV, hence eliminating debt.
The right decision would be to drive a beater for several years until you have enough money to buy a decent car. If you decide to buy a car by taking out a loan, pay attention to the interest rate as well as the duration of the loan. Let’s compare two loan terms on a ten thousand dollars loan, for instance.
|36 months||60 months|
|Total Interest Paid||952||1,600|
Although monthly payment is lower for longer duration loans, the total interest paid for longer duration loans is much higher than the shorter duration loan. Therefore, reduce the loan duration as much as possible.
Therefore, focus on total amount (principal and interest) and not on monthly payment if you decide to take out a loan for car purchase.
For most people, a house may be the largest single purchase they make in their lifetime. While the goal of home ownership for most is pride and the dream of owning a home, the added benefit to home ownership is building equity. Equity is the difference between the market value of the home and the balance on mortgage. Building equity reduces loan amount, hence reduce debt. Let’s compare two mortgage terms on a $200,000 loan, for instance.
|Term||15 Years||30 Years|
|Interest Rate, Annual||4%||4.5%|
|Total Interest Paid||66,288||164,813|
Similar to the car loan example above, although monthly payment is lower for longer duration loans, the total interest paid is much higher than the total interest paid for shorter duration loans. To reduce the cost of home ownership, first, consider a 15-years loan versus 30-years loan even if it means buying a smaller house. Second, If your budget allows, make extra payments towards principal to reduce the overall loan duration.
Wealth Building Summary
Follow the tips below to start your wealth building journey:
- Track your spending and prepare realistic budget
- Stick with your budget and use it as a guide
- Delay purchasing small ticket items until you save enough and pay cash for it
- Do not use credit card unless you pay full amount on monthly basis
- When borrowing is necessary, such as for a home purchase, understand all the terms such as interest rate, duration, and penalties associated with the loan.
- Save 15% to 20% of your income
- Start early and invest consistently
This is just a start. We have not talked about several other topics such as investment vehicles, time horizon, risk tolerance, asset allocation, and portfolio building.
Have you set-up your short-term and long-term goals?