10 Common Questions about Saving

The median American household had only $11,700 in savings and 29% of households have $1,000 or less, according to a recent CNBC article. Whether it is retirement savings or savings for a specific long-term or short-term specific goal, there are many reasons why we should crank up our savings and boost our financial security.

This third article in the “10 Common Questions…” discusses the essentials of savings, including how much savings you should have, your savings rate and what you should actually be saving for.

Q: What classifies as savings?

Savings can include a variety of things. Some people refer to just their money in a savings account as their savings, but there are a few more savings to consider. Really “savings” refers to “any money you have set aside waiting to be used at a future time”. With this definition contributions to retirement funds as well as investments made can also be classified as savings.

Another way to describe savings are “any payments that improve your long-term finances”. This adds yet another option: paying off debt. After all, by paying off debt, you take away the interest charges as well as your dependency on your creditors.

In short, savings can be any or all of the following:

  • savings account
  • retirement fund
  • investments
  • debt payments

Q: How can I save if I never have any money left over at the end of the month!

A not uncommon situation that many people can find themselves in is that they have no money left at the end of the month, let alone any money to make those savings contributions.

But the solution to this problem is answered by the problem itself: “I never have any money left over at the end of the month.” If you wait until the end of the month to set aside money to save, other expenses become a priority. Whatever you allow to be paid closer to the beginning of the month, will naturally have a higher chance of being purchased as there is a higher likelihood that money is still available, whereas the closer towards the end of the month you leave a payment, the lower the probability that there is any money left over.

So in order to start saving you need to change your habits: put your savings allocations to the start of the month and make this one of the first payments you make. Then, with whatever is left, you need to make ends meet and not spend more than you have coming in. By switching the order around you ensure that you hit your savings targets AND stay within budget for the rest of the month.

Q: But currently interest rates are terrible!

At the time of writing, interest rates are indeed extremely low, often even below inflation. But there are several pro´s to keeping up your savings rate:

  • An emergency fund means that you don’t need to borrow money and go into debt if you need money for an emergency.
  • Cash is king, and having some funds available immediately when needed is a huge peace of mind.
  • If you are looking for higher returns upon investments, instead of setting money aside into a savings account, consider investing the money or adding more to your retirment funds.
  • Another way to use your money if you don’t want it to sit idly in a savings account is to pay off debt faster. In this way you avoid the accummulation of interest payments.

Q: How much should I save per month? 

You should save how much you can and want to save each month, but a common answer to this question, at least to start with, is to save 20% of your net income. (This is based on the 50/20/30 rule that says to aim to spend 50% of your money on essentials (rent, food, utilities), 20% on savings goals and 30% on discretionary or fun expenses (holidays, nights out) ). Of course, these are only guidelines, and since your situation is unique you need to decide for yourself how much you can really save. But it’s a good starting point if you are not sure what a good amount would be. As your lifestyle is so different to other people’s, using a savings rate is much more helpful than using specific amounts.

Q: What’s so important about this savings rate?

Your savings rate tells you how much of you income you don’t need for your day to day life. The higher your saving rate, the less you live off. This is helpful in two ways:

  • If you lost your job or were without an income for a while, it means you need to eat into your savings less simply because you’ll need less money to pay your bills.
  • The more you save, the sooner you hit your savings goals.

Let’s look at an example. Say you earn $2,500 net a month and that you save 10% of this money $250 and therefore spend the remaining 90%: $2,250. That means it would take you 54 months to save up for a 6 months living fund ($2,250 x 6 / $250).

If instead of saving 10% you were able to set aside 20% each month, your monthly savings would be $500, your spending would be $2,000 and it would only take you $2,000 x 6 / $500 = 24 months to get together that 6 months living fund.

Q: What is my savings rate?

You can quickly calculate your savings rate by looking if you know your last month’s income and savings. If you keep a register of everything that you spend and save, this process is even easier, but even if you don’t and you need to work of approximations, that is fine too. To calculate your savings rate, find out how much money you allocated to  savings expenses: this includes contributions to your savings accounts, retirement provisions, paying down debt and investments. Total these amounts, then divide this by your total net income.

If you set aside $50 in your savings account, $100 towards your retirement, $75 to pay down debt and invested $75, your total savings expenses were $300. If you take home $2000 each month that gives you a savings rate of 15%.

Q: What should I be saving for?

  • Emergency fund – for any emergency expenses that are unexecpected and that you have to make in the moment, for example when your car or washing machine breaks
  • 3 – 6 months living fund – to cover your expenses if you suddenly find yourself without an income
  • Specific targets (vacation, new car, children’s education) – these can be adapted depending on some of your own personal short term and long term plans
  • Retirement – this can be in the form of a retirement fund or your own private investments

Q: What are some savings targets I should aim for?

Although there is no ONE answer to how much you should have in savings, here are some common guidelines that you can use in order to decide for yourself how much to save:

 

Q: paying off debt, savings, retirement funds, investing… what should I be doing? 

In order to truly cover yourself in all financial areas, you want to be doing pretty much everything. But of course, you’ll likely not have heaps of money available to do all at the same time to the maximum amount that you’d ideally set aside. So what should you be focusing on? Here’s a helpful guideline that you can use and adapt to make it work for you.

  • Start doing ALL of the above, but start small with those that are less of a priority right now (for example investing) if you still have other ones that are more urgent (paying off consumer debt or saving at least 1 months of expenses).
  • Decide how much $ you can put aside each month, then allocate a % of that money to each of your savings, for example: 70% paying off debt, 15% saving, 10% retirement fund contributions and 5% investing.
  • Every 3 months, re-evaluate your % as well as your monthly total amount you can save and re-adjust where possible. You might decide that once you’ve paid off all your consumer debts with an interest rate of over 4%, you reduce your % to pay off debt to just 40%, using the remaining 30% to boost your savings or to one or several of the other saving goals you have.
  • I’m a huge fan of scheduling dates as those three months will otherwise fly by and be forgotten about, so block in this appontment with yourself already!

Q: Where should I start?

  1. Begin by putting away a set percentage of your wage. If you need to begin small then that’s okay. This could be 5% or even just 3%. It’s better to start small than to not start at all.
  2. Set saving goals and if possible open different bank accounts for each one. Saving goals can be anything from short to long term.
  3. Decide on your savings allocation for each goal: Of all the money you set aside each month, set aside 50% for goal A, 30% for goal B, 10% for goal C and another 10% for goal D for example.
  4. Little by little start increasing your savings rate, until you get to your ideal savings percentage..

This article is part of the “10 Common Question series”, where I address issues about some key financial areas, including Financial Independence, paying off debt, increasing your income, retirement provisions, saving, investing, financial protection and much more. If you want to find out more about Financial Independence, you can sign up to my newsletter to stay up to date or get a free sample of my book 100 Steps to Financial Independence. 

Image by Andreas Breitling from Pixabay

Part 6: Increase Your Income

Get your FREE sample of the 100 Steps to Financial Independence Book here

Many people see their income as something fixed that they have little to no control over – apart from the rare moments of salary negotiations such as when starting a new job or during performance reviews. Part 6 of the 10 Parts to Financial Independence will look at how you can influence your earnings in many more ways than you might think.

Part 6: Increase Your Income

We commonly think of our income as whatever we get from our jobs. But that’s only one way to earn money, when there are actually seven different types of income streams! 

These seven different ways to generate an income are described below, along with some prompting questions and ideas to help you decide whether you can and might want to develop one of these streams further to increase your income. 

The seven income streams are:

  • Earned income from a job – money you earn through your work for a company. This income stream is generally based on getting paid for your time. 
    • To increase your income, can you increase the likelihood of a bonus by making yourself more indispensable? Can you up your earnings by doing another course or pursuing a promotion? Is it time for a new / better paid job? 
  • Profit – money you make by selling products or services as part of a business activity at a higher price than the cost price.
    • Can you start a side hustle selling things you make or offering your services? Think about an Etsy shop, tutoring or a specialised IT service.
  • Interest income – Money you get from lending money to others, such as to a bank, the government or through investments.
    • Can you increase your interest income by increasing your savings, your investment in bonds or your crowdfunding contributions?
  • Capital gains – Money you receive as a result of selling something that you acquired at a much cheaper price than what you are selling it at.
    • Can you invest more into the stock market, houses or antiques to build up a bigger portfolio and sell that later on when these assets have appreciated?
  • Dividend income – Money you get from shares if the company whose shares you own makes a profit they can pay out.
    • Can you buy more shares to increase the amount of dividend earnings at the end of the year?
  • Royalties – Money you receive on products you have made or from franchises of your brand.
    • Can you write a book, compose music, design stationary, wall paper or a new software to generate an income stream from royalties?
  • Rental income – the rent that you collect from renting out assets that you own (usually property).
    • Is buying property in order to rent it out an option for you?

Go through the above income streams and work out how much you are receiving from each of them each month. Then decide which one(s) of these you can further develop on the short-, mid- and long term to increase your income to keep progressing on your path to Financial Independence!

The above is an adaptation of part 6 of the 10 parts in the guidebook to Financial Independence100 Steps to Financial Independence: The Definitive Roadmap to Achieving Your Financial Dreams where you can find more details as well as action plans and guidelines to each of the 10 parts. Available in both ebook and paperback format!

Get your FREE sample of the 100 Steps to Financial Independence Book here

Coming up next: Part 7 of the Journey to Financial Independence!

Day 8 / 31 Learn about Compound Interest

Day 8: Learn about Compound Interest

Day 8: Learn about Compound Interest
Day 8: Learn about Compound Interest

The thing with compound interest is simple: it can either make or break your financial future. That might sound like an exaggeration but it really is that powerful. Today’s challenge is to learn (or refresh your knowledge) about compound interest and see where you have compounding interest affecting your finances positively or negatively.

Compound interest is nothing more than interest over interest over interest. When this happens over any savings or investments you have, this is generally a good thing as it means your capital is growing more each year. Instead of receiving interest over your original amount, you also get interest over any interest you have generated in past years. In this way if you have an investment account with an 8% annual return and an initial starting amount of $10,000 that amount will be worth $46,000 after 20 years. Continue reading “Day 8 / 31 Learn about Compound Interest”

Step 94: Beware your Credit Score

Step 94 of the 100 Steps Mission to Financial Independence: Beware your Credit Score
Step 94: Beware your Credit Score

Your credit score is important when you want to qualify for a loan, such as a mortgage or a car loan, or many other financial products including insurance policies. Only with a high credit score will money lenders want to give you a loan. If your credit score isn’t high enough they won’t want to give you a loan, meaning you either won’t be able to buy your house, or you might only be able to get loans with high interest rates. Nowadays some employers even check credit scores of job applicants so maintaining a positive score is truly important not just in order to get a loan but potentially also when it comes to applying for a new job.

The importance of having a high credit score:

  • It gives you lower interest rates on loans and mortgages. As you know by now, even small differences in percentages can make a huge difference over time.
  • Landlords usually evaluate rental applications on credit scores as with a higher credit score they believe you are less likely  to default on your payment of the rent.
  • Other financial products such as insurance policies as well as investment opportunities are sometimes only granted to those who have a sufficiently high credit score.
  • Certain companies and employers don’t hire people with low credit scores as they believe these people have less self-control and are less goal-oriented.
  • Higher credit scores increase your chances of getting a higher credit limit. This in turn helps you decrease your credit utilization rate (see further below)

Tips to improve and maintain a credit score:

  • Don’t ever default on a credit card payment. At the end of each month make sure that you pay the minimum you are required to pay.
  • Start paying off your debt, this shows that you are a responsible person looking to reduce your debt instead of constantly living with outstanding amounts.
  • Once you’ve paid off all outstanding credit card debt, make sure to pay off your credit card in full at the end of each month from now on.
  • Maintain a low credit utilization ratio, i.e. the percentage of your credit limit you use. Try and keep it below 30%. For example if you have 3 credit cards with a $1,000 limit, aim to use no more than $900.
  • Don’t apply for credit too often or for too long. A credit company will keep track of any inquiries they receive and if somebody has been marked with having made lots of enquiries or over an extended period of time, your score again goes down.
  • Close cards you are no longer using. This might reduce your credit utilization percentage, but having many different cards also imposes a risk of fraud, theft and temptation to use more than you need.
  • You usually get a better rating for cards that you’ve had for a while, so avoid closing long-term cards.
  • Keep track of your credit score regularly, e.g. monthly. You can easily check your credit score online.
  • Start build your score early on. The longer you give it time, the better your score.

Continue reading “Step 94: Beware your Credit Score”

Step 71: Investing through Crowdfunding

Step 71 of the 100 steps mission to financial independence: Investing through Crowdfunding
Step 71: Investing through Crowdfunding

Once you’ve got a taste for investing, you’ll likely want to investigate other options that allow you to invest some money, either to diversify your portfolio, support a small start-up, increase returns or simply for fun to see what happens.

A hugely popular new way of investing (or indeed raising money if you are on the other side of it) is crowdfunding. Crowdfunding is a way for companies, entrepreneurs and start-ups to get together a sum of money to set up a business, launch a new product or expand and open a new project or department.

Types of crowdfunding

There are different types of crowdfunding:

  • In P2P (peer-to-peer) lending, capital is raised by getting many different loans of small amounts together. Instead of getting one loan of $30.000 from the bank, entrepreneur(s) might get as many as 200 different people lending them amounts between $50 and $1000 for example. Like with a bank loan, the entrepreneurs are then paying the loans back over time with interest to their investors.
  • Pre-sales in which people can pre-order even before a product has been produced. Those initial investors will get a first release or even a small present several times a year (for example a new exclusive wine or another small new release).
  • Selling shares and having people invest in your company in return for a small ownership in your company.

Continue reading “Step 71: Investing through Crowdfunding”

Step 70: Pay off your mortgage

Step 70 of the 100 steps mission to financial independence: Pay off your mortgage
Step 70 : Pay off your mortgage

Now that you’ve been through the various steps on expenses and budgeting, saving, pensions, investing and planning for your future, it’s time to go back again to the bit on debts with one debt in particular which is probably your biggest debt: your mortgage (providing you have one – otherwise you can skip this step). We of course spoke about paying off debt at the start of our mission, but as we said there, since your mortgage has a lower interest rate than most of your other debts, chances are you haven’t yet started paying it down faster.

As commented before many people would argue that a mortgage is a different type of debt and therefore not to worry about as much as they see having a mortgage as an investment. At the end of the day they say, your house is an asset that will probably increase in value over time. I disagree for several reasons:

  •  first of all it isn’t the same type of assets such as stocks and bond that you can just sell to generate some extra money. The only situations in which you can argue that your house is an asset like any other is when you don’t need it anymore for example because you decide to:
    • travel
    • move in with somebody else
    • live in another house that you already own or rent
    • scale down and don’t need a mortgage on a new house
    • live on the streets
  • secondly, you never know when you can sell your house. Some houses are on the market for years, so liquidating that asset isn’t as easy as with other assets.
  • thirdly nothing guarantees your house will truly increase in value or have increased in value by the time you need or want to sell. During the recent house market crash, many houses were sold below their original purchase price.
  • fourthly you are still losing money by having a mortgage in the form of interest payments and you are tied to paying back regularly so until you pay off your mortgage in my eyes this is a debt that takes a big toll on your monthly finances.

Continue reading “Step 70: Pay off your mortgage”

Step 49: The Difference between Shares and Bonds

Step 49 of the 100 steps to Financial Independence: The Difference between Shares and Bonds
Step 49: The Difference between Shares and Bonds

Stock markets have a vast selection of stocks and bonds that can be invested in and before deciding what to invest in, understanding the main differences between stocks and bonds well is absolutely key if you consider getting in the stock market. Investors can decide whether they want to invest in just shares, just bonds or whether to create their own mix of stocks and bonds. With time, many furthermore decide to slowly reallocate their investments, so even if you start with a certain percentage shares and bonds, this needn’t stay as such for the rest of your investment life.

Here we’ll look at the main differences between shares and bonds from an investor’s point of view and how they both offer different advantages and disadvantages.

Volatility

  • Share prices vary more day-to-day but also over long periods of time: their value can increase or decrease fast.
  • Bonds are generally more price solid and fluctuate less over time and at a much slower pace than shares.

Continue reading “Step 49: The Difference between Shares and Bonds”

Step 48: Understanding Bonds

Step 48 of the 100 steps to financial independence: Understanding Bonds
Step 48: Understanding Bonds

In step 47 we looked at an introduction of what shares are, but they are only part of the stock market, there is another major player to be found on the stock exchange, which are of course bonds. In this step we’ll look at bonds in greater detail and find out why they might be interesting to invest in.

What is a bond

A bond is in essence nothing more than an IOU that a government or company issues when they borrow money. In the case of a bond, the debtor (i.e the government or company that issued a bond and therefore borrows money) agrees to pay back the full amount of the original loan, along with interest.

A bond is traditionally an official paper to confirm the loan and when bonds are issued, they usually have the following information:

  • Value of the original loan, i.e. how much money the bond was for.
  • Interest rate that the company or government will pay back yearly.
  • Redemption date: this is the date when the issuer of the bond will pay back the original loan. This is usually anything between 5 and 30 years.

Like with stocks, companies and governments often issue many bonds at the time in order to raise a total amount of money they need for a new investment or expansion.

Why do bonds exist

So why do companies issues bonds and not just borrow money from the bank? The main reason to choose for bonds is that companies can often agree lower interest rates with investors than they can with banks. It also means that they don’t need to adhere to the restrictions that many banks impose on entities when they borrow money. By issuing bonds it guarantees that companies have more flexibility and freedom when it comes to chosing between reinvesting or loan repayments.

So why not issue shares then? A drawback of shares is that a company cannot just continue issuing more and more stocks without annoying their investors as the more shares are out, the more owners of the company there are, the more reduced the Earnings Per Share (EPS) are: the same profit has to be divided amongst more investors. With bonds, companies don’t have this problem as they can issue more so long they can find new investors willing to lend them money. Of course the disadvantage of bonds over stocks is that the full amount needs to pay back, which as we saw in step 47 is not the case when a company issues shares.

What do bonds give

Bonds give investors the possibility of making money in the following two ways:

  • Interest payment – as with any loan, a debtor agrees to pay interest on an outstanding loan, so if you lend somebody $100 at an interest rate of 5%, you can expect to get $5 every year until the redemption date, when the bond will be paid back in full.
  • Capital gains – similar to shares an investor can decide to sell their bond to somebody else, meaning the new investor takes over the loan. Since bonds are traded on the market, their prices can go up (or down). Bonds can be sold for more or less money than was originally lent to the company or than what the original investor paid, so as with shares, one can make and lose money on the buying and selling bonds.

What affects the price of bonds

The fluctuation of bonds prices is usually a result of the following three main factors:

1. Interest rates of the national and global economy

Investing in anything on the stock market always brings a risk as well as a cost with it. You pay fees somewhere along the line, be that to a stock broker or your brokerage account.. at some point you’ll pay. Added to that, bonds might cease to exist if the company or government goes bankrupt. So if you get 5% interest on a savings account with you bank, you’d be silly to buy bonds at 4%, as not only will you get less money on it, you will also run a higher risk of losing your money and you haven’t even paid for any costs at this stage. When interest rates of the economy go up, bonds have to offer more interest, otherwise people will invest their money in their own savings accounts. Add in inflation rates being high or low and you can imagine that it might be more interesting to put your money in stocks instead of in a low-interest bond.

2. Risks associated with the bonds

Every bond issuer is different and is either more or less likely to actually pay back the loan. If the entity goes bust, you simply won’t get any money back. Safer bond issuers might be more interesting as they are less likely to go bankrupt, although returns (i.e. interest rates) are generally lower than on bonds from more risky entities. To indicate how safe a bond is, there is a credit quality rating or bond rating, which ranges from AAA (highest level of safety) to AA, then A, BBB, BB and B and continues with CCC, CC and finally C, which indicates a low quality bond. During different economic times, people are willing to take more or less risk.

3. The remaining life span of the bond

Bonds that have a long life span have a higher risk of a payment default (the issuer not being able to pay) or a change in their credit rating. A company might be very healthy at the moment, but what will they look like in 30 years’ time? Because of the associated risk, longterm bonds usually have a higher interest rate to correct for the increased risk or insecurity. Bonds getting closer to their redemption date can go up in prices as they become more interesting to have as the chance of payment default or bankruptcy of the company goes down.

Two last warnings

  • Remember that if you bought a bond of $100 for $110 (thinking you’d either get enough interest on it to counter for the $10 difference, or would be able to re-sell at an even higher price), since the bond was originally issued for $100 at the end of the its date, you will only be given $100 by the issuer! If on the other hand you purchased it for $90, you will make $10 on the bond by its expiry date.
  • If a company has issued both bonds and stocks, then their bondholders must be paid interest before any profit can be given to the share holders. At the same time when you buy a bond, you won’t be given any part of the profit.

Step 48 – Understanding bonds – in detail

Like in the previous step, we are for now just finding out about bonds and how they behave on the market.

  • Type in bond prices + a company to find out more about the characteristics of bonds, such as their interest rates, maturity date / redemption date, and current prices. See how this evolves over time. Don’t worry about the actual details or number, just try to get an idea of how bonds trade on the market.
  • It’s harder to find information on bonds in the news, as news items tend to focus more on shares since they sound more exciting due to their prices fluctuating more. Try and see if you can find some information on bond prices, defaults and other information on bonds.

And that ladies and gentlemen is the introduction to bonds. Does the whole stocks-and-bonds-story still sound little confusing? Good, as the next step is completely focussed on comparing the two in greater detail.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.

Step 46: On Inflation and Interest Rates

Step 46 of the 100 steps mission to financial independence: On Inflation and Interest Rates
Step 46: On Inflation and Interest Rates

We’ve mentioned inflation in several earlier steps, so it’s time to have a closer look at this economical phenomenon, how it works and what effect it has on the economy and your personal finances specifically.

Inflation

Inflation is an increase in the prices of goods and services over a period of time, leading to a  loss of the relative value of our money. If you have $1,000, you can buy 10 items that cost $100 each today, but when the item price goes up to $110, the $1,000 will only buy you 9 items in the future. Inflation leads to us being able to buy less for the same amount of money.

Deflation

The opposite of inflation is deflation, with prices dropping and therefore our money increasing in value. Although this might initially sound like a fantastic situation, a period of deflation is normally a sign of economic recession. When customers know that prices will go down with time and that their money will be worth more tomorrow than today, they hold off making new purchases or investments. Often times this is a vicious circle, as interest rates on loans drop (see further down as to why) so holding off bigger purchasing such as a house means not only that it will be cheaper if one waits a little, but also that the interest on a mortgage will be lower. The more people do this, the more prices drop further, the more interesting it becomes to wait even longer. Less money is spent, the government needs to make cuts as less taxes are coming in, more businesses struggle to survive, people lose their jobs and money is no longer flowing, meaning the economy is becoming unhealthy and in no time the economy is affected negatively tremendously. So in reality a situation of deflation is not generally a desirable one. Continue reading “Step 46: On Inflation and Interest Rates”

Step 35: Income stream 3: Interest Income

Step 35 of the 100 steps mission to financial independence: Income stream 3: Interest Income
Step 35: Income stream 3: Interest Income

So we have thought about our first income stream, which was a wage coming from a paid job, as well as the possibilities of a second income stream in the form of profit income. For most people either of these might be their main and only income stream and they might have never thought of other sources of income. Yet there are five more possibilities and even though that doesn’t mean you need to pursue them all, it is always good to at least find out more..

Let’s have a closer look at a third income stream: interest income from money lent out. Money lending and borrowing isn’t usually free, as the lender runs a risk (they might never see their money again), so the person who borrows money is required to pay interest on the loan in return, to make lending money more attractive.

Continue reading “Step 35: Income stream 3: Interest Income”