I’m no money manager, so get professional advice elsewhere. But I have been blessed with a few shekels that I could rub together that has allowed me to learn some of the pitfalls and upsides. I’ve also been in the business of selling money for the last 25 years, so I’ve had to explain my thoughts on how to make financing decisions several hundred times (but never written in a page and a half). At different times of your life, you’ll focus on different techniques of managing your money. In general, there are two main factors to think about – cash flow (basically funding your lifestyle) and net worth (basically creating savings and investing).
It’s a Maslow’s thing when talking about money and timing. If you’re below the poverty line and you get your next incremental dollar, you’ll probably use that dollar to satisfy some of your basic needs – food, clothing, shelter. If you’re young and on your own and get an incremental dollar, you’ll probably do the same if you earn barely enough to get by. As you move north of that line of satisfying your immediate needs, you’ll need to figure out what to do with your growing abundance. So this Letter is more practical in nature.
Immediate Safety Net
If you have debt, I’d limit my savings to 1 month’s expenses as a cushion to handle unexpected events like a car malfunction or parking ticket or medical deductible, say $2-3000. This will test your ability to leave money in savings. If you can’t leave a couple grand in savings, then the rest of my advice below is worthless. After you’ve paid your basic expenses and have accumulated the cushion, then aggressively apply the rest of your paycheck to paying down debt.
This will highlight the difference between cash flow and net worth fairly clearly. You may have student loans, car debt, and credit card payments. Each has an interest rate and a repayment rate. The interest rate is the daily rate you are charged for money you owe – say 10% on credit card, 6% on the car, and between 5-8% on student loans. The repayment rate is the minimum payment required by your debt agreement (expressed as a percentage). It’s somewhere between 2-7%. So if you owe $5,000 in credit card debt and pay $250/mo your repayment rate is 5% even though your interest rate is 10%. The two rates are obviously not the same. Usually, the lower the interest rate, the higher the repayment rate so they can get you to pay things off faster. Also, the higher the interest rate, the lower the repayment rate so they can get more money out of you.
So here’s the scenario – you’re bouncing along with a job breaking even on your living expenses while paying your student loans, car payment, and a little credit card debt. You get a raise of $500/mo. Do you invest the money in the stock market? Buy a couch for your apartment? Pay off your credit card debt? Car loan? or pay down your student loan debt? Or, screw it, go to Mexico?
There’s several ways to look at it. Your psychology plays the determining role in what the right choices are. What are your goals? Are you sleeping on the floor and don’t want your girlfriend to come over because of it? Are you conservative in using your credit card or do you rack it up to the limit every time?
To decide on what to do with your extra $375/mo (25% taxes) is dependent on your particular personality features. But what I’d do is get a little breathing room on cash flow. I’d promise myself that if I was diligent for a few months, I’d reward myself a little at the end. I’d take 3/4ths of the raise I got ($282/mo) and apply it to the payment that cost me the most cash flow, i.e. the highest repayment rate. I’d focus all my $282 on paying extra on that loan till it was gone. As I said, cash flow is about lifestyle and net worth is about growing wealth. The other 1/4th of the incremental cash flow, I’d save for a couch or that trip to Mexico. So by the time I was up for that next raise, I’d have a bunch of debt paid down and a new couch. But beyond the couch (and here’s the challenge), I don’t raise my standard of living. I don’t go to Starbucks more or out to dinner more. That’ll just eat up your extra cash. You gotta keep your lifestyle the same except for the couch.
The best investment you can make when you’re young and not expected to make a boatload of money in the short run is to pay down unsecured debt (student loans, credit cards, car) and leave secured debt (house) alone. Unsecured debt is lifestyle debt and says the most about your personal disciplines. I have financed guys that make enormous amounts of money who also spend enormous amounts of money. When trouble comes, they’re ill prepared to handle it. Divorces and bankruptcies are commonplace for those kinds of guys. In your life, you will face difficulty – debt will make it worse.
Once you’ve paid down all your consumer debt, put an aggressive path toward paying off student loan debt. A good plan would be to take your car payment dollars and apply it towards student loan debt. Pay off the highest interest rate first. After each loan is paid off, take that payment and add it to one of the others. The key to the whole thing is to delay moving the cash flow to lifestyle until you can actually afford lifestyle. The challenge here is that student loans could last for 7-10 years. You might not want to postpone your lifestyle that long.
The world wants you to owe. If you owe lots and lots of money, you are a slave to the machine. You’re just a ATM machine that VISA and the government can just tap into. You’re a coppertop in the Matrix. You are therefore forced to work to pay your debts. So pay off your debt and remain debt free. Free is freedom. The only situations that debt makes sense from this point forward is when buying an appreciating asset (house) or when you invest with positive leverage (for another day).
You can never save yourself to wealth; but you can spend yourself to poverty. Don’t use consumer debt.
To your economic success,