Introduction - Why Save When first starting out in investing, most people will not have an existing asset base to leverage against. The first step to acquiring an investment – particularly investments such as real estate – is to find enough money for a deposit. If you own existing property, for example, your principal place of residence (PPOR), you could refinance part of the loan to draw out equity you might have available – and use that as the basis for your deposit. Naturally, there is an increased risk in doing this, since you are increasing the amount of leverage you are using by effectively borrowing the deposit as well. Assuming you either don’t have such an asset base, or else you don’t wish to use that method for acquiring additional real estate, you have few choices but to use the tried-and-true method of saving for a deposit. I have heard many people complain that they find it difficult to save their money, and certainly many people find saving a slow, boring, and very unexciting chore. Indeed, I would agree with them – saving can be all of these. However, I usually challenge these people to consider saving as merely a means to an end, a launch pad into the exciting and challenging world of investing – and as such, it becomes a more interesting and valuable task. There are two main reasons to save: The first reason is what I have previously described – saving money for a deposit on an investment such as real estate. The second reason is not so much saving, as it is making cash flow available to service investment debts. Leverage (borrowing money) is one of the key elements in making it possible to invest in expensive assets such as real estate, but you do need to be able to service the debt and expenses – pay the interest costs, and perhaps loan principal repayments, plus the expenses incurred in owning real estate or other investments. This is especially true if the income received from rents or dividends won’t be enough to cover those loan payments and expenses. Cash flow Cash flow is an extremely important concept in any business, and is equally important in the business of owning investment properties. Cash flow positive investments are great in that they don’t require you to service them from your own pocket. Unfortunately, a significant percentage (possibly even a majority) of the real estate available in Australia would not fall into this category, and will require some form of additional cash flow to maintain and service the expenses and debt. The concept of cash flow in investing terms is simple – an income stream – money that comes in to your pocket regularly, and that you can hopefully count on for the future. For example, your pay-packet from your job is cash flow. Income from rents or share dividends or managed fund distributions is cash flow. Pocket money is cash flow. The general idea is to ensure that the cash flow from all of your income sources is greater than all of your expenses. Otherwise you eventually go broke (unless you can do some clever, but risky things like converting equity into cash flow – but that’s another complex topic we’ll have to put aside for now). You can utilise this cash flow for a number of purposes – living expenses, servicing debt, or simply accumulating it to purchase investments (shares, or a deposit for a house for example). So, once you understand that saving is a useful exercise, the next question many people may ask is – how do I actually save my money? Many people effectively live payday-to-payday, using all of their income just to live. Worse still, many people choose (or are forced) to live on credit – creating large credit card bills that soak up cash flow just in maintaining the debt, let alone repaying it.
How to start; Budgeting; Credit Cards How to start saving There is really only one rule in saving. Spend less than you earn. It’s as simple as that – on paper at least! I know the reality can be much more difficult. There are two fundamental methods for increasing the amount of spare cash flow you have available to set aside for investment. First is to increase your income – pay rise, change jobs, second job, overtime, there are lots of different ways to do this, some easier than others. The second method to increase your cash flow is to decrease your expenses. Cut back on eating out, don’t buy that new pair of shoes, don’t take that overseas holiday, downgrade to a more economical car, there are lots of things you could do. To maximise the increase in cash flow, you could even try both increasing your income and decreasing your expenses. The biggest challenge with both of these options is that they typically require a level of sacrifice that may be difficult, or even impossible for any number of reasons. What is important here is setting goals – identifying compelling reasons for yourself, that motivate you to want to make the changes required to start saving. Goal setting is another topic all of its own, so I’ll just summarise. It really helps to spend some time thinking about why it is you want to invest – write these goals down, pin them up on the wall so you can see them clearly every day, and focus on the goal and on the reason for the sacrifice you’re making to get there. Budgeting One important way of finding spare cash flow is to analyse your current income and spending. If you don’t know where your money goes, it can be difficult to identify areas where you could cut back on spending to free up cash flow and invest. I suggest personal finance programs such as Quicken Personal – it requires a bit of commitment to get the most benefit out of them, but they are simple to use and allow you to develop a useful picture of your true financial position. In conjunction with this analysis, creating a budget can also make a lot of difference. Allocate a realistic amount of money that you allow yourself to spend on particular items, especially discretionary items such as entertainment, dining out, holidays and such. Try to stick to the budget and save the leftover money. It is still important to have fun, but if you can balance that fun now with a commitment to your personal goals – you’ll reap the rewards in the future. Credit Card and other personal debts One of the most limiting factors in someone’s ability to save is usually personal debt. More specifically, servicing the debt creates a significant drain on cash flow that might otherwise be put towards saving and investing. Personal debts that are for non-investment assets (an asset is something that makes you money, or grows in value) are often referred to as “bad debts”. Leverage is an important tool for investors – but only where the debt actually increases your wealth or cash flow. Credit cards charge very high interest rates for outstanding balances, while “store” cards from department store chains and such can be even higher. “Interest free terms” are only free if you pay the store by the due date – which many people don’t, and some of the interest rates are as high as 2.5% per month – that’s approaching 30% per annum! It is very important to pay down these debts, and avoid taking on more debts, if you truly want to save money to invest. For many people, the accumulated debts can be a very daunting figure, and you can find yourself in a position of never making any real inroads into your debt – becoming a slave to credit. The very first thing to try and achieve – when you find yourself in a “hole”, stop “digging”! If you want to get rid of your credit card debt, it is important to try very hard to avoid taking on more debt. It can be a bit of a catch-22 though: to increase savings, you need to reduce debt; before you can reduce debt, you need to increase your savings. Avoiding this situation in the first place is always the best possible strategy. If you do find yourself with a large amount of unproductive debt that is holding you back from your goals, it pays to start small. Set yourself small goals in finding money to pay back part of your debt. The more debt you can pay off, the less you will have to spend on interest payments, freeing up more money to pay off more debt – it accelerates the more you do, and is actually quite exciting! It is important to understand how different interest rates and payment expectations can affect your ability to maintain or reduce debt. Specifically, the example of making extra payments on a house loan when there are outstanding credit card debts might not be the most effective strategy. We will explain this in more detail shortly. If you really have too much debt and you are even faced with the possibility of bankruptcy, then it is time to seek professional financial help to work out a plan that can avoid those circumstances. Perhaps refinancing some or all of the debt to more favourable terms might be possible – your advisor will be able to help you there.
Where to start with debt reduction Where to start with debt reduction Try this - if you have multiple debts, grab a calculator (or spreadsheet), start with the monthly payment of each (if weekly, fortnightly, bi-monthly etc, do a simple recalculation to work out an equivalent monthly payment), and then divide that monthly payment figure by the amount still owing. This ratio of the payment amount to amount owing is basically a "payment rate" - i.e. the higher this number, the more you are paying as a percentage of the size of the loan. An example here might be a credit card, with a $5000 outstanding balance and monthly repayments of $400. The payment rate would be $400 / $5000 = 0.08. Next, Rank the loans you have in the order of highest to lowest based on their 'payment rate”. Now, concentrate on the making payments on the loan with the highest payment rate first, once that has cleared, go onto the next one and so on. For example, let's say we had the following debts: House (PPOR) loan, $150,000 owing, monthly payment $1000, payment rate = 0.0067 Credit card, $4,000 owing, monthly payment $350, payment rate = 0.0875 Car loan, $10,000 owing, monthly payment $220, payment rate = 0.022 Ranked in order from highest to lowest payment rate, we have the credit card (0.0875), then the car loan (0.022), and finally the house loan (0.0067). So, first we'd concentrate on the credit card. Put every last cent you can spare, into paying that off. Pay only the minimum you have to on all the other loans and put the extra money (if any) into the credit card. Once the credit card is under control (and kept under control!), move on to the car loan - you should now have an extra $350 a month that was being spent on the credit card loan to pour into the car loan - it will disappear surprisingly quickly now - pour any other extra money you have available into that loan too. Now that you've got rid of your car loan too, you might choose to concentrate on your non-tax-deductible PPOR loan - you have an extra $570 a month to put into this - look how fast that's going to disappear! Alternatively, you may choose at this point to save some or all of that $570 a month for a deposit on a new investment property, or to invest in shares or similar. So why do it this way? Why does it work? It's all about cash flow, again. By concentrating on the loans which eat the most relative cash flow, you can make the biggest dent first. The reason it works so well is that, the loans with the shortest term and the highest interest rates are the ones that eat the most cash flow for you. These typically are the credit cards, the car loans and such. Pay them off and you will free a disproportionately higher amount of cash flow to pour into other debt that you would have if you tried to just pay off the long term PPOR loan first. Interestingly, if you apply the same formula to some low interest (or no interest) debts like HECS (Higher Education Contribution Scheme), you may find that it is worth less to pay them off before something like your PPOR debt. If the effective interest rate is very low, and total repayments are also low, it may be best to just leave it and concentrate on other forms of debt or investment first.
How much to save How much to save You do need to maintain a balance between extreme saving and living a reasonable lifestyle. Sure, you can save a lot of money by moving out of your house and living in a tent – but is that really realistic? If you are prepared to do that, then good luck to you, you will do very well in your savings. Personally, I’d prefer to maintain a comfortable (but not extravagant) lifestyle, even if it meant my savings goals took a bit longer to achieve. Many people aim to set aside 10% of their take home pay for savings. I think this is a good start – a nice number to aim for. Be careful that you don’t overextend yourself – if you are having difficulty maintaining your savings, then you are either spending too much, or you had overestimated just how much you could realistically save in the first place. It pays to set achievable goals, especially when starting, but then raise the bar once you have achieved the first goal, strive for something higher. Something you might like to try first before embarking on a longer term process such as saving for a deposit on a house, is to try saving for things you know you need or want to buy. Get out of the habit of paying for things on credit and then having to pay off those huge interest bills. Learn delayed gratification by saving – it makes the purchase that much sweeter when you have worked diligently to save the money for it first. Savings Goals I remember when I got my first full time job after finishing university. I was newly married, and we didn’t have a lot of money, but we were fortunate to not have accumulated any significant debts by this stage, although we did have my HECS debt and a car debt, but my wife’s diligent saving as a teenager helped deal with those. Naturally she takes credit for teaching me how to save – and I do have to acknowledge her expertise there! We were living in a small unit with mostly borrowed furniture. We made a list of things we really wanted to buy for our home and prioritised them in order of most importance to us. Then we did the research into what the things we wanted were going to cost, and set ourselves a series of goals to save the money to buy each item. First I think was a set of kitchen table and chairs. I still remember saving for that first purchase – I kept a close eye on the money accumulating, made charts and graphs so I could report to my wife about our progress, and we felt a great sense of satisfaction when we finally had enough to make the purchase. There were several other items we did the same with, including a television, VCR, bedroom furniture, and eventually, a deposit on a house. In fact, we got so good at it, that when we finally purchased a house, we had money left over from the deposit. As a reward for our success, we used some of this left over money to buy a stereo system and a BBQ for our new house too – and the remainder went straight in to pay off part of the loan. It was immensely satisfying – but the key was that we waited until we had saved the cash before we purchased! Interestingly enough, nearly 10 years later, we still have and use all of those first things we bought – we have resisted the desire to upgrade them and instead, used our surplus income for investing and building our wealth.
Dealing with temptation Dealing with temptation A big problem many people have – especially when trying to cut back on lifestyle to find money for saving – is the constant temptation to go out and spend. There are always new and unexpected expenses, always things that you can’t avoid having to pay for, and always things that would really come in handy if you could buy them now. Discipline is important, but is also difficult to maintain over the long periods of time required. One of the important concepts in dealing with temptation is to “pay your self first”. I’m not sure where this term first originated, but I have read it in a number of books on the topic of saving and investing, with one of the most famous being George Clason’s “The Richest Man in Babylon”, in the chapter The Five Laws of Gold. Fundamentally, the term refers to changing the way you allocate money to living expenses versus saving or investing. Typically people tend to spend money on their expenses first, and then the money left over at the end of the month (if anything) is put aside as savings. Of course, there are always unexpected expenses and things that you just have to have, which seem to eat up that money to the point of never having anything left. Alternatively, if you were to set aside some of your money up front, as soon as you receive it – then in many cases people find it easier to live with out it. In fact, if you can have that money taken directly out of your pay and put into a savings account or investment automatically so that you never even see the money, it will hopefully get to the point where you forget that you ever had the money in the first place, and will learn to live on what is left over. I know the reality is not always that easy – but it does work and is worth trying. Most employers who pay salaries directly into your bank account will allow you to allocate a certain amount or percentage of your pay to go into a separate account. If they don’t, try asking them if they would consider doing so – it only adds a little administrative overhead, yet can add a lot of value to their employees and help build loyalty by offering flexibility as a benefit. There are high-interest earning savings accounts now that many banks offer, earning interest rates much higher than a normal transaction account. These are great tools to help maximise your savings – put the money aside into a separate account so you reduce the temptation to spend it, and earn a bit of interest on it at the same time. If you find this difficult, choose an account that does not provide easy access to your money via ATM (Automatic Teller Machine) cards and such. If you really have trouble keeping your hands off your money – maybe some extreme measures are called for – put the money into a term deposit which you cannot access until it matures. It does pay to be careful – you don’t want to get caught out in an emergency with no money available for the really important things. Taking on more debt because you can’t access your savings will actually send you backwards in reaching your goals – the interest rate you pay on credit card debt or personal loans is far higher than the interest you might earn in a term deposit or similar investment. You do need to balance the risks versus managing the temptations. The tricks to making this process work for savings are: Have a single operating account that your pay (minus “pay yourself first" funds) goes into, and all bills come out of - including credit card payments and personal debt payments. Have a separate savings account that you do not normally have access to (especially not via ATM card) - and just ignore it. (The most important part) - Learn to live on what goes into your operating account. If you can't, you're either spending too much money, or you're setting aside too much money, or both! The trick, and discipline, is in learning to live on only what goes into and out of your operating account. If you can truly hide the other money from yourself, you will learn to live without it - you will get to the point that you don't even miss it. Just don’t forget about it! At some point, when the amount is significant enough, you will want to use that money for an investment – you can potentially earn far more money with a sound investment than you would by leaving it in the bank. If paying off debt, see if you can possibly divert a set amount each pay to be deposited directly into your loan account or credit card account. Pay slightly more you would normally – enough to make real progress into reducing that debt, and learn to live without the extra money.
Summary; Suggested Reading Summary Saving requires sacrifice, commitment, diligence, and a bit of careful planning. It’s not easy, especially when you are already struggling to make ends meet. It does, however, get easier the more progress you make – and if you can focus on your clearly defined goals, it can help make the pain bearable. The concept of “pay yourself” first extends beyond saving. It is a useful tool for when you are ready to invest as well. There are automatic investment plans available through most managed fund and similar types of investments – and there are even investment platforms that allow you a high degree of choice in your investments without requiring large sums of money to invest. Having money set aside automatically into one of these products and allowing compounding growth to weave its magic on your money can be very rewarding. It can be even more rewarding if you learn to live without that extra money for the short term – and reap even larger benefits in the future from your efforts now. Just remember to choose your products carefully based on your personal goals and circumstances, and seek professional advice before investing. See also Discussion about this article Managing Money discussion forum Managing Money articles Investing Book reviews Glossary of Investing Terms
