The Easy 4-Step Guide to Financial Independence
Markus Muhs - Nov 14, 2016
November is Financial Literacy Month and November 20th to 26th is officially “Financial Planning Week” in Canada. In that spirit, I'm providing here - free of charge - my basic 4-step guide to financial independence.
Most of my clients aren’t very high-income earners. They’re average Joes who just managed their personal finances well throughout their lives and understood the importance early on of living on very limited debt and saving as much as they can. I believe good financial habits start at an early age, and hopefully by reading this you can set yourself up to join the ranks of the "mass affluent".
A lot of this is going back to the basics and sharing from my past experience as a personal banker at a major bank, where I dealt with a huge range of clientele, from people who get it to people going out of their way to ruin themselves financially.
Consider these steps in order from the most elementary step onward. Once you have one step mastered, move on to the next.
The first exposure any of us get to the world of finance is through our day to day banking. I still remember signing up for my first kid’s savings account, getting my first pass-book, and practicing my signature a couple times before signing the signature card (years later, after my signature had devolved into an illegible squiggle, I signed new signature cards).
You should never have to pay more than around $5 a month in fees for a checking account. Though banks offer accounts with atrocious monthly fees as high as $30, there’s always a way to avoid them through multi-product discounts or keeping a balance. If not, then you have to ask yourself, do you really need unlimited transactions? Instead of using your debit card all the time, which counts as a transaction with every single purchase, use a credit card for all your purchases, collect points, pay it off in full with one transaction each month. That, plus your monthly bills, shouldn’t break 10 transactions per month.
Where to start here? This will be a longer section because there's just so much that people get wrong. There was a Simpsons episode where Homer and Marge were forced to take parenting classes along with some hapless yokels, where the instructor was teaching basic life rules like "when you throw out garbage, put the garbage in a garbage bag," to Marge's embarrassment. You can easily skip over most of this section if you, like Marge, don't need to be told such basic things, and you have a good handle on your credit already.
Don’t carry a balance on your credit card(s)... ever. I don’t know why that isn’t common sense; third-world countries pay 18%+ interest, you shouldn’t have to! Don’t hesitate to use your points/cashback credit cards on all purchases, because all retail prices are marked up to account for merchant terminal fees and those points/cashback are a way to at least recoup some of that money. Pay it off in full though, always.
Should you accept credit limit increases? Yes, a higher limit equals a higher denominator in your credit utilization rate, and that’s generally positive for your credit score, or rather using too high a percentage of your limit each month can negatively affect your credit score. For example, using $1000 of your limit on a $10K limit card looks better than using $1000 of the limit on a $2000 limit card.
Tell your credit card company(ies) to take a hike when they call/mail you to offer balance transfers or credit protection. The latter is completely unnecessary if you pay your balance in full each month and actually will end up costing you even if you are.
The thing about balance transfers that you need to understand (if you are ignoring my advice and carrying balances), is that when you choose to transfer a balance from one card at 18% to another at a 0% special the transferred balance becomes the first thing your payments go toward while all new purchases remain and accrue interest at the normal rate.
Unless you’ve been hit with job loss, there is absolutely no excuse to carry any consumer debt. The only types of debt which are acceptable are:
- Mortgage/Home Equity Line of Credit for the purchase of your home or an income property
- Student debt, which was an investment in you
- Car loan with a term of 5 years or less
These are debts we incur because a large amount of capital – in excess of what we can earn within a few months – needs to be spent at once and our creditors give us the chance to repay them over a longer period of time at a reasonable interest rate.
When I was working at the bank there was something called a “Vacation Loan”. Can you believe that? Borrowing money to go on vacation! The banks aren't going to look out for your best interests when it comes to borrowing; that's your responsibility.
I used to do a lot of consolidation loans during my early days at the bank. People rack up debt on various credit cards, including ultra-high-rate store cards and other small debts, and we consolidated it all into one more manageable loan at a lower rate, with a monthly payment. It seemed like to some people this was a normal transaction: rack up cards, consolidate, repeat. It’s not! A consolidation loan is literally 2 steps away from bankruptcy (the in-between step being a consumer proposal). Again, you simply shouldn’t be accumulating debt for day to day consumer needs to begin with.
Don’t ever co-sign on a loan with anyone, not even a family member. This excludes instances where you are joint-mortgagor (and joint-owner) on a home purchase. Co-signing doesn’t mean you’re just lending your superior credit score to help someone out. YOU are taking responsibility for that loan! The bank won’t lend to your friend/family member because they know they’re not good for it, but they’re okay with you being on the loan because YOU will repay it. If I had a dollar for every situation where I had a parent coming into the branch wondering why their daughter was simply removed from a loan and why it’s just in their name now…
Credit scores. The utmost important thing here is that you simply don’t screw it up. So many people screw up their credit by doing stupid things (like some of the stuff mentioned above) while they are young without realizing how detrimental it can be for their entire lives through adulthood.
A bad credit score not only affects your ability to get credit at a reasonable rate, a mortgage, or to be able to buy the car you like, but it also affects your ability to get a job, with many employers checking credit. Your employer isn’t lending you money; they want to know your financial character: are you someone trustworthy?
People seem to be divisible into two camps: the ones who don’t care at all about their credit score, and the ones who care way more than they really need to. Whether you have an 800 FICO score or 750 doesn’t affect the interest rate you’re offered or what types of credit products are available to you. If you have a FICO below 650 then yes, it does severely restrict what credit products are available, leading to higher costs; you are what we call sub-prime.
If you've never done so, it would be a good idea to check your own credit with one of the major credit bureaus, Equifax and TransUnion. Ensure your information is accurate and have them correct any errors. If you get the full report, they'll show you where you rank among the general population. In general, I would say a 750 or higher FICO is pretty good and you don't need to sweat it. If you're below 700 you need to find out what you're doing wrong.
No, a young person doesn’t need to apply for a loan to build their credit. They just need to get a student credit card and pay if off in full each month and not screw it up, that’s all. I highly recommend getting a credit card while you're in post-secondary because the banks are very easy at giving these out with a $500 limit or so. Afterward, you will need to have already had some credit established when applying for credit or may need to offer collateral for the first year or few years.
Lastly on mortgages: don’t ever walk into a bank to get a mortgage; use a mortgage broker. I say this having been the person at the opposite side of the desk from you at the bank, offering you the mortgage. Banks list their mortgage rates at “posted rates” much higher than what anyone actually pays (for example 5%). The bank, of course, offers you a discount to this rate, but my incentive as the banker was to offer as low of a discount as possible. If I managed to offer only 1% off posted rates (ie: 4%), I accumulated more points towards my semi-annual bonuses than if I went to “max discretion” of 1.8% (IE: 3.2%) every time. If you bypass the bank entirely and go to a mortgage broker they shop around for you and get you a mortgage at or better than “max discretion. It completely changes the mortgage getting experience from negotiating with a banker to having someone shop for you.
3. Disaster-Proof your Financial Life
The most basic bit of financial planning you can do for yourself is to build an emergency fund. This is the wall around your castle and needs to be taken care of before any other type of financial planning, before you consider investing one cent in long-term investments, before you pay any heed to your retirement plan. If this wall collapses or is non-existent to begin with, all other financial planning fails.
Having an emergency fund means not having to go to your parents for cash, or your kids, or neighbors, or friends, co-workers, etc. It means not having to cash out of your RRSP at a time when it’s not tax-wise to do so, not having to apply to the government to make a “financial hardship” withdrawal from locked in plans, not having to obliterate long-term investment strategies at the worst possible times.
At the bank I witnessed many people making RRSP contributions before the deadline with the best of intentions, only to withdraw the money (paying the tax and fees, sometimes taking a capital loss) in March or April because they needed some cash.
Some say a good emergency fund is 3 months of cash flow needs, some say 6 months; it really depends on your circumstances, including the type of industry you work in and what kind of fixed and variable expenses you might have. For most people 3 months should be the bare minimum, 6 months a more comfortable target, and if you’re in a very cyclical industry (like oil & gas) you might want to target having 1 year of cash flow saved up.
In a situation where you have other debts, like a mortgage and car loan(s), where your extra cash might be better suited paying down debt at 3%+ rather than sitting idle in savings at 1%, a line of credit can substitute as an emergency fund. It’s not ideal though, as they aren’t guaranteed to always be available for you if you hit hard times.
When I got my first car at 16 I immediately learned the biggest expense of owning a used car at that age was the insurance expense. Something like $3500-$4000 a year for my age and gender, including a discount for having done driver training. What a racket, I thought, someone makes it law that you have to have a vehicle insured to operate it and these insurance companies rake it in. Can’t I just take a chance and drive without insurance?
Insurance is about not taking chances, mitigating financial disasters. When disaster can affect third parties (like driving or liability insurance for your home) it isn’t optional. When it affects just you and your family you have the option of leaving your loved ones destitute if you die unexpectedly, or ensuring that they’re well taken care of.
An insurance needs analysis looks at the worst case scenario of you and/or your spouse dying tomorrow: how much does it cost to put you in the ground, what liabilities need to be paid off, what ongoing expenses might there (ie: childcare), how much money is needed to meet enduring financial goals (ie: your spouse’s retirement or kids’ education), and how much money is needed to leave your survivors in a comfortable financial position. If you haven't yet accumulated enough wealth to take care of it all, life insurance covers the gap.
Beyond life insurance, other types of insurance to disaster-proof your financial life are critical illness, which insures against the incident of specific life-altering illnesses such as cancer and heart attacks, among other things. Disability insurance protects you against other things that might keep you away from work short-term or long-term.
*Insurance offered through Canaccord Genuity Wealth & Estate Planning Services Ltd
4. Long Term Saving
This very generally includes retirement saving, education saving, or saving for other large purchases. How much exactly you’ll need for retirement requires a bit more comprehensive planning, however if you haven’t gotten that far yet, I have links to some calculators in the Resources section of my website to play around with.
The sooner you start saving, the easier it’ll be. Sounds pretty logical, doesn’t it? A lot of people are surprised though just how much of a difference it makes. Let’s say your goal is to save $1 million, in today’s dollars, by the time you’re age 60. If you start saving at 40, and your investments earn 6% net of inflation, you’ll need to save around $2300 per month. If you start just ten years earlier, you’ll need to save less than half as much.
Start saving $200/mo when you get out of college, let’s say age 23 (if you've completed all the other steps above), and you’ll have over $20,000 saved up by 30. From that point forward you’ll only need to save $900/mo to make it to $1 million at 60. I calculated all these numbers using the Millionaire Calculator.
What’s a proper amount to save, once you’ve got your emergency fund well situated? To know for sure a financial plan will determine your future goals, growth rates, inflation, tax rates, your ability to save, and map out a long-term strategy. If you haven't had a financial plan done yet, a good starting point is saving 10% of your income for retirement. If you do nothing but save 10% of your income for your entire working life, maybe you won’t quite be a millionaire when you retire, but at least it’s something and you won't be 100% dependent on the government at retirement.
If you can, try to save 20% of your income, inclusive of whatever retirement saving benefits your employer offers.
A comprehensive financial plan puts together all these aspects of your life and more. It can determine if you’re on pace to meeting your goals as well as estimating what your financial situation looks like 10, 20, 30 years from now. It can help you implement a course of action that is attainable, measurable and regularly reviewed and revised along the way.
Most of the steps above are easily implemented on your own; you really don't need a financial plan to tell you not to screw up your credit and to save an emergency fund. When you’re ready to take the next steps, contact me. An initial consultation costs nothing other than your time and perhaps one or two hours of downtown Edmonton parking.
My commitment is that even if you choose not to become a client, you’ll leave the meeting with a few extra steps to go along with the above.
Markus Muhs CFP, CIM
Public Domain images courtesy Pixabay