Efficient Capital Strategy – Use Credit Cards

I have read several personal finance books over the last five years. One of the books I read was written by Dave Ramsey.  In his book he talks about using an envelope system to budget. If you aren’t familiar with the envelope system, you basically have separate envelopes for every budget category in your household (i.e. groceries, water bill, house payment, entertainment, etc.) and when you get paid you put the budgeted amount of cash into the corresponding envelope. When you buy something it comes out of corresponding the envelope, and when the envelope is empty you stop buying things.

I think this method is for people with absolutely no self-control. If you have just a little self-control and care about being better in life like I do, then you need to be using credit cards rather than cash and envelopes.

Paying in cash is not efficient!No Cash

Let me explain why. Every time you use a credit card the credit card company charges the merchant a small fee to process the transaction. You pay the merchant the exact same amount whether you use cash or credit. Where you gain efficiency is that some credit card companies offer to split their earnings with you as a way for you to use their business. These are called rewards credit cards.

Before I get into the benefits of rewards credit cards, let me interject my disclaimer for credit card use.  You MUST pay off your credit card in full every month. Just like with the envelope system, where you cannot use more cash than is in your envelopes, you should not be charging more than you have the cash to pay for.  Acquiring credit card debt with high interest payments is a very poor idea and inefficient way manage your capital.

Ok, so back to rewards credit cards.  There are basically two schools of thought when it comes to rewards credit cards.

  1. Sign Up Bonus Only

The first school is to look for credit cards with initial sign up bonuses. Many credit companies offer high bonuses to sign up with them and then spend X amount of dollars.  After the initial sign on bonus the “cash back” incentive is usually nothing to very low (less than 1%).  Therefore, to make this reward work in the long term you have to look for and sign up for new reward credit cards with high bonuses.  In my opinion this option has higher total rewards, but is much more time intensive.

  1. Best Overall Rewards

The second school of thought is to look for credit cards that offer the best overall rewards.  Credit cards that offer best overall rewards offer “cash back” in the form of up to 2% of the money you spend.  Although this may seem like a lot less than initial sign up bonuses, the 2% is for the duration you hold the credit card; thus, you set it up once and the time needed to manage your finances will be minimal.

Both of these types of rewards credit cards give you money back for your purchases and help you gain something from your spending, rather than using cash and gaining nothing.

Risk and Reward

When most people think of risky things they think of the bad things that can happen. Thinking only in terms of “bad things” is an incorrect application of risk. The technical definition of risk is: the amount of uncertainty in the outcome of an event.

This definition of risk relates to the efficient use of capital through investing, because the amount of uncertainty in the return you are expecting from your investment is directly correlated to the amount of return you will get. I know that sounds confusing, but stick with me this gets good. Think of it this way, if a bank offers you 1% return on your investment you should expect to get exactly 1% return on your investment. If you invest in the stock market you should expect to get around 7% return on your investment.  Unlike the bank, the stock market return is unpredictable.  Your actual return on investment can range from +45% and -35%, but on average you can expect your long term investment return will be 7%.

To demonstrate this concept I’ve drawn the picture below. The far right of the picture shows what the stock market expected returns looks like. People are averaging about 7% a year, but they experience years where the return of +45% and other years where the return of -35%. In the middle I’ve shown what the bond markets expected return looks like. On the left of the image is what a typical government bond would look like. If we took it to the extreme left a bank savings account would have no distribution. It would just be a flat line because you are going to get exactly the return the bank tells you. No more no less.

Risk Return

 

So how can we use this concept to manage our capital more efficiently?

By planning when you will need to use your money you can invest at the appropriate risk level. For example if you don’t need your money for another 35 years you should be willing to take on a large amount of risk, because the investment carries the highest long term average return. Sure you will have bad years where you lose more money than you’d like to admit, but you will also have amazing years to go with it.

If you need your money in a few months to buy a car don’t invest it in the stock market. Yes, you could end up driving a Porsche, but you might also end up having to buy my neighbor’s car.

The Porsche

 

Beater car
My Neighbors Car

 

 

 

 

In a future post I’ll cover negotiation to help you get a really good deal on my neighbor’s car, unless he reads this also. Please subscribe on the right hand side of this post so you get that update.

 

Be Efficient with Capital Through – Your Company 401k Match

The other day at work a group of my coworkers and I were discussing our 401k options.  An informal poll took place. I asked my coworkers if they participated in our company 401k, if they knew what amount the company matched, and if they were getting the full matching amount.  I was surprised to find out that not everyone was taking advantage of the company match on our 401k. I am generally not a very judgmental person and I managed to keep my mouth shut, but I really wanted to scream, “WHAT ARE YOU THINKING!?!?!”

Today I am going to walk you through the math of why If you tell me you aren’t getting your company’s full 401k match I am going to silently judge you. Every company is different so it is important to understand what your company benefits are exactly. Getting the full match from your employer means you are contributing enough to meet their requirements to give you the most they will give you.

Let’s say my coworkers were earning an average mining salary of $88,000.  Let’s compare one coworker who is getting the most they can get in company match to one who isn’t getting any company match because they aren’t participating. In this example we will say the company matches all 401k contributions at 50 cents on the dollar up to 6% of your salary.

First we will start by calculating their taxable income. *Note that company 401k match isn’t subtracted from base pay when calculating taxable income.

Table 1

Next we will look at both of my coworkers take home pay after taxes.

Table 2

At this point you will notice the full match coworker has a $4,000 lead over the no match coworker in Gross after Tax plus 401k.  This isn’t a fair comparison because all the 401k money is before tax.  So now we’ll look at what would happen in a worst case scenario where the full match coworker had to take all their money out of their 401k and pay the full penalty and all their taxes to get use of the money.

Table 3I hope at this point you are convinced that your employer matching is the best return for the risk you’ll get on any investment.

So to close I have an offer for my non-contributing coworkers (you know who you are). If you happen to read this post, I would be willing to give you the money upfront you need to start contributing to your 401k and getting the company match and in return you pay me back in full at the end of the year and we split the efficiency bonus money. I am willing to offer a 50:50 split since I am such a fair guy. This would result in wins all around. You win because you wouldn’t see any difference in cash flow. I win because I get half the newly created bonus money. You win again because you also get half of this newly created bonus money.

Image: iStockphoto