Why 2% is Such a Big Number

The average American spends 94.6% of their income every year.  This means the average American saves only 5.4% of their income!  I’m going to show you how much impact the tactics of using a rewards credit card (that I showed you last post) can change your savings and life.

I’m going to present two cases to you and demonstrate the long term effects.  Case One: You use cash and debit cards for your spending and save the average American amount of your income (5.4%). Case two:  You use your 2% rewards credit card for spending, with the rewards earned invested forever.  You save the average American amount of your income (5.4%) plus your rewards from your 2% cash back credit card.

First things first, I need to talk about my assumptions that I’m making for this exercise.  My engineering professors would be so pleased with me right now.

ASSUMPTIONS

  1. Over the long term, your investments are going to make 7% a year. Some years better some year worse. This is considered your compounding rate.
  2. Inflation is going to chew up 3%, leaving you with a real gain of 4%. This 4% is considered your safe withdrawal rate.
  3. You’ve won the game and are financially independent (you do not have to rely on any particular job for income) when your investments are equal to your expenses divided by your safe withdrawal rate. This means your investments income is greater than your expenses. You should know your expenses because you’ve been tracking them on your balance sheet, right?
  4. You have a constant savings rate. In reality nobody gets paid the same amount and saves the sames amount throughout their life, but seriously the math turns into calculus if I don’t make this assumption.

These are rough assumptions and we could debate them all day, but they work for getting my point across.

So to put this into terms everyone can relate to I’m going to measure everything in years that it takes you to reach financial independence. The point where your investment makes as much money as it costs you to operate your life style at your current efficiency levels.

The math involves solving for the future value of a normal annuity (a fixed amount of money) where the future value is set to the amount of money you need to be financially independent.

Here is the formula for the future value of a normal annuity

Normal Annuity

Now here is what that formula looks like when we substitute in our variables.

Sub in our variables

We can also substitute our variable in for the amount of money needed to be financially independent by taking 1 minus our savings rate, which is equal to your expenses rate. You are either spending money or saving money. The expenses rate divided by your safe withdrawal rate gives us the total assets needed to be financially independent. Here is what that formula looks like.

sub in assets

 

And now by the power vested in me by my TI-89 we can solve for Years. Here is what the final formula looks like.

Sub final

Here are the results for the cases using the above formula.

CASE 1 (Cash or Debit Card)

Case 1

 

CASE 2 (Rewards Credit Card)

Case 2

 

As you can see, FOUR AND A HALF YEARS of a person’s life are saved just by upping their savings rates by a small fraction!

The readers of this blog; however, are decidedly better than the average American, you wouldn’t be reading a blog that talks finance or efficiency if you weren’t. So I’ve also included a table were you can look up how long until you are financially independent.

FI Tables

I made a spreadsheet to do all of these calculations.  I have made it available as a download from my Dropbox.  For those of you who want to tinker with my assumptions please go for it. Spreadsheet

If you have any questions about how I came to these conclusions please let me know in the comments.

 

The One Credit Card Everyone Should Have

Previously I talked about how important it is to use rewards credit cards. Today I wanted to share with you the best credit card I have ever found and explain why it is the card everyone should be carrying.

Unlike basically every website in the world that discusses/reviews/recommends credit cards I am not getting anything in return for this recommendation. In fact, when I was doing research for this post I found that most credit card sites don’t even mention this credit card. My only motivation for creating this post is purely to help you operate your lifestyle in a more efficient way. I have no bias what so ever when I give you this recommendation.

So what is this secret miracle cure all credit card?

The Fidelity Visa Signature Card.

IMG_1725
My Fidelity Visa Signature Card

This card is special because it offers 2% cash back on EVERYTHING. If you are using cash or debt cards to make your purchases this is a life changing amount! You might think, oh who cares 2% is nothing, but the difference is huge. It is going to take me an entire post next week to fully explain the implications.

This card does require you to sign up for a Fidelity brokerage account to receive your cash back. This is a slight inconvenience, but only takes a one-time effort to setup and from then on you can deposit your cash back into your brokerage account and have your brokerage account transfer the cash into your normal checking account.

Another point worth mentioning is that this card does not have any annual fee. You will never have to worry about using it enough to justify its cost like other rewards cards.  The interest rate is 14.24% on purchases, but it shouldn’t matter because you will not be paying interest on the card, right?

There are other cards out there that offer higher percentages of cash back rewards (and I recommend a few of them), but none are as simple as this card. Everyone should be carrying this card as a baseline. Without having to think you can be assured you are getting 2% cash back everywhere Visa is accepted.

Let me know in the comments what tactics you typically use when it comes to credit cards.

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