Category: Foundational

Should I… Pay off High Interest Debt or Invest or Build an Emergency Fund?

Depending on which expert you read, you might get a different answer. Each has it’s pros and cons…

  • High Interest Debt, such as credit cards or payday loans, are terrible for your financial health. Paying them off and not accruing anymore is vitally important, and quickly. It’s the most sure and best investment you could make in yourself.
  • The longer your investment horizon, the more compounding will turn a meager start into a sizable end result. Investing for 35 years instead of 25 yrs, given regular contributions the whole time, can nearly double the money over those last 10 years. Historically, the S&P 500 will return just shy of 10% so it’s less than your credit card interest rate, but not too shabby either.
  • An emergency fund is necessary. Dave Ramsey says save $1,000 cash asap. Given inflation since his Baby Steps were first printed, many don’t feel comfortable until they have $5-10k or more.

So, which is the most important or which should you do first? All of the above is likely the right answer. Here is what we recommend:

  • Start building that emergency fund NOW. You will sleep better at night and it doesn’t have to be more than $1k until all your high interest debt is gone. Once all your remaining debt has interest rates below 10%, or if you experience a job loss or a global pandemic w/ shutdowns cripple the economy for a few months, then bump that emergency fund up to 1-6 months of bare-bones expenses.
  • Invest 5% of your paycheck, or more if required to get your full employer match. It’s a free 100% return and it starts building the right habits of automatic saving and investing. If you don’t have a match or even an employer plan, still contribute 5% to an IRA. It’s about building habits and early positive results at this point, not earth-shattering wealth. Automate wherever you can. We always enjoyed manually clicking transfer, but you will never save as much compared to automatic contributions. You will forget, or another bill will come up and you will promise yourself you’ll make up the savings next paycheck (but won’t).
  • PAY OF HIGH INTEREST DEBT and STOP SPENDING!!! If you live in a First World Country today, you live in a time of massive convenience and consumerism even for the lower middle class. No matter what you’re income level, you are only hurting yourself (and your kids) by spending more than you make. STOP IT! I know it’s hard, having years where we made less than $25k total ourselves. But you have to live within your means. TV, cable/streaming services, fast internet, mid-to-high end phones, computers, and tablets, cars more than $5k, etc are all luxuries you cannot afford until you have at least a positive Net Worth. And even then, you should still practice delayed gratification.
  • Increase your Emergency Fund to 4-6 months worth of core expenses (mortgage, food, etc) and your investments contributions to 15-20% after your 10%+ interest rate debt is gone.
  • Start paying down your additional debt, perhaps excluding your mortgage. Given how ridiculously low mortgage rates are right now, it is hard to justify paying it down instead of investing the difference. In the last 30 years, the US Dollar has lost about half its purchasing power (relative to the cost of goods and services, not other currencies). 15 years into your mortgage, the “real” value of your loan could be a 25% less of what it was compared to your income and value of your home with inflation.
  • Once you are debt free from everything but your mortgage, increase your savings rate to 25-50%+ if you really want to get ahead. But 20% of your income really should be the minimum that you save. There is no guarantee you will have a job until your late 60’s nor do you want to be dependent on a shrinking [due to inflation] fixed income from an underfunded Social Security.

What Should I Include in My Net Worth?

Your Net Worth is all of your Assets minus your Liabilities. In other words, all your money + equity – your debts. The Net Worth value is important to track, even if just once a quarter, to make sure you are building wealth. A doctor making $300k/yr could have a low Net Worth if they spend 99% of their income; whereas a teacher could have a higher Net Worth than that doctor if they save $10k over the year. Your Net Worth quantifies how well you are converting your income into wealth, as opposed to luxuries that have no value after they are used. For many, equity from the home they live in is a large chunk of their Net Worth. This isn’t bad, per se, but it means only a smaller portion of your Net Worth is being productive (i.e. earning interest).

Here is what to include in your Net Worth with examples:

Cash – The balances in your Savings + Checking accounts that aren’t already spent, Cash in a safe or safety deposit box (or under your mattress), savings in your HSA or FSA, money owed you that you realistically expect to receive soon, etc

Subtract Debt – Credit Card balances, auto loans, and other lines of credit

Investments – Retirement accounts (401k, 403b, 457b, 529, IRA, etc), investments in your HSA, brokerage accounts, Robin Hood, WeBull, peer-to-peer lending

Real Estate, minus any mortgages or loans – Take a fair appraisal and subtract your mortgage balance. Zillow may or may not give you a realistic value. You could compare estimates from Zillow, Redfin, and ReMax to get in the ballpark. Personally, since we have only owned our home for a few years and want to be conservative, we’re using the last official appraisal. Not required, but do be conservative and honest here. We also don’t update this value but maybe once a year or two as we want to see the organic growth of our Net Worth from frequent saving and investing, not frequent “artificial” increases from our home value jumping around.

Precious Metals – This shouldn’t be a huge chunk of your portfolio, but some is usually good. Gold and Silver aren’t the best investment nor even the best hedge against inflation, but it’s part of not keeping all your eggs in one basket. There are times when gold is worth it’s weight in, well… gold. For example, some Jews fleeing Nazi Germany sewed gold coins into their clothes knowing they could restart their lives elsewhere (rather than having German Marks in say Japan or Argentina).

? Vehicles – IF using conservative values and mostly offseting loans, in our opinion. To be honest, the only reason we included our vehicles’ value in our Net Worth is because Personal Capital automatically added the loans (update: when we had the loans, but they are paid off now). Because vehicles decrease in value each year and we only buy reasonable ones (currently <$10k) we actually need, we wouldn’t sell them unless we were destitute because they get us to and from work and family. When a car loan was in Personal Capital, we added a manual asset offsetting the loan. This manual asset was always less than the actual value of the vehicle. In our opinion, the Net Worth should be about growing your passive investments and overall wealth; not having expensive luxuries that decrease in value but look valuable on paper. Would you rather have $200k “equity” in a super car or $200k in a 401k? Unless your net worth is >$2-5 million depending on your other lifestyle choices, the 401k is the correct answer.

Dollar Cost Averaging is Timing the Market!

There is a common misconception about Dollar Cost Averaging (DCA). Let’s say you’re paid twice a month, and on each payday you regularly contribute to your retirement accounts. “I’m dollar cost averaging!” you might say. No, you’re not. You are doing something even better! Investing as soon as you have the money and maximizing time in the market with compounding over decades because no one can guess the future. See The Market goes UP and DOWN.

Dollar Cost Averaging implies you are choosing when to invest the money you already have.

Let’s say you saved $2,000 over 3 months in a savings account…

  • Option A: The stock market dips for three days straight and you buy! You are timing the market. Only hindsight is 20/20; you’re betting it was actually a good time to buy.
  • Option B: You keep the cash in savings because “the market is over-priced”. Again, you’re timing the market.
  • Option C: You’ve been studying the market for those 3 months and you are sure which stock is under-valued. Confident in your answer [but having absolutely no idea what will actually happen], you click “Trade”. You are timing the market.
  • Option D: You Dollar Cost Average by buying $500 worth of stock a week for the next 4 weeks. Or should it be $250/wk over 8 weeks? Or… It’s the reasonable option, right? Right? Again, you are timing the market. You are smoothing out the volatility, sure, but will have lower or higher returns based purely on happen-chance.

Exploring “Option D: Dollar Cost Averaging” further… Let’s say stock prices plummet starting on week 3 of your averaged stock purchases. You’ll be ecstatic you waited to buy at least some of your shares. What if instead of a recession, stock prices soar week after week after week? You’ll be kicking yourself for not buying all your stocks when prices were low. What if stock prices stay flat? No harm, no foul.

No matter which stock market scenario, you were guessing. Dollar Cost Averaging could have made you money, lost you money, or not mattered at all. All you did was average your volatility; any return potential was pure guessing!

Have some made money actively trading? Yes.

Has anyone consistently beat the overall market, such as the S&P 500 index, for 2+ decades straight? Only a handful like Warren Buffet. And no disrespect to the legend, but besides his hard work and acumen, there are always outliers in statistics for even improbable or uncontrollable factors. Could someone flip heads 50 times in a row. Absolutely! Very unlikely, but entirely probable. There is a reason Warren Buffet advises index fund investing. The returns you would have seen from passive index fund investing over Buffet’s career would have made you a millionaire many times over anyways.

Instead of Dollar Cost Averaging, focus on…

  • Spending much less than you earn
  • Hustling to increase your income
  • Increasing your savings rate
  • Passively investing in US index funds

This combination has historically proven to be an exponential creator of wealth, no matter your starting point or career path. And there are no clear shifts in the market proving it still isn’t. After all, we’ve seen incredible market crashes over the past 75+ years and each time the economy in general, and businesses in particular, come back.

Of course, if you are a business owner, there is the potential that re-investing in your business provides the greatest returns. But it is also placing all your eggs in one basket. Eventually you should diversify in the stock market, real estate not associated with your primary income, etc.

FIRE Options: Financial Independence Retire Early

FIRE, or Financial Independence Retire Early, is for those who don’t believe they will be employable for a full 45+ years or they won’t want to be. And to be honest, the most important part is the “FI”. Financial Independence is empowering, no matter what age, lifestyle, or income. JL Collins describes it as “F*!# You” money on his blog. And you don’t even have to be full FI to see the benefits. Your ability to say yes or no won’t come from a position of fear of losing your job or missing the next promotion, but one of “I don’t need you like all your other employees do”. And in a twist of fate, that will likely give you more options than them.

I won’t belabor the “How” as many have already covered this topic. Search “Trinity Study” and “3.5 to 4% Safe Withdrawal Rate” for more. Let’s focus on the “What” and “Why”.

None of these terms or definitions are my own, merely boiling down some of the FIRE acronyms for simple understanding…

FIRE

FI or Financial Independence: Have enough money invested where your passive income (no work other than occasionally re-balancing or meeting with advisors/agents) can completely cover your current and future lifestyle. Often earned through giving your all at a 40-60-80+ hr/week job for 10-15 years until you completely reach your financial goals, then working, or not, on your own terms. For many, this is $40-60k/yr of indefinite income from $1-1.5 million in investments.

Note: Owning rental property can lead to FI, but for many landlords, it’s a very active endeavor managing tenants and repairing/maintaining the property. So although you have the money/income, you technically aren’t FI because if you stop working, so will your income. Transferring the operation of your business, rental homes or otherwise, to managers and becoming an absentee owner may be all that is required, given you have enough business income to offset their fees and still afford your lifestyle.

RE or Retire Early: I mentioned earlier that Financial Independence is the most important goal. If you want, you can keep working, or find another gig with less hours or more meaningful work, or you can quit working altogether. The choice is yours. But don’t excuse not saving and investing because you cannot see yourself quit working before 65 years old.

PROS:

  • Enjoy full retirement and FI earlier than any almost anyone else and for 50+ years
  • Once you’re done working, you are done! No more levels of bosses, pointless meetings, endless policies and procedures, poor health and wellness, etc

CONS:

  • 10-15 years of work that will almost certainly burn you out
  • You may have to move from the HCoL area when you have earned FIRE, away from your existing social circles and old haunts
  • You missed out on enjoying your 20’s and some of your 30’s

Lean FIRE

You will be eating lean and living simple with Lean Fire. For many, this is about ~$750k of investable assets generating $30k or so per year. The dollar amount varies, but most in this camp expect to need between $2k to $3k/mo to maintain a low cost of living indefinitely.

PROS:

  • Reach FIRE earlier, because you have to save less
  • Enjoy your 30’s, and maybe even some of your 20’s
  • You’re going to move to a low cost of living area, maybe even internationally, so why would you slave away for more years than absolutely required?

CONS:

  • Stuck with a lower middle class income for the rest of your life, regardless of future goals or surprise medical expenses
  • No fudge factor
  • Have to re-enter the workforce when you are much older and your skills are rusty if you eventually want a better lifestyle (see Barista FIRE)

Fat FIRE

You’ll have enough to live fairly well in a high cost of living area (HCoL) like New York City or SoCal, or live like royalty in a low cost of living area (LCoL). Many need $100k/yr and $2.5 million invested at a minimum to live like this indefinitely.

PROS:

  • You will live like a king or queen enjoying a luxury vacation all day everyday, as long as it isn’t ridiculous
  • Your social circle, family, and favorite places are all in expensive areas
  • Leave a large inheritance to your adult children and even grandchildren

CONS:

  • Your working career will likely span 15-20+ years in a high-stress, but high-paying job
  • What if you only want to live with excess for a few years, then you delight in simpler things? You would have worked for 5-10 years longer than you needed to, maybe even missing out on your 40’s.

Barista FIRE

Similar to Lean FIRE, where you NEED to draw from your investments when you leave full-time work, but also MUST immediately pick up a part-time, lower-paying job or gig for additional income to offset a better lifestyle and perhaps provide some benefits/discounts. You could have reached Lean FIRE with your investments and the additional income takes you to full FIRE, or require the additional job to reach even Lean FIRE.

PROS:

  • Reach almost-FIRE fairly quickly, as you might only need $500k saved and invested
  • Barista-type jobs can be in pleasant places all over the world, where you might want to retire and plug into a local community anyways

CONS:

  • The grass isn’t always greener: You’re probably glorifying a low-paying job from the cubicle or corner office of your high-paying job. Similar-enough boss, a schedule to follow, lower pay and you are burning your hands in hot water while washing dishes and dealing with impossible customers.
  • What if you don’t want to work anymore, or can’t, or have surprise medical bills with no insurance?

Coast FIRE

With Barista FIRE, you’re “retired” but you MUST work?! With Coast Fire, cut back how much you save while keeping the same or similar job, or something completely different that still pays the bills. But you don’t have to save anymore nor will you withdraw from your investments until much later in life. You’re working to pay for your current lifestyle, letting your nest egg compound in the background. At Coast FIRE, you’ve saved enough in your nest egg, if left to compound until you reach your desired retirement age, you will have enough money to fully retire without contributing a single cent more (if your calculations are correct). And you’ll have a better lifestyle for the second half of your working career since you are saving less, or nothing, for retirement once you reach your Coast FIRE number.

PROS:

  • Better lifestyle in your 30’s, if you saved up enough in your 20’s to start coasting
  • Many people prefer to stay employed, but in a less stressful and/or only 40 hours per week job (or less). Provides health insurance, travel perks, sense of purpose, decent lifestyle, etc.

CONS:

  • Be cautious of completely stopping all saving for retirement before reaching FIRE. Continue to contribute up to your employer match or maxing an IRA each year, at a minimum. When your coasting period is 15-20 years or less, there is a statistical 10-30% chance the 7-8% returns after inflation may not happen. The safer bet: decrease your savings rate from 50%+ down to 15%, so you can still inflate your lifestyle considerably while also building a safety net.

The advantage of Coast FI is access to more money, time, and a better Quality of Life at an earlier age. The tradeoff of Coast FI is a smaller retirement nest egg or retirement at a later age.

Flamingo FIRE

We recently discovered this term by an Aussie blog based on the same name, and we really like it. In fact, it is a really good way to view our own plan! In a nutshell, use your after-inflation return and calculate how many years for your portfolio to double. If it’s the historical stock market return of 7%, then your portfolio will likely double in 10 years. When your investment portfolio is 50% of your FIRE number, Coast FIRE for that many more years while your portfolio doubles in the background. And then do whatever you want! Like Coast FIRE, Flamingo FIRE lets you sample semi-retirement, easier work, or however you want to cover your current living expenses. Since many don’t/can’t quit all work cold turkey, and will likely get bored and pick up a income-producing hobby at some point, it’s a good way to step down your work.

PROS:

  • See Coast FIRE pros, but likely fewer years of working/Coasting

CONS:

  • Not many, but see the Coast FIRE cons

MISC

  • BalloonFI – Inflate your lifestyle (balloon) to match your safe withdrawal rate
  • LifestyleFI – Adjust your lifestyle to your net worth

Our Plan

Short Story: A mix between FIRE, Coast FIRE, Flamingo FIRE, and Fat FIRE.

Long Story: Between the Great Recession and taking a long time to discover a career then building skills and experience to earn >$40k/yr, earning a college degree while working 2 jobs and 70+ hours per week, plus several children who will graduate high school before we could reach full FI… We have decided to pursue FIRE as best as we can, then probably a Coasting Fat FIRE depending on how things go. For us, the current goal is saving $50k/yr and investing it mostly in a Total Stock Market index fund.

Because no one knows the future or what the job market will be in 15, 10, or even 5 years, we want to reach Lean FIRE and then full FIRE as soon as possible (~40-43 yrs old). But we also want to travel and spend time with our kids before they leave the house; so we are doing those things on a budget focusing on experiences rather than luxury vacations. Think road trips and staying with family near natural beauty.

Once we reach FIRE, likely after our oldest two kids leave the house, we will work fewer hours (just 40 hrs a week sound nice) and either continue to save 50% of our income to reach true Fat FIRE by age 50 or drop our savings rate to 10-20% and increase our travel budget. …and retire when we want to. Either way, our goal is to enjoy FI with our older teen/young adult children, and hopefully eventual grandchildren.

What is Debt?

Some Definitions:

Debt – something, typically money, that is owed or due. OR the state of owing money.

Own/Ownership – have (something) as one’s own; possess. OR the act, state, or right of possessing something.

Metaphor – a figure of speech in which a word or phrase is applied to an object or action to which it is not literally applicable.

 

Congratulations, you just bought a home!  Or, did you?  More like the bank bought it and you are “renting to own”.  I struggle with the textbook definition of being an “owner” because possession is equated with ownership.  Just because I am driving around a rental car (aka possessing it) doesn’t mean I own, because I don’t.  But the same could be said of most automobiles; the driver may be a part owner, but it’s the bank who really owns it.  Ownership implies not just possession, but the exclusive right to something.  And if a payment is involved, you are only one missed payment away from losing it – so do you really own it?  As we look at our collective lives, we notice we own very few valuable things.

 

Describing Debt in Metaphors:

Treadmill – When I am on a treadmill, I want to get off.  But I set a goal (and timer) and keep going until I hit it.  But as soon my workout is complete, I am off the treadmill.  But what if you couldn’t get off that easily?  In the treadmill of debt, there is no emergency stop or pause button – there isn’t even a “free” decrease incline or decrease speed button.  Every little bit of debt you take on increases the speed and incline, and the only way to reduce either is by paying the interest plus something additional.  Just as it is hard to adjust a treadmill when you are running at 8mph with a 5% incline, so is paying off lots of debt.  It’s possible, but it takes extra work, cutting unnecessary expenses, and doing that for a while.

Leeches – I heard this metaphor on JL Collins NH financial blog, and really like it.  Imagine being covered in leeches as you trudge through a swamp.  That is what debt is like.  It’s a struggle to succeed at life already; don’t make things harder on yourself.

 

Given these rosy pictures, one should stay away stay away from debt.  And if you have to have some debt (a first mortgage on a reasonable home, or a loan on a basic car to get you to and from work), you should keep it as tiny as possible and pay it off fast!