The real secret to building wealth

If you watch late night cable you’ll find a lot of infomercials that promise they have the secret to building wealth. Google the secret to building wealth and you’ll find thousands of entries. Many people think there is a some secret that only the wealthy know.

So how does one really become wealthy?

1. You have to learn to live on less than you make

It may seem obvious that you can’t build wealth when you are spending more than you have coming in, but evidently it isn’t because this is exactly what many people do.

You will never be able to save any significant amount of money when you are living a deficit month after month. So what does that mean?

First, you need need to have a spending plan, otherwise known as a budget. Without a plan money will disappear and you’ll never quite know where it went. Without a plan you may not even know if you are spending more than you have coming in.

Second, you might need to cut some spending. It is a balance. Sure you need to live your life. But the more margin you can create the more you can save.

Third, if you can’t make ends meet but you don’t have much spending to cut then you need to find ways to increase your income. Short-term that may mean a part time job. Longer-term it may mean taking steps to pursue a different career path.

The bottom line is you will never build wealth when you are spending money as quickly as it comes in.

2. Be passionate about eliminating debt

Step 2 goes hand in hand with step one. When members of the Forbes 400, that is the 400 wealthiest people in America, were surveyed about the keys to building wealth, 75% indicated the most important key was to live a debt free life.

It can be difficult enough to live on less than we make. When a significant part of our income is going out each month in debt payments, it can be almost impossible.

Debt is a thief. It will steal your peace. It will steal your security. And it will steal your ability to build long-term wealth.

3. Save early and often.

The most important key to saving money is, you have to actually do it!!

The earlier you start the easier it is. Assuming a 10% rate of return, a 20 year old need save only a little over $100 a month to have a million dollars at age 65. Wait until 40 and that same person would need to be saving $770 a month to get to a million. Time really matters.

This is not meant to be a discouragement if you are older. You still have a choice. You may need to save more. You may not be able to build as large a nest egg. But you can do something.

The most effective way to save is a little by little over a long period of time.

4. Interest rates really matter

Let’s say you were able to save $200 a month from age 20 to age 65. If you did that you would have saved $108,000 of your money. Now let’s see what impact interest rates have.

Let’s say you put it in a savings account earning 1% interest. In 45 years you would have earned about $29,000 in interest so your account would be worth $136,910.
Suppose instead you put it in some long-term CD’s and made about 2.5% instead. Now over 45 years you would earn over $92,000 in interest, giving you a total of $200, 529.
Maybe you decide to invest the money conservatively in some bond funds or conservative stocks and earned a 6% return. You are getting a little more than double the interest rate but your interest earned isn’t double. It is more than 4 times as much, at $433,000! So now you put in a little more than a hundred thousand but at age 65 you have $541,219.
Finally, let’s say you invested your money in a well diversified stock portfolio. The S&P 500 has averaged just under 12% over the years. At 12%, you would have earned 3.5 million in interest! So your total investment is now worth $3,650,923.

Here is what many people don’t understand. You work hard for your money and you don’t want to lose it. You watch the news and there is always some “expert” talking about the coming crash. So you decide to be safe. But if safe means you are only earning savings or CD rates the problem is you really aren’t even out running inflation. By playing it safe you are actually losing money.

Now I understand that you can’t count on making 12% every year if you were to invest in quality mutual funds. Once in a while that “expert” will be right and your investment will lose money. Some years you may not make much at all. But some years you might make 20 or 30%!

The point is we are saving for the long-term. You only ever lose money on your investment if you cash it in when it is down. If you are saving over a period of many years, when those down years hit, you have plenty of time for things to bounce back.

The key is to understand risk. How much risk are you willing to take. That largely depends on how much time you have. Just be aware that not taking enough risk will cause you to lose money as surely as taking too much risk because everything you make will be consumed by inflation and taxes. The trick is to find that happy medium where you are comfortable with the risk you are taking and you are taking enough risk to build wealth over time. Just remember that as we saw in the examples above a couple percentage points in interest can mean hundreds of thousands of dollars over the course of a lifetime.

5. Avoid the tax man where you can.

The final principle to remember is to do the best you can to avoid taxes. I am not suggesting you ever do anything illegal. Integrity matters. I also believe that as an American we live in the greatest country in the world and our government does provide many services and protections that make my life better and I have a patriotic duty to pay a reasonable amount for those benefits. But, I also believe in making sure I don’t pay taxes that are unnecessary.

Long-term investments are one place where you have a great opportunity to save on taxes through things like IRA’s and 401K’s. The benefit of programs like these is they allow your investments to grow tax deferred or in the case of the Roth IRA tax free.

This can make a huge difference over time. We have seen previously how the length of time and the amount of interest you earn on your savings can make a radical difference in the amount of wealth you build. If you can protect a quarter to a third of that money from the taxes by saving it in a tax advantaged account like a 401K or IRA, you can make sure those dollars continue to make more and more money for you instead of for the tax man.