Financial Freedom for Beginners

Growing up, the concept of money was always a source of great contradiction for me. It was both a highly valuable commodity and something that shouldn’t be sought after. My immigrant parents would have me believe that it was the most important thing in the world. Yet, the teachers in school encouraged us to pursue our “passions” and to think about money last, if at all. I couldn’t decide if money was to be valued or devalued. Guarded, as my parents insisted, or relinquished as just another vice. 

As I got older and better understood how the world worked, it became obvious how incredibly important personal finance is. Regardless of the value one places on having lots of money, it’s still important to properly manage it as a resource. Financial freedom translates to actual freedom because money is the vehicle by which we obtain the things we need and want. But how do we get there? This wasn’t something we were taught, at least not in my school — we were too busy learning about our “passions”. 

After spending some time trying to answer these questions for myself, I’ve distilled the key points below. My goal is to provide a starting point for anyone interested in becoming literate on this topic. This should not be taken as a definitive action plan for every individual. While I make many suggestions and allude to my own strategy, it’s important to note that there is no one size fits all approach. Given the individual nature of personal finance, this guide should simply act as a springboard into further research on these topics.

The Idea Behind Credit

The first thing to do is open up a line of credit and start building a credit score. Think of your credit score as a digital measure of social and financial responsibility. It’s how you prove to banks that you’re trustworthy and should be allowed to borrow money. This comes into play when you’re trying to buy a car, a house, or negotiating a better interest rate for those pesky student loans. The simplest way to establish a score is to apply for a credit card. By “spending” on your card, or more appropriately, borrowing and paying it off every month, you prove that you’re a responsible person which will be reflected in your score.

What if I Have Bad Credit?

Starting with a bad or nonexistent credit score makes it difficult to get the ball rolling. It can be tricky to be approved for a credit card if you’re in this boat. Fortunately, there are a couple of workarounds.

1. Apply for a secured credit card. As the name implies, these cards require a deposit or “security” from your end. In the event that you fail to pay your bill, the deposit will kick in and act as a form of security for the credit card company. The idea is to use one of these cards to build up your credit history and then apply again for a regular card.
2.  Another option is to become an authorized user of someone else’s credit card. This person, usually family or friend, should already have an established credit history. As long as payments are made on time with this card, your credit score should also receive a boost by association. 

Credit Cards (Advanced)

The world of credit cards runs deep and there are a lot of rewards for those willing to take the time to understand how the game is played. A whole online community is dedicated to getting the most out of the hundreds of different credit cards out there. If you’re interested, check out credit card churning. The basic idea involves capitalizing on the sign-up bonuses and point systems of different cards — usually applying for multiple cards to maximize on these reward schemes. While this works out for some people, it definitely comes with its share of risk and is not recommended for beginners. 

No matter what you decide, it’s still worthwhile to find out what different cards have to offer and pick one (or more) that makes the most sense for your personal spending habits.

Remember:

1. Late payments will lower your credit score.
2. Failing to pay outstanding bills could result in intervention by a collections agency which opens you up to legal liability as well as lowering your credit score for up to statute of limitations of seven years. 
3. This one seems obvious, but many people forget it when they see something they like: Never spend money on your card that you do not have.
4. Always pay off your credit card statement in FULL. If you only make the minimum payment, the rest of the statement is subject to interest fees because you technically borrowed that money. You can avoid this unnecessary cost by always paying off your statement in full which shouldn’t be a problem if you never spend money on your card that you do not have (refer to point number 3).
5. The payment due date for your credit card statement usually falls at least 21 days after the statement cycle. Different cards have different cycles, and it’s easy to mix them up if you have more than one credit card. So make sure to keep track of them!
6. Credit card sign-up bonuses are great because they give you back a sum of money after you reach a spending limit (ex: As of April 2020, Chase Freedom Unlimited offered $200 after you spend $500 or more in the first three months). Don’t make the mistake of artificially spending money just to reach this limit — you can always ask friends and family to put their spending on your card and pay you back in cash.
7. Credit card companies profit off the law of averages which states that over a period of time, an event will occur at a frequency similar to its probability. The probability on average that people will mess up and forget a payment is quite high. In 2016 alone, credit card companies hauled in $63.4 billion in interest payments and $12 billion in penalty fees. This means that they are banking on you to mess up and have to pay late fees and interest. Remember, statistics apply to averages, not individuals. If you stay educated and on top of your game, not only will you never have to pay them a single penny but you could also stand to profit on the bonuses and rewards. 
8. Building a great credit score takes years while tanking one only takes a few mistakes.

Retirement Accounts

The next thing you should do is set up a retirement account. If you’re like me, in the prime of your life, thinking about retirement probably isn’t on your radar. That would be a mistake for one simple reason- compound interest. In finance, this is the beautiful little concept of earning interest on your interest. It’s what people mean when they say, “let your money make you more money.” Because it’s such a great concept, I’ll make time for a slight digression.

Einstein once said, “Compounding interest is the 8th wonder of the world. Those who understand it, earn it. Those who don’t, pay it.”

He’s implying that this idea extends to far more than just money. The concept of reaping increasing benefits from your investments the longer you keep at is relevant to all aspects of life. Apart from money, these investments can come in the form of the routines, habits, and values you hold. 

Take, for example, exercise. The immediate return from exercise is little more than body ache and soreness. Yet, we all understand that if you continue to invest in this activity you will begin to see changes. In a few weeks you’ll become noticeably stronger; give it a few months and you could be enjoying a completely new level of physical fitness and added mental clarity. If you consistently exercise for years, it wouldn’t be unreasonable to assume that you’re now on a completely different trajectory than you would be otherwise. The discipline and mental fortitude developed from exercising in addition to the physical gains will permeate into all areas of your life. The benefits of making the right choices over and over tend to stack.

The whole idea of retirement accounts rests on this notion. To oversimplify: the money you contribute to the account gets invested in a variety of options such as stocks, bonds, and equities. These investments allow your money to earn interest — resulting in a profit that is then reinvested for more profit. In combination with your consistent annual contributions, these two factors will make your retirement account grow exponentially.

Types of Retirement Accounts

The 401(K) and the IRA are the two main kinds of accounts to consider. Earned income is required to contribute to either one of these accounts which means you have to have a job or some form of self-employment that pays you money. Both types of accounts can further be broken down into either Roth or Traditional which differ in the timing of taxes. Roth retirement accounts take post-tax contributions with the advantage of being not having to pay taxes on the payouts you receive in retirement. Traditional retirement accounts are just the opposite and take pre-tax contributions. In this case, the benefit of having potentially more pre-tax money to contribute is offset by having to pay taxes on eventual retirement payouts. 

Selecting the right kind of investment account has to do with predicting your expected retirement tax bracket. In general, those who expect to be in a lower bracket nearing retirement should go with Traditional while those expecting to be in a higher tax bracket should consider Roth. 

401(K)

This type of plan is generally offered by your employer and often comes with a contribution match. The match is basically free money so I highly recommend you maximize on this opportunity when available. Opting into your company’s 401(K) program is by far the easiest option because a portion of your paycheck goes directly into your retirement account. Your investment portfolio will mostly consist of mutual funds and index funds which are often highly diversified and low risk.

IRA

You should look into an Individual Retirement Account if your work does not offer a matched 401(K), you’ve already maxed out on your employer 401(K) match, or you’re self-employed/independent contractor. Opening up an IRA takes a little more work and requires that you select a brokerage company to manage your funds. Fidelity, Charles Schwab, and Vanguard are all good options and have been in the business for a very long time. In practice, you’ll treat your Individual Retirement Account like you would any other bank account and deposit money into it up to the annual contribution limit which changes from year to year. Once deposited, you have to then decide where to invest your money. With an IRA, you have more flexibility over investment options and can select from any number of mutual funds, index funds, ETFs, target-date funds, and other monetary assets.

How to Invest

Now that you have a basic understanding of the most common retirement accounts, let’s get granular on what investments to choose. Generally, your investment portfolio should become more conservative as you near your retirement date. A good rule of thumb is to use your age as a percentage of your portfolio invested in Bonds since they are widely regarded as extremely safe investments (i.e. 30% of your portfolio in bonds at 30 and 60% when 60).

If you’re anything like me and prefer an “invest and forget” strategy, then Target Date Funds and Broad-Based Index Funds are the way. Target Date Funds automatically readjust your portfolio to become more conservative as you near your retirement date. This means that as you get closer to retirement, more risky but potentially high growth assets are swapped for low-risk assets such as bonds. 

My personal favorite are Broad-Based Index Funds. These are offered at all major do-it-yourself brokerage firms and track economic indexes like the S&P 500 by being made up of equal portions of all 500 companies in that index. This provides natural diversification and ensures stepwise growth with the market — which always grows over the long term. While economic recessions do happen and can be devastating, the market has historically always been marked by robust upward growth over the span of decades. 

Remember:

• Roth IRA is a popular option for young people who are in a low tax bracket now but anticipate being in a higher tax bracket toward the end of their career.

• Maxing out on an employer-matched 401(K) and then putting any leftover money in a Roth IRA is a powerful investment combination.
• You can theoretically possess any combination of 401(K) and IRAs. 
• Maximum contribution total to 401(K) in 2020 is $19,500 including both Traditional and Roth (ie. Roth 401(K) contributions + Traditional 401(K) contributions < $19,500 per year).
• Maximum contributions to IRA are in 2020 is $6000 including both Traditional and Roth (ie. Roth IRA contributions + Traditional IRA contributions < $6000 per year).
• There is No Required Minimum Distribution at any age for Roth IRA which means that if you don’t need it, you will never be required to take minimum payments as with other retirement accounts. This makes it easy for your account to be eventually passed on to a designated beneficiary.
• Be aware of the expense ratios for the investment funds you select for your portfolio. These should be thought of as management fees that take a percentage of your earnings or capital gains. They may not seem like a lot initially but can really add up over the years.

Final Remarks

While I can’t guarantee that this protocol will make you personally rich, I’m certain these tips are foundational for any version of financial freedom. Keeping all of this in mind, all that’s left is having an honest conversation with yourself about what it is that you want out of life and how money will help you get there. Even though there’s nothing especially complicated about anything I’ve said, mastering your finances is no easy task. Ideas that are simple in theory can still be just as hard to execute. 

It’ll go a long way to have a clear understanding of your values and to remember why your efforts will be worthwhile. Personally, I like to keep it simple. Money improves my quality of life by allowing me to do things on my terms. It’s nothing special but nevertheless ties me to a clear and attainable motivation.

After having this conversation with yourself, you may realize that you don’t actually value the things that money can buy. Or maybe you do, but not enough to spend 80% of your waking hours in the pursuit. If that’s the case, it’s even more important to figure this out early so you don’t waste your precious time. Thinking about early retirement is all the more relevant in this situation. I firmly believe that an understanding of money management is necessary for any prosperous life. However, as long as your burn rate is lower than your income, you’ve attained financial freedom in my book.