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Financial Freedom
“Too many people spend money they earned… to buy things they don’t want… to impress people that they don’t like.”
Will Rogers
40% of the UK’s working age population has less than £100 in cash savings.
- House of Lords Financial Committee 2017
70% of the US population have less than $1,000 in savings and 45% have nothing
- GOBankingRates 2019 Survey
Isn’t that incredible and so utterly depressing. Today I got a flat tyre, we pulled into a garage and got it repaired so we could continue on our journey. The bill was £110. 40% of the UK wouldn’t have been able to afford that (closer to 60% in Northern Ireland).
Money is sadly what makes the world go round. Understanding it, how to make more of it and how to look after it and keep it should be an essential part of everyone’s education. But it is not taught in schools.
Some critics of the UK’s (and US’s) education system would argue that it is not designed to prepare you for life but for the a job, perhaps even a Victorian notion of one. The problem with an education system like this is that there is a distinct lack of financial education. Apparently you simply don’t need it, your employer will take care of it all for you… be good and you’ll get paid what you deserve.
But despite universal education and 95% employment in the UK, 40% of working adults have less than £100 in savings and 48% worry about money every week. So the old model is clearly not working. Whilst I’m no accountant, here are some notes and thoughts I’ve picked up on the subject of how to be financially secure and if possible free.
Free to live your life to its fullest potential instead of wasting away the years doing a job you hate for a person you hate.
Anyone who lives within their means suffers from a lack of imagination.
Oscar Wilde
Your Personal Balance Sheet
“Your economic security does not lie in your job; it lies in your own power to produce—to think, to learn, to create, to adapt. That’s true financial independence. It’s not having wealth; it’s having the power to produce wealth.”
Stephen Covey
The first place to start with a financial education is with two simple accounting documents, the Balance Sheet (which lists positive financial assets and negative financial liabilities) and the Income Statement (which lists your resulting income and expenses).
In very simple terms, putting both together looks like the following:
Construct one for yourself.
Your income and expenses should be obvious, however assets and liabilities perhaps not for many. In simple terms, an asset is something that produces an income, whilst a liability produces expenses. Try creating one for yourself. Fill it in (some suggestions for things to include have been included above) based on your monthly transactions. Are you positive or negative at the end of the month?
I’ve taken this idea of a personal financial statement from Robert Kiyosaki who has written a series of very easy to read books on the subject, his most famous being Rich Dad Poor Dad and I know many people for whom he has had a transformational impact on their lives. So despite the fact he’s a big fan and friend of Donald Trump he does have some interesting wisdom to share.
The objective of looking at a financial statement like this is:
To observe where the things you buy, or decisions you take end up. Is that car I just bought an asset or a liability? Is borrowing money on my credit card to pay for next years holiday going to help me reduce my liabilities?
To start making strategic choices to increase your assets so that you can reduce your reliance on having a salary.
To obtain financial freedom so you only have to work if you want to.
“The philosophy of the rich and the poor is this: the rich invest their money and spend what is left. The poor spend their money and invest what is left.”
Robert Kiyosaki
So lets look at some classic examples of personal financial statements in action and the implications they have. In the words of Robert Kiyosaki there are 3 basic profiles of people: “Poor” people, who have no assets or liabilities, they tend not to own anything but still have bills to pay and hopefully a job that covers them. Then there are the “middle class”, people with good jobs and potentially high salaries, but everything they own tends to be an expense (big house, nice car, private schools etc…).
Finally there are “Rich” people. These people have invested the money they have into assets. Things that generate a positive cash flow. Yes they may have lots of liabilities, but as long as the assets produce more than the liabilities cost they are financially free and no longer need a job or a salary at all. Of course many “rich” people still work, but they don’t have to and so can choose to work on things that really matter to them.
If you’re an accountant you might be shaking your head at this. In proper accounting terms an asset is anything that has value. So your house or your car is an asset by their terms, and to many people their biggest ‘asset’ is their home. But having something of value is different to having something that makes money, and financial freedom needs money. If I only have £100 in savings but need to pay a £110 car bill, I can’t cash in a few bricks of my house.
So using Kiyosaki’s definition is the key to breaking free.
What the “middle class” (Kiyosaki’s words) often get wrong is that rather than using their good salaries to invest in assets that help them reach freedom, instead they increase their liabilities… a better job means a larger house, better car, more private schooling, more debt and spending. So whilst they have lots of stuff they are prisoners to it.
The Unfortunate Bottom
This is the very difficult position many people find themselves in. A job, or perhaps unemployment benefits is just enough to cover the basics. Without a better income it’s difficult to see how you could progress anywhere.
Mr Money Moustache has some great advice (excuse the odd name) on how you might be able to cut your expenses without compromising your quality of life.
The Fortunate but Wasteful Middle
A good job leads to the ability to buy lots of stuff. Whilst a very fortunate position to be in, if you’re not aware of the bigger picture you might end up in a vulnerable cash cycle:
Have a good job, spend the money, get a better job, spend more money, need a better job, need a bigger house, need an even better job…. Before you know it your liabilities and expenses each month are huge. If anything happens to that high paying job you’re in big trouble.
Some people call this the “golden handcuffs” trapped in a cycle of earning just to stay still.
“The three most harmful addictions are heroin, carbohydrates, and a monthly salary.”
Nassim Nicholas Taleb
The Prosperous Top
The reason rich people seem to keep getting richer whilst everyone else suffers, no matter what economic tragedy is unfolding is simple. The rules of the financial world are designed in their favour…
Use the income from your job to buy assets that work to produce money for you. Either work less or continue to work so that you now have more spare money to put to work, and repeat. With economies of scale, the more assets like this you have, the cheaper they become (managing multiple rental properties is cheaper, per property than managing one, investing more money in the stock market get give you preferential rates, having multiple businesses can give you shared resources thus reducing the overheads of each, etc…)
To turbocharge your game, use leverage and borrowing to exaggerate your asset buying ability. The more assets you have the cheaper the rates of borrowing will be, and as a helpful bonus many of your expenses relating to assets are also tax deductible because governments want people to do this.
Compound Interest
Getting it to work for you.
Compounding interest is the ability for a sum of money to increase exponentially, a truly effortless way to make money. To use it to your advantage requires only a few things:
A source of money to go in (savings from your salary or other incomes)
A place to put it where it will reliably earn interest
Enough spare money that if you have a raining day, you don’t touch it.
In my experience, for many the last point is the hardest. I have a good job, my expenses aren’t huge and I can put the money into a stocks and shares ISA (a UK tax free saving ‘vehicle’) that if invested sensibly will generate a steady return (5% maybe?).
Now 5% doesn’t sound like much. But if you don’t touch it, 5% could turn
a single saving of £1,000 into £18,700 after 60 years
or £1,000 saved every year (£60,000) into £354,473 after 60 years
The problem with compound interest is that it takes time to warm up, If rather than saving money now (and collecting 5% on it) you wait until you have a big job that pays a huge salary. In order to make the same ‘profit’ (354,473-60000=294473) by the time you turn 60 you’d need to save £92,000 a year from when you turn 50. £1,000 a year now sounds much more achievable.
If you’d like to download a compound interest excel table I’ve put together, then please click here.
“Compound Interest is the eighth wonder of the world… He who understands it, earns it; he who doesn’t, pays it.”
Albert Einstein
In summary, the sooner you start and the longer you wait, the easier it is. Here are some examples (which you can find in my excel table example worksheet:
At aged 21, you start saving £1,000 a year and invest is in something that generates a 5% return. By the time you’re 60 you’d have a retirement pot of £120,000 (3 times what you put in, £40,000)
To make the same amount of ‘profit’ as example 1, you’d have to save £25,000 a year when you turn 50.
Rather than put £1,000 a year till you’re 60, you put in £4,000 a year till you’re 31 (so still the same total, £40,000)… at 60 you’d have £220,000 (5.5 times what you put in).
If instead of waiting till you’re 21, you have very generous parents who put £4,000 a year into an investment vehicle for you from when you were born. With the same £40,000 investment, by the time you’re 60 you’d have £580,000 (14.5 times what you put in).
Now let’s say you have a good life and when you get to 60 you think, actually I don’t need this money, I’ve got enough of my own and I’m worried about my kids. So what I’ll do is let it continue to compound and I’ll leave it for them. By the time they turn 60 (assuming I had a child at aged 30) they would have a savings pot of £2.5million (62.5 times the amount my parents put in).
Just a few notes, £4,000 a year used to be the limit a parent could put into a child’s Tax free ISA, but that’s recently gone up to £9,000 a year.
Why do you think rich people keep getting richer and richer at a faster rate than everyone else? Compound interest.
“Work, Rest & Invest”
Dizzee Rascal, with Ocean Wisdom - “Blessed”
MrMoneyMoustache
Want to find help and advice on how to obtain financial freedom and ‘retire’ early? MrMoneyMoustache is a hugely popular financial advice website where people share tips and ideas on how to save more or invest wisely.
They also have a handy compound interest calculator… put in your salary, how much you spend a year and it’ll tell you how long it would take before the interest on your savings equalled your expenses (thus ‘retiring’ from the day job).
“It is not the man who has too little, but the man who craves more, that is poor.”
Seneca
Debt & Leverage
Some things are expensive and you need to borrow money to buy them. Borrowing money is called leverage (as in using a lever), your own money is enlarged by the borrowed money so now you’re able to do more or access things you couldn’t before.
Business founders do this to grow their businesses.
Investors might do this to buy more of something they are convinced will increase in value.
Homeowners do this to buy a house when they can’t afford it outright, in the form of a mortgage.
Landlords do this to increase their earnings ratio…
Let’s suppose there’s an opportunity to buy a run down house in Bath for £400,000 and you can put 4 students in there who collectively pay you £2,000 a month and don’t care about the condition. That’s a 6% return on your investment. Not bad and possibly less risk than putting money into the stock market.
But what if you could borrow some of the money from a bank? At the moment you might be able to get a 75% value mortgage for 2%…
So we borrow £300,000 and each year have to pay 2% (£6,000) in interest.
So we earn £24,000 from the students, pay £6,000 and are left with £18,000.
£18,000 of earnings each year on an investment of £100,000 (not the full £400,000 because we borrowed most of it) is a return on investment of 18% a year.
In the years building up to the 2008 financial crash, some banks were lending 110% the value of a property for landlords… meaning you didn’t need any money to buy a house. So the return on investment, if only a few pounds was infinite compared to the money you’ve invested. It’s hardly surprising that the bubble burst.
TAX Breaks?
Another reason why so many investors and property developers love borrowing money and using debt (for property in particular), is that in many countries there are generous tax breaks for paying off debt. For instance you might assume the £24,000 was all earnings and thus would need to be taxed, but up until a few years go, the tax rules allowed you to remove the £6,000 interest owed, 10% of the income (£2,400) for wear and tear replacement of stuff, plus any other expenses such as letting fees or agents… So an employee earning £24,000 a year would pay tax on that, but a landlord earning the same amount would only pay tax on £15,600 (and I’d guess the landlord didn’t work 36 hours a week like the employee).
How do you think Trump hasn’t paid tax in years? Debt and property tax breaks.
But before you all rush out and buy property, the tax rules change all the time, and recently changed in the UK to remove interest payments as tax deductible. But if you were being a cynic you’d still have a good case to say they were unfair.
Tax
If you’ve found any of this interesting, I’d recommend watching a few videos of Robert Kiyosaki. He explains things quite well. However he is driven by a very American (Republican) belief that tax is evil and you should do whatever you can to avoid paying it (did I say already he’s a friend of Donald Trump?).
As a socially minded European I believe tax is essential to any caring society and so would never suggest anything that meant avoiding taxes that were due.
But to explain where some rich people are able to seemingly avoid paying any tax is based on a few simple principles:
For political reasons salaries are taxed the highest, so if you make money from assets rather than a salaried job, you’ll pay less tax.
On everything other than a salary (and VAT), tax is based on profit rather than the total takings. So if I reinvest the profit from my assets into more assets I’ll pay less tax whilst also increasing my earnings. If I run things through a business I can also claim the VAT back, only the end consumer (the salaried person on the street typically) ends up paying it.
If my business and assets are also things I can use in my private life, then my private life can be enjoyed through tax deductible work expenses that reduce my profit and tax without impacting my lifestyle.
If you think any of this is unfair, vote for a political party that will change it.