Sunday, September 4, 2011

How to Save When You're Young, So You Have Money When You're Old

Financial Advice for Young Adults: Conventional Wisdom is Wrong!

How many times have you heard the phrase, 'your home will be the largest investment you ever make' or 'the first step to financial security is to pay off your mortgage early'?    I have heard this advice from most parents to their children and I see these general guidelines repeated over and over again in newspapers and articles on various internet sites.  They are propagated because they are 'safe' guidelines that will save the author from being ridiculed or represent the life experience or value system of most parents.  It is easier to go with the flow than against it, and it is easier not to take financial risks in life.  Well if you want to achieve financial success in life, IGNORE that traditional advice. If you want to succeed financially you need a different strategy.

Historically, those who have embraced this conventional wisdom about paying down mortgages have arrived at retirement with a paid off house and little money to spend on lifestyle.  If you want to take a 70% salary cut at retirement, keep following that advice.  If instead you want to enjoy an active and entertaining retirement read further.

The largest investment you NEED to make in your life is the funding of your retirement.  The average house price in the GTA (Greater Toronto Area) is about $486,000 in 2011 according to the Toronto Real Estate Board.  Now compare that figure to the amount required to fund a $50,000 annual income, assuming an inflation rate of 2.5%, for 30 years of about $2.2 million.  Do you get the picture? 

Now this does not mean that you completely ignore your mortgage balance and pay interest only, it means that since you will be receiving a lifetime of shelter from your home, then you can spread the cost of this shelter over the standard 25 year amortization.  More importantly, BEFORE you decide on how much house you would like to have, you need to base your decision on 80% of your take home pay. My experience as a financial advisor has shown most people cannot save enough because they bought too much house when they were first married.  This placed them behind the proverbial 8-ball and restricted them from the ability to accumulate wealth.

To ensure you build wealth and have enough to fund your retirement, the first 20% of your monthly income should be devoted to retirement savings (18%), and various forms of insurance (2%) to protect you from life's various risks of morbidity, critical illness, and mortality.  In addition, you should ensure you start with a 25% down-payment to not only save on the government insurance on your mortgage, but more importantly to make your mortgage payments more affordable and to have an equity cushion in your home value.

In Canada, only 5% of the population earns more than $100,000 per year or more, so if you want to achieve a financially successful lifestyle, you need to take your advice from those who comprise that small group.  Even better, take it from the even smaller group who earn more than $250,000 per year.  This elite group of income earners is populated primarily by university graduates and to a lesser extent, entrepreneurs.  Small business owners represent a large portion of wealthy individuals, and having a university degree increases the chances of somebody's small business venture in succeeding.  You can still have a successful small business without a university degree, but the odds are against you and you must be highly motivated, resourceful, and focused individual.

When you graduate from university, if possible, live at home for two years to accumulate your down-payment for your first home.  Save diligently during that period and invest it wisely seeking the guidance of a competent financial advisor. At the same time the first 20% of your paycheque should be invested for long-term wealth accumulation as noted above.  If you cannot live at home, then consider sharing a place with a friend or family member with the assumption that the arrangement will be limited to two years so you don't have a chance to sour the relationship.

There are three components to wealth accumulation: savings, rate of return, and time.  Of these three, 'time' is the most critical element because it is what allows for the compounding of your wealth.  Compounding of your investment returns is considered the 8th Wonder of the World by Albert Einstein.

One last thing, stop procrastinating, the time to act is not tomorrow, but today, so go get started!
John Soutsos, Senior Financial Consultant, Investment Planning Counsel