Money Management

How To Make Your Money Work For You

How to Make Your Money Work For You
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Making your money work for you rather than against you is one of the most powerful ideas in personal finance. 

Money doesn’t care if you’re tired, stressed, hanging out with friends or on vacation — it can work on your behalf no matter what. 

But the opposite is also true. If you’re not intentional with your money it can lead to slower wealth building (at best) or serious financial hardship (at worst). 

Your goal is to get as many dollars as possible going to work for your benefit. 

In this post, you’ll learn tips and investment strategies that will help every dollar work harder.

The Big Ideas (TLDR)

  1. Compound interest will either work for you or against you. If you remember nothing else from this post, remember this. Months, years and decades from now, most of your success (or lack thereof) will be the result of compound interest. Making your money work for you is all about having compound interest on your side. 
  2. Grow and invest your gap. To make your money work for you, your job is to grow the gap between your income and expenses as wide as possible. This allows you to put more money into what I like to call your “compound interest machine.”
  3. Time and patience. There’s no magical investment that’s guaranteed to double your money in six months. However, there are many legitimate ways to get compound interest on your side. The catch? They take time and patience. But the results are worth the wait. 

Five Tips To Make Your Money Work For You

Tip #1: Understand the Power of Compound Interest

He who understands interest earns it. He who doesn’t understand interest pays it.

An unknown ad copywriter

Compound interest is what gives the average person like you and me a fighting chance to build wealth. It’s the safe road the — the closest thing to a guaranteed way to get rich

But there’s a catch, of course. Actually, there are two. 

First, it takes time. One or two years is too short of a timeframe to experience the power of compound interest. 

Second, it’s hard. You need to continue to invest, even when everyone else thinks it crazy to do so.

But even with those caveats, it’s still the most powerful weapon to build (or destroy) your wealth. 

Consider this example:

By making a minimum payment of 4% on a $6,000 credit card balance with an interest rate of 18.9%, it will take you 144 months and $9,758.80 to pay off that balance. 

For many people, this decimates the ability to build wealth. 

Now consider this example:

Starts ContributingStops ContributingAnnual ContributionTotal ContributionAnnual ReturnTotal at 65
Investor A1930$2,000$22,0007%$360,623
Investor B3065$2,000$70,0007%$295,827

The 19-year-old, who had seven more years of compounding on her side and invested $48,000 less, grew her account to $360,623. Investor B, who at the age of 30 contributed $2,000 every year until she was 65, ended up with less.

The point is not to beat yourself up because you didn’t start contributing to an IRA at age 19. You are where you are today, and your only option is to make the right decisions going forward. So use these two examples of compound interest as a principle to guide your decisions. 

Tip #2: Savings Rate Is More Important Than Returns

Most investors are obsessed with their rate of return. 

But consider this example:

Annual ContributionYears InvestedYearly ReturnTotal at 65
Investor A$6,000207%$263,191
Investor B$5,000208%$247,115

An investor who saves $5,000 a year and earns a 7% return will have $219,326 in 20 years. Increase that return by 1%, and this same investor will earn $247,115.

Yet, if this same investor ended up investing $6,000 a year, and “settling” for 7% gains, their total balance would grow to $263,191 in 20 years. 

The big takeaway is that, for younger investors, it’s more important to focus on how much you save than on trying to pick perfect investments. 

The problem with focusing on returns is that anything above what the market as a whole makes you is not guaranteed. Studies show that 95% of financial professionals don’t beat the market average over the long-term. 

So, instead of dedicating time to trying to earn an extra 1% or 2% in returns, it’s much better to:

  1. Put that focus into making more money.
  2. Use that increase in earnings to save more money.

At The Ways To Wealth, we call this growing the gap:

the gap between your income and expenses

Tip #3: Don’t Lose Money

If you want your money to work for you, you must not lose money. 

Just ask the greatest investor of all time: 

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”

— Warren Buffett

Yes, this does sound quite basic. But people fail to follow this rule disturbingly often. 

Whether it’s through a bad stock pick, bad market timing, bad real estate investments, taking on high-interest debt or gambling, many people end up making one significant decision that sets their finances back for years. 

Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, sums it up best:

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Tips to keep in mind:

  • Build an emergency fund. Aim to get to at least three months worth of expenses. Yes, this money doesn’t earn much in a high-yield savings account (we recommend CIT Bank), but it can help you get through the inevitable hard times ahead. 
  • Insure yourself against catastrophe. Health, home, auto and life insurance are the types of insurance that come in handy, as they can truly prevent financial catastrophe. Most other types of insurance — like insuring your smartphone or a warranty on your TV —  are best handled with an emergency fund (a.k.a. self-insuring). 
  • Never invest money for the long-term that you can’t afford to lose in the short-term. Over time, stocks have always gone up. But in the short-term, nobody knows what the market will do. We’ve seen years with 50% market declines. They’ll probably happen again. But the only people who actually lose money are the people who sell. Those who hold are often rewarded, such as those who held on through the market crash of 2008 (which was followed by a decade-long bull run). 

Tip #4: Minimize Taxes

You want as much of your invested money in tax-advantaged accounts as possible. 

Traditional and Roth IRAs, 401(K)s and even HSAs can help more of your money work for you. 

For context, the difference between investing $5,000 in an IRA and a taxable account, over 30 years, comes out to $125,490.

Taxable AccountTraditional IRARoth IRA
Current investment balance$0$0$0
Annual contributions$5,000$5,000$5,000
Number of years to invest303030
Before-tax return7%7%7%
Marginal tax bracket25%25%25%
After-tax return5.30%7%7%
Future account value$346,814$472,304$472,304
Future account value (after-tax)$346,814$391,728$472,304

Tip #5: Keep Investment Expenses Low

“Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.”

— John Bogle, founder of Vanguard

There are very few things you get to control with your investments. 

Taxes are one of them. Fees are another. 

The difference between investing $5,000 while paying .20% and 1% amounts to $60,345 over 30 years.

.2% Fee.5% Fee1% Fee
Current investment balance$0$0$0
Annual contributions$5,000$5,000$5,000
Number of years to invest303030
Return7%7%7%
Total$455,645$431,874$395,291

Eight Ways To Make Your Money Work For You

Now that you understand the rules behind successful money management and investing, it’s time to incorporate that advice into your own financial plan. 

Below are the basic steps to putting your money to work for you. These should be followed in order. 

In other words, don’t move on to Step #2 until you’ve completed Step #1. Doing so will violate the basic principles (outlined above) of having as much money as possible working for you day in and day out. 

Step #1: Build A $500 Emergency Fund

Hopefully, you already have this amount in your bank account — which means you can quickly move on to Step #2. If not, it should be your top priority. 

According to the Federal Reserve, 40% of Americans don’t have $400 in their bank account

Research shows that low-income families with $500 stocked away for emergencies were able to improve their financial situation more than middle-class families with no emergency savings

Step #2: Pay Off High-interest Debt

Remember how compound interest is either working for you or against you? Well, high-interest debt, like credit card debt (which compounds month after month) is a similarly powerful force. 

That’s why you want to pay off this debt as soon as possible.  

Step #3: Build A Proper Emergency Fund

A proper emergency fund, which can ideally sustain you for at least two months, helps you avoid losing money (Tip #3). 

Put this cash in a high-interest bank account, such as CIT Bank. I even recommend keeping it in a separate bank account from your checking account, as it will be a bit harder to access the money. 

Yes, you won’t get much with today’s interest rates. But that’s not the point. Unexpected events, such as a car repair, home repair, or even a job loss, can be stressful and costly.

These things are inevitable in life, and an emergency fund helps minimize the damage they cause. While you may only earn 1% on your money in an emergency fund, you’re preventing yourself from paying high-interest debt if you need to use a credit card when something goes wrong (often at a rate of 18% or higher). 

That’s a great return. And over time, it means that more of your money is working for you. 

Pro Tip: When you do draw from your emergency fund for an unexpected expense, your priority needs to be replenishing it. 

Step #4: Employer-Sponsored Match

Up until now, it’s been all about not having compound interest work against you. It’s here where you start leveraging the power of compound interest in your favor. 

The best way to start investing, if available, is by contributing to your employer-sponsored plan all the way up to your maximum company match. 

The company match is part of your compensation. It’s free money

But even with that free money on the table, 25% of people don’t take advantage of an employer match — missing out on a combined total of $24 billion a year.

Step #5: Consider Paying Off Other Debts

After inflation, the stock market provides returns of about 7% per year. But as we discussed earlier, some years that return could be -50%, while other years it could be +40%. It’s over long periods of time that you’ll average about 7%. 

But when you pay off debt, you know exactly what your return will be — the interest rate of that debt. 

This is why it’s so important to focus on paying off that high-interest debt: it’s a guaranteed good use of your money.

For example, if you have $1,000 of credit card debt at 18%, paying off that debt will save you around $180 over the course of the year. That’s a guaranteed 18% return — which you’d be lucky to get in the market.

How do you handle other debts, such as student loans, car loans or a mortgage? Should you also pay those off before starting to invest more?

A good rule of thumb is to pay off any debts that have a rate of 7% of more. This is by no means a personal finance law, however. If you feel strongly about paying off all your debts, or about wanting to get started investing while you pay down your 6.8% student loan, that’s up to you. 

But keep this in mind: paying off debt gets you a guaranteed after-tax rate of return. This is something the market does not provide, unless you’re getting the free money of an employer match. 

As for how to pay off your debts, I recommend the debt snowball method, in which you pay off your debts in order of smallest balance to largest balance. Yes, this goes against the numbers. But research shows it’s the most successful way to get out of debt.

Related: How to pay off your student loans in five years.

Step #6: Contribute To An IRA

With your debts paid off or prioritized, it’s now time to focus on investing. 

As you learned, taxes do make a big difference. It’s for this reason that you’ll want to continue to leverage tax-advantaged accounts. 

After your 401(K) match, that’s likely to be an Individual Retirement Account — more commonly called an IRA. 

In 2020, if you’re under age 50, the annual contribution limit to an IRA is $6,000. If you’re over 50, the limit is $7,000.

Your goal for this step is to contribute the maximum amount possible to your IRA. 

But why an IRA rather than your 401(K) plan? 

Because IRAs give you more control over your investments and fees. The average person pays about .45% in fees on their 401(K).

But when you open an IRA with a provider like Betterment, you can expect to pay about .25% for an optimized portfolio that you never have to adjust. 

With a company like M1 Finance, you can pay even lower fees — although you might have to make a few decisions along the way.

Given this, it’s a good idea to shop around before signing up for an investment account. 

You can learn more about the different types of IRAs here.

Pro Tip: You can contribute to an IRA for the previous year up until next year’s tax deadline. For example, you can make contributions to a 2020 IRA up until April 15th, 2021. 

Step #7: Look Ahead To Future Expenses

Now that you’re out of high-interest debt, you want to stay there. 

Having contributed up to your employer match, as well as having maxed out an IRA, it’s now time to look at short-term and medium-term goals that, if not saved for, would have to be financed with debt. 

Do you wish to someday own a home? If so, saving 20% for a down payment can save you significant money over the course of your mortgage. Even shorter-term goals such as buying a car or an engagement ring can and should be planned for.

The idea is to look ahead at the next few years and identify any big purchases that might be on the horizon. Then, start setting aside money to make those purchases when the time comes.

Step #8: Take Advantage of Other Tax-Advantaged Investments (Maximize Your 401(K), HSAs and College Savings Funds)

If you’ve made it this far and still have room left over to invest, your first priority is still to leverage tax-advantaged accounts to the fullest possible extent.

The maximum you’re allowed to contribute to your 401(K) in 2020 is $19,000 ($19,500 for those over 50). If you’re looking to have as much of your money work for you as possible, it’s here that you’ll want to work your way towards contributing as much as you can. 

There are other tax-advantaged accounts worth knowing about as well. Depending on the state you live in and how you withdraw the money when that time comes, these accounts could offer a rare “triple tax advantage” in which you get (1) a tax deduction for making a contribution, (2) your money grows tax-free, and (3) you can withdraw your funds tax-free.

  • 529 College Savings Plan. If you have kids, or even plan to have kids in the future, you could look at a college savings plan to invest excess money. In some states, the money you invest is tax-deductible. Money is then able to grow and be withdrawn tax-deferred for eligible education expenses. 
  • Health Savings Accounts (HSAs). If you have a qualifying high deductible health plan, you’re allowed to make contributions to an HSA. Money invested in an HSA can be withdrawn tax-free to pay for medical expenses. After the age of 65, you can withdraw the funds in your HSA for any reason. 

Related: Lean more about Lively, one of our favorite HSAs.

FAQ

Should I invest in mutual funds or individual stocks?

The answer to this question depends on many factors, including your age, your financial know-how, your risk tolerance and your goals. But with all of that said: the overwhelming majority of investors will get the best returns by continuously contributing a passive investment plan such as index funds or ETFs. 

Picking stocks is very difficult, and you’re unlikely to beat the market. With that said, it’s never a bad idea to speak with a financial advisor who can look over your specific situation and help you develop a customized investment strategy. 

Here’s an article I wrote explaining how to find cheap or free financial planning help.

What’s the best way to grow the gap between my income and expenses?

For most people who want to save money, the first step is figuring out how to make money and increase their income stream. If you’re interested in starting your own business, I’m a big proponent of launching a blog — after all, it’s worked well for me! If you’re just looking for a way to increase your cash flow, these side hustles and online jobs can be a great option. And if none of those options work, you can focus on these easy ways to cut your living expenses.  

Closing Thoughts on Making Your Money Work For You

This article was written through the framework of maximizing every dollar you have. 

In a perfect world, you’ll work your way diligently through each step, never having to start over or move backward. And in a few decades, you’ll have built up a compound interest machine that’s churning out passive income for you every month. 

But the chance of living a life that avoids financial setbacks is slim to none. We all hit rough patches in life. When you do, it’s your job to not only be prepared, but to work your way out of the weeds as quickly as possible. 

That’s why having things like an emergency fund in place and minimizing your debt are so important; they allow for more days for your money to go to work for you, rather than going backward. 

Where are you in your financial journey? What’s your next step? Let me know in the comments. 

R.J. Weiss
R.J. Weiss is the founder and editor of The Ways To Wealth, a Certified Financial Planner™, husband and father of three. He's spent the last 10+ years writing about personal finance and has been featured in Forbes, Bloomberg, MSN Money, and other publications.

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