Saving money is important, whether you're creating an emergency fund or working toward a long-term goal like a vacation or retirement. But there is a difference between saving money and building wealth.
If you save 10% of your income each year, the money will add up over time, and you will end up with savings that you can dip into when you need it. If you invest the money that you save, however, your money can create more money through earning interest or dividends.
This is where you begin to accumulate true wealth.
How Investing Builds Wealth
Using the money you save to earn more money is the trick to building wealth. Investing allows you to do this in two ways.
- The money you invest earns interest, so you eventually have more money than what you put in.
- If you invest in dividend-earning stocks and funds, your money pays you as it grows.
Investing allows you to take advantage of compound interest. Over time, you earn interest not only on the money you save but also on the interest you have earned in previous years. This passively grows your wealth over time.
If you save $50 per month for 30 years, you will save $18,000. But if you earn 5% in compound interest every year, at the end of 30 years you will have over $39,000.
That extra $21,000 is wealth that your money has built.
Steps to Start Building Wealth
Investing money is often a learned behavior. Some people come from families where they were taught savings strategies, but it never went farther than putting the money into a savings account at the bank.
Some people come from families where savings was not taught, and the family always lived at the edge of their income. And some people come from families where investing is part of financial planning and actively taught to the next generation.
No matter what kind of financial environment you grew up in, you can decide what strategy you want to use once you are an adult and making your own financial decisions.
Step 1: Set Savings Goals
If you are focused on building wealth, it helps to have a clear goal in mind. Decide whether you want:
- Financial independence
- Comfortable retirement savings
- The ability to retire early
- Money to start a business
- Extra income each month
- A financial safety net
Once you know your goal, that will help you determine:
- How long you have to reach that goal
- How much you need to save
- How risky your investments can be
- What type of investments to make
- How much you should put into investments each month
You should also have savings you can easily access for things like:
- An emergency fund
- Travel and vacations
- Unexpected home and car repairs
Step 2: Start With a High-Interest Savings Account
Before you can begin investing, you have to save for your initial investment. Many institutions have a minimum initial investment, usually between $1,000 and $10,000, though $3,000 is a common threshold.
You can still take advantage of compound interest as you save up that $3,000 by using a high-interest savings account. This allows your money to grow more quickly as you are saving but before you begin investing. High-interest savings accounts also offer higher yields on deposits compared to traditional savings accounts.
If you can't open a high-interest savings account through your bank, you may be able to use a local credit union or an online savings platform such as Smarty Pig.
Some institutions offer high-interest checking accounts as well, though these usually require you to jump through hoops to earn your interest, such as posting a certain number of debit transactions per month or having a certain value in deposits in a set amount of time.
Another option is to use a certificate of deposit or CD. These accounts guarantee a certain amount of interest paid at a fixed date and are relatively reliable in the short-term, especially at lower values. Choose a CD that matures in a short period of time, usually between six months and five years, depending on how long you expect you will need to save to earn your initial investment.
Step 3: Learn About Investing
If you did not grow up learning about investing and your parents did not invest, it can be intimidating to start. There are so many different options to choose from, including individual stocks, index funds, government bonds, and mutual funds. It can be difficult to predict growth or understand when you should buy and sell.
If you are open to risk, then you may be interested in buying and selling individual stocks in order to make the highest possible profit. This can earn you significant money, but it also requires high levels of attention to your investments and can cause you to lose significant amounts of money as well.
If you are new to investing, the safest and easiest way to invest is to choose a few good mutual or index funds with a proven track record and then stick with them even as the market goes up and down. This allows you to recover from the low points in the market and protects you from market fluctuations.
Pay off high-interest debt, such as credit card debt, before you begin investing. The amount you pay in interest on this type of debt is usually more than what you will earn on your investments.
When you look at a mutual fund you want to choose one that has been open for several years, charges low fees, is run by trusted managers, and has a history of earning a profit more than losing money.
As you start investing, other things to consider include:
- Diversification. Having a variety of investments will offer you more protection from market fluctuations.
- Tax advantages. Certain bonds may be exempt from state, local, or federal taxes. Investments in retirement or education funds often offer tax advantages as well.
- Access. Some investments, such as stocks or bonds, can be sold at any time, while accounts like certificates of deposit may restrict when you can cash out. Be sure that you can access money for an emergency without paying steep fees.
Step 4: Make Steady Progress
Take steps each month to make progress. Instead of saving a large amount some months, then pulling money out of savings other months, put a smaller amount in each month so you are always saving. This allows your money to continuously earn interest and grow.
Making regular investments, even if they are smaller, also spreads out your risk by ensuring that you never make all your stock or fund purchases at the highest point in the market. This is known as dollar-cost averaging.
Set up recurring transfers from your bank to your investments (or high-yield savings). This allows you to automate your contributions, which is the easiest way to make sure you continue to invest.
Step 5: Work With a Financial Planner
A financial planner can help you to understand the different products available and the risks associated with each one. The higher the return generally means that there is more risk involved. When you are in your twenties, you can choose products with a higher rate of return because you have the opportunity to wait for the market to recover.
As you grow closer to retirement, you may want to work with a wealth manager to help you switch to more conservative investments to protect your money. You may also want to work with a financial planner if:
- You are investing larger amounts of money.
- Your goals or income have changed drastically since you started investing.
- Your family is growing and you will need to pay for education expenses.
- You would like to transition to living solely on investment income, rather than a salary or wages.
If you aim to put 10% of your income straight into investments, especially if you are allocating other funds to retirement savings, you will begin to build wealth and create a more stable financial future for yourself.