Should you Build Emergency fund, Invest first or Pay off your mortgage faster? Increase your Personal Free Cash Flow and Focus on your Net Worth
One very common question that I get a lot is about how should we allocate with a few very competing financial goals.
And I hope today in this short article, I give you some ideas how to work this out.
The problem I feel is that there is excessive tidbits about what you should do:
- You should build an emergency fund
- You should invest in a STI ETF
- You should set aside for investment
- You should put your money into Singapore Savings Bonds
- You should top up your CPF SA
- You should pay off your home loan early
When it adds up, it can be very confusing.
Which one to do first?
How do you rank one above the other?
Now let us break this answer into 2 parts, the Wealth Foundation and Advance Wealth.
Wealth Foundation: Implement whatever Increases your Net Worth
I have a series on my site called the Wealth Foundation. If you read that, and comprehend most of the stuff written in there, and implement them in your life, you should do fine.
The first part of the answer addresses this.
In life there can be tangible metric, there can be intangible metric.
Intangible metrics are whether you have lead a fulfilling happy life. This is very subjective, so we differ to evaluating the tangible metric.
The key tangible metric here is whether we are doing well financially.
Whenever someone suggested to you to do something, you got to ask whether it improves you financially today, if not tomorrow.
In my wealth formula (explained in detail here), you will generate a lot of wealth if you
- find ways to earn more
- learn to optimize your spending
- whatever you have left between #1 and #2, that is your net cash flow/additional wealth capital/free cash flow. You deploy this to building wealth wisely
If you repeat doing those 3 steps very well, you will be OK. To dive deeper into the formula, you can read that article.
Now let us look at it from another angle.
Your take home pay, you either spend it or save it. The spendthrift one will spend a lot. If not enough, the spendthrift one will borrow and take on debt. The prudent one will optimize her spending and save more.
Thus, your take home pay you spend it.
What is left over is what I would term “The Gap” or your free cash flow, like a listed company.
Now in theory, your expenses are mandatory. This means that it is well optimized such that you have good justification why you spend them.
This means that if Kyith asks you why you spend on this and that in your expenses, it does not feel guilty.
What is left over is the free cash flow.
Like a listed company or stock, you can do all sorts of thing with this free cash flow:
- Save in bank
- Put in investment
- Pay off your debt
- Reinvest in yourself or your spouse
The key success in your wealth foundation is that majority of the decisions that you take in the wealth foundation with your free cash flow will improve your finances.
The key metric of measurement is your personal net worth.
This is what financially you can be worth. It is made up of your total assets minus your total liabilities.
Most of what you decide to do, will improve the net worth.
Here are some examples:
- Build an emergency fund. This increases your total assets. Your net worth goes up.
- Invest in STI ETF. This increases your total assets. Your net worth goes up.
- Set aside for Investment. Similar to #2, this increases your total assets. Your net worth goes up
- Buy cryptos or Singapore Savings Bonds. ditto
- Top up your CPF SA. Your CPF is part of your total assets. This move converts liquid assets to illiquid assets. Your net worth goes up
- Pay off more of your home loan early. This reduces the interest expenses you need to pay. It leaves more future cash flow with you, thus retaining more assets. Also when you pay off more, this reduces your liabilities/debt. The combine of this 2 actions in increases your net worth
But what you want to know is which one gives me the most bang for the buck, or the sequence for which to do first.
And I am telling you that is Advance Wealth.
In Why You Should Not Force Yourself to Start Investing ASAP, I explain the relationship between funneling more of your free cash flow to building wealth, versus the rate of return you get on average for investing your wealth.
When you deliberate on whether to top up CPF SA first, build an emergency fund first, or pay off your home loan first, what you are doing is optimizing the overall average rate of return you will get.
In the table above you see 4 different rate of return from 0% to 9%.
Whether you do well or not, your average should be between them.
But to build up $300,000 from $0, as the table above, you realize the bigger determinant at the start, is your monthly savings or the amount of free cash flow you have, to build wealth.
For example, if you free up $1000/mth and you can invest, save, pay off debt, which result in different rate of return, the time to get to $300,000 is between 13.7 years to 25 years. If you bump it up to $1500/mth, the time is shorten to between 10.6 years to 16.7 years. So you get a 3 to 8.3 years improvement.
With more free cash flow, or if you increase “The Gap”, the rate of return matters less.
So the more important question you should ask Kyith is, have I really optimize my expenses well, and whether I have maximize my earnings potential?
Let the Net Worth Lead You
Another aspect that I think does act up is that we have different relationship with the financial actions that we need to do.
Some of you hate debt and feels anxious if you have more of that.
Some of you felt not good if you are not saving money.
Some of you are absolutely impatient about money rotting in the bank account and would want to invest it.
If you wish for things to be less confusing, you track the net worth, or the rate of change in the net worth (read this why you should track it).
If you absolutely need to invest, but the right thing to do is to pay off your debt, don’t feel discouraged that you cannot.
Just do a monthly tabulation of your assets, debt and work out your net worth.
Then plot it like what I did above.
Doing well means it is rising.
If its not rising as fast as you want, or declining, then we talked about the advance wealth: which financial action should you prioritize.
Works for those with no debt, works for those with debt as well (as it crosses over to zero net worth)
Consider if you are one of the follow 3 ladies:
- You have a lot of personal loans and student loans left over. You learn to optimize your expenses, minimizing those non mandatory spending and don’t live life so much. You manage to free up $1,500/mth in “The GAP”. You decide to put away $200 for emergency and the rest into intensive debt clearing. Your net worth graph goes up
- You start off with a clean slate, and don’t have a clue about investing, but willing to learn. You learn to optimize your expenses, minimizing those non mandatory spending and don’t live life so much. You manage to free up $1,500/mth in “The GAP”.For the first 12 months, you put that $1,500/mth into high interest hurdle accounts earning 1-2%. You do this while learning to invest. Then you deploy $10,000 of the $18,000 build up into a Mapletree Industrial REIT earning 5.9% with some residual growth and $8,000 into the STI ETF. You continue to channel your $1,500/mth into the high interest hurdle accounts, to think of where to deploy next. Your net worth goes up
- You start off with a clean slate, don’t have a clue about these money stuff, but listen to the advice in a group like Seedly. After spending, you reckon you have $600 to invest. So you put $300 in Stashaway, and $300 in a Prudential Savings Policy. Your net worth goes up
#1 to #3 start off at different state, yet the conclusion is that things will improve for them. #1 is weaker in that she has some baggage, but she should see bigger improvements than #3 because she puts away more into improving her net worth.
#2 doesn’t really know what she is doing, but at least she is taking the prudent route. While learning, her net worth is still growing. And you realize, compare #2 to #3, #3 decide to put into recurring plans passively, while #2 deploys her money in an active manner. Both started off not knowing what they are doing, one is more willing to learn.
My money is on #2 to do better than #3. This is not because active manage trumps passive. It is basically that #2 seems to take a more conscientious role to managing her money and have more personal free cash flow per month.
As a summary, whichever actions you take first, or if you do a mixture of them, would improve your net worth today, if not tomorrow.
And that is good enough.
If I can, let me go into the advance wealth portion next week.