Perhaps the most frequently asked question in all of personal finance is this–How do you become a millionaire? Although we often focus on the idea of becoming a millionaire, there’s really a different question lurking just below the surface–How do you become financially independent? It’s financial independence that we are really seeking, although for most of us, achieving millionaire status would get us there or at least be a great start.
While $1,000,000 is a big number, it can be attained. The journey to $1 million may be a long one, but each step along the way is not difficult. In fact, each step is down right easy. With the right planning, commitment, and execution, anybody can become a millionaire. While there are certainly more than 5 ways to build wealth, what follows are 5 of the most practical concepts and methods that anybody can follow to become a millionaire in the making.
Real Estate Millionaire: Home ownership is probably the most significant asset for most people. Given the poor real estate market over the last couple of years, however, many have given up hope as they’ve watched their home’s value plummet. Don’t let the current market discourage you. Over the long term, real estate has gone up by the rate of inflation. While that may not seem like much, it’s actually good news for home owners. Home ownership offers several financial advantages:
- Tax Advantages: Both mortgage interest and property taxes are, with some exceptions, tax deductible. The gain on the sale of real estate is also tax free up to certain defined limits. These tax advantages of owning a home set it apart from just about all other investments.
- Favorable Financing: The interest rate on home loans is generally lower than most other types of loans. Of course, a home loan is secured by the property, but the rates are still very competitive.
- Automatic Savings: Owning a home is a great way to automate wealth building. With each passing month, the principal balance on the loan declines as payments on the home loan are made. And the value of the home, over the long run, steadily increases.
While home ownership can be a key element of your financial success, owning a home is not a guaranteed ticket to wealth. Many people own real estate for years without building much wealth at all. Here are some of the mistakes people make that should be avoided if possible.
Don’t think of your home as an ATM: While there are legitimate reasons to take out a home equity line of credit, expensive vacations, jewelry and clothes are not among them. Resist the urge to use your home to fund a life style you can’t otherwise afford.
Stop playing musical chairs: Life sometimes requires that we move. And for some, moving from town to town every few years is a reality of life. But recognize that buying and selling a home involves tremendous expense. Factoring in the cost of financing, moving, realtor fees, and taxes, moving can easily shave off 10% or more of the value of a home. To see your wealth build with real estate, choose your home carefully and stay put as long as reasonably possible.
Don’t buy more than you can afford: Too much of a good thing can really hurt your finances, and real estate is no exception. When we buy more home than we can reasonably afford, several things often happen. First, we look into exotic home loans (option arms, for example) as a way to afford the property. While these loans look attractive at first, they eventually result in significantly higher payments. Second, we are forced to spend too much of our monthly income on our home. This prevents us from making other important investments, like funding a 401(k). If you are considering buying a home, check this article on calculating how much home you can afford to buy. And finally, we are more likely to fund other expenses with credit cards or personal loans.
401(k) Millionaire: For most people, investing in a 401(k), IRA or other retirement account is the easiest, least costly, and most effective way to build wealth in the stock market. Whether the retirement account is a traditional tax-deferred account, or a Roth account, the tax advantages help boost overall returns. In addition, most plans run by major brokerage firms or mutual fund companies offer educational tools to help you become a smarter investor.
Given enough time, retirement accounts can grow into substantial sums. To get an idea of what’s possible, check out the table below. I’ve assumed that contributions each year increase by an assumed rate of inflation of 3.1%. For each annual contribution amount and assumed rate of return, you’ll see the approximate number of years it will take to accumulate $1 million. These results are pre-tax.
|$5,000||32 years||29 years||26 years|
|$10,000||25 years||23 years||21 years|
|$15,000||21 years||19 years||18 years|
To make the most of your 401(k), IRA, or other retirement account, here are some tips:
- Start early: As you can see from the above table, the key to building wealth is time. The earlier you start, the greater wealth you can accumulate.
- Invest Smartly: You’ll also see from the table the big difference a few percentage points can make. While there is no way to guarantee a 12% return or any return for that matter, even basic investing knowledge can go a long way. If you are uncertain where to start, I’d suggest reading The Bogleheads’ Guide to Investing. Don’t let the goofy name of the book distract you. The Booglehead’s are a group of investors named after John Bogle, the founder of Vanguard. This book is an excellent place to start if you are new to investing.
- Let it be: Avoid 401(k) loans or early withdrawals. You don’t want to do anything to interrupt the power of compounding.
10% Millionaire: Thinking beyond retirement accounts, a good rule of thumb is to save at least 10% of everything you make. Some or all of this savings may go to retirement accounts. In some cases, you may invest some of this money in taxable accounts with discount brokers or mutual fund companies. But the key is to consistently save and invest a portion of your paycheck. Ten percent is a good start; fifteen or twenty percent is even better.
Assuming a family income of $75,000, an annual investment of $7,500 increased for inflation will turn you into a millionaire in about 25 years before taxes.
Young Millionaire: Some of the most important wealth building years are between the ages of 18 and 30. These aren’t the highest earning years for most, but the saving and investing decisions made during these early years will have a major impact on your ability to achieve millionaire status. Allow me to demonstrate.
Let’s assume you begin investing $2,500 a year at age 18. Your annual investments increase each year by the amount of inflation, and you earn a 10% return on your investments. By age 68, your balance pre-tax is $1,668,657. But what’s most impressive in this example is the break-down of your investment balance. Of the more than $1.6 million balance, guess how much represented your (1) contributions, (2) simple interest, and (3) compound interest (interest earned on the interest):
Simple Interest: $318,749
Compound Interest: $1,157,073
Compound interest, which Albert Einstein described as the most power force in the universe, requires one thing–time. The more time you give your investments, the more compound interest can power your investments over the $1 million mark.
The lesson here is simple–begin saving and investing as soon as possible.
Part-Time Millionaire: What I call part-time millionaire is really nothing more than a way to earn a side income. Jason over at Frugal Dad calls it a side hustle. The idea is to find a way to make extra income above and beyond your regular work. I make extra income blogging, but there are many ways to earn extra income. But here’s the key–extra income that you use to save, invest, or pay down debt goes a long way. But can it make you a millionaire? Yes.
I know bloggers who have made seven figures. I’ll repeat that. I know bloggers who have made seven figures. No, the humble Dough Roller is not one of them (but I’m working on it!). However you approach earning extra income, the beautiful thing is that it is above and beyond what you need for your monthly expenses. In other words, it all goes to increase your wealth.
And this leads to one very important realization about building wealth. Many reading this article will tell themselves that there is no way, using any one of the above methods, that they can become a millionaire. Fine, then use them all! Personal finance is not an all or nothing proposition. Most of us will build wealth in a 401(k) or other retirement account, while at the same time owning a home, saving outside of a retirement account, and perhaps by earning some extra money on the side. And hopefully we’ve started early.
By combining all of the above methods, and perhaps even more, we increase the likelihood that our net worth will meet and exceed the million dollar mark.