Editor’s note: This article was first published in January 2019 as a 2019 remaster of one of the author’s earliest articles. The rates it uses for savings accounts, an investment fund, a fixed-term deposit and five-year government bonds reflect older conditions, and returns on some products are no longer what they were.
To reach the financial freedom so many people long for, you undoubtedly need a financial education, and that is something schools, high schools and universities simply don’t teach. The rich keep getting richer and the poor never manage to escape poverty.
*This is one of the first articles I wrote about financial education. Although the returns on some investment products are no longer what they were, I think the idea still holds when it comes to explaining two paths to financial freedom. I’ve taken the liberty of remastering the article for those who missed it at the time.
What stops us from reaching financial freedom?
To find the answers, I’ll draw on the fundamentals of financial education. I’ll do it with two examples of two lives and two different paths, both of real people. One path leads to debt and the other leads to wealth.
The road to debt
Eduardo’s story.
Eduardo finished his university degree at 24 and got a job paying €1,500. At that age, a good-looking young man with a stable job decides to buy a nice car, albeit a mid-range one. He lives with his parents, so he can easily afford a car payment of €250.
He goes out at weekends and has fun like any young person. Money doesn’t worry him, because he has it. His income is far higher than his expenses, so he lives a carefree life.
One night Eduardo meets a girl, Estefanía, and they start a relationship. They date for a year, during which both of them work and can afford nights out, dinners at restaurants and month-long holidays in the summer, and they are each still starting to save, separately, to buy a home.
Two years go by and, since the relationship is going well, they decide to get married. They start looking for a house or a flat to live in. She earns €1,300, which added to Eduardo’s €1,500 gives them a household income above the average for couples: €2,800.
They decide to buy a house that is very well located and on offer. They’ve found a real bargain: right in the city centre, it costs only €200,000.
They don’t think twice about signing, since their mortgage payment will be only €850. Now it’s time to furnish the house. In the past, banks would lend you more than the value of the house so you could furnish it with the mortgage money, but not anymore. They’ve been lent exactly the amount the house was valued at.
Still, that’s no problem. They buy the furniture through an interest-free instalment offer. They can pay off the €12,000 over 12 months: €1,000 a month. It doesn’t worry them too much, because their salaries can easily cover it, and after a year they’ll have that €1,000 to save.
So their adventure begins. They pay for the wedding themselves, with part of it covered by their families.
Between the reception, the outfits and the ceremony, the costs are enough to cut the savings they both had by 50%.
Once they’re married and settled in their new home, their income and expenses look like this:
Income:
- Estefanía €1,300
- Eduardo €1,500
- TOTAL €2,800
Expenses:
- Eduardo’s car €250
- Estefanía’s car €215
- Mortgage €850
- Furniture €1,000
- TOTAL €2,315
Of course, Eduardo and Estefanía hadn’t counted on the fact that they no longer live with their parents, and that new expenses crop up, such as:
- Electricity €80
- Water €15
- Food €200
- Insurance €35/month (cars and home; a deliberately low estimate)
- Property tax
- Clothes
- Medicines
- And so on
For the first time, Eduardo and Estefanía are struggling financially, even though they both have stable salaries. But they both think that once the furniture is paid off things will go back to normal, so this is a temporary situation that they’ll keep getting through with…
Credit cards
Let me describe what a credit card is. I know you think you already know, but you’ve probably never stopped to think about what it really is. A credit card is a way of spending money you don’t have. Since you’ll pay it back in small amounts month by month, you won’t mind maxing it out: whether you spend €800 or €2,500, your monthly payment will be the same. You’ll even tell yourself that credit card interest isn’t all that high.
The problem is that the interest is charged on the card’s entire outstanding debt month after month, which makes it more dangerous than a personal loan. That’s why, the moment you activate a credit card, you’ll never finish paying it off: you’ve entered the credit game.
That’s the problem Estefanía and Eduardo face. When they finish paying for the furniture, they’ll have another debt on their credit card.
Eduardo and Estefanía now depend entirely on their jobs to keep up their standard of living, which is a life full of debt, like that of 90% of the population. If either of them lost their job at some point, it would be financially traumatic, not to mention that two people with stable jobs will think twice before having a child, because they won’t be able to afford to support one.
They’ve entered the cycle Robert Kiyosaki called the rat race, and without a financial plan they’ll never get out of debt. This example uses estimated costs, erring low on expenses and high on the deals.
To see how they could have taken a different path, look at the next example, based on another true story.
How to start down the road to financial freedom
This is Pedro’s story.
Pedro was even poorer than Eduardo, the young man in the previous story, so much so that he had to combine his studies with a job to help his family financially. Pedro and Eduardo were even classmates at university.
While Eduardo went out partying on Friday and Saturday nights, Pedro worked behind the bar of a pub every weekend.
He had no time to go out because he was working. Pedro was exhausted and tired of studying and working, so in his free time, of which he had little, he spent a while studying finance and trying to understand money, looking for a way to get rich so he wouldn’t have to work so hard.
None of this stopped Pedro, after handing over part of his wages at home, from putting €100 into a savings account every single month. When he finished his degree, in the same year as Eduardo and also at 24, Pedro had €5,765 in his savings account.
He had saved €5,500, which had earned him €265 in interest. That’s not much, but it was enough to learn that money makes more money. Pedro joined the same company as Eduardo, on the same salary: €1,500.
He needed a car, but he didn’t want to take on payments the way Eduardo had. He bought a second-hand car for €3,100 and paid for it in cash from his savings. Pedro’s €1,500 had no outgoings except the €300 he kept giving at home.
Pedro started his financial planning: every month he put €800 into an investment savings fund with compound interest, and he kept putting €100 into his savings account. After two years, Pedro’s financial position was as follows:
- Investment fund €17,600
- Interest €1,408
-
TOTAL €19,008
-
Savings account €5,065
- Interest €123
- TOTAL €5,188
TOTAL IN ALL ACCOUNTS €24,196
And he still had his €1,500 salary.
Then the same thing happens to Pedro as to Eduardo: he meets a girl and they start a steady relationship. It’s not that he doesn’t take her out to dinner or go out partying with her, but he does it knowing he can spend €300 a month, because the rest of his salary goes into his savings accounts and his investment fund, and he’s still contributing at home.
See also: 3 formulas that will help you achieve financial freedom
Pedro follows a financial plan without straying from it, and he’s ready to continue his financial education
Pedro withdrew €10,000 to invest in five-year government bonds and another €10,000 to invest in the stock market over the medium term. In six months he turned that €10,000 into €19,200 thanks to a well-timed trade during a rising market.
He looked for ways to take part in businesses as a small shareholder, with a new investment of €7,000 in small, diversified lots of shares and in stakes in some companies that Pedro thought were good investments. He put €8,000 into those companies.
See also: The difference between starting to save at 25 and at 35
He put another €10,000 into a 12-month fixed-term bank deposit paying 2.5% interest.
At 27, Pedro’s capital stood at €75,349, not counting the €10,000 he had invested in government bonds, which gave him some annual return.
Pedro kept his job, but he was now aware that he earned more money from his money than from his effort at work. He kept investing, working his money through the stock market, bank deposits and investment funds, on top of the money he still kept in his savings accounts, which also earned him interest.
Then it was time to get married. Pedro had a civil ceremony at the courthouse with only his closest family, rather than a big wedding. They found a flat to rent for €450, which Pedro called “My Love Nest”.
The rent doesn’t hurt his finances at all, because he shares the expenses with his partner. He advised his father on his finances; his father no longer needs money from his son, because thanks to Pedro he now has investment income of more than €430 a month on top of his pension.
Today Pedro is 33 and has capital of €347,500. He owns three small businesses, is a shareholder in four large companies and is an investing partner in five business projects. He bought an old house and renovated it to rent to students. He still lives in rented accommodation and has two children, aged three and a year and a half, so his love nest bore fruit.
He left his job to devote himself fully to his businesses and investments. One of his businesses earns him €1,300 while he sleeps, and his average net profit is €12,550 a month.
Pedro estimates that next year his capital will reach €580,000. When asked whether he plans to buy a house to live in, Pedro replies:
You have no idea how reassuring it is to live in a rented home knowing you could buy a house outright.
This is an example of someone who isn’t rich but has achieved financial freedom many times over. You could say you’ve reached financial freedom when your passive income (income you don’t have to work for) is greater than your expenses.
For anyone who thinks this example is absurd, let me say again what I said at the start: these are two real cases. In fact, Pedro (not his real name) has been a friend of mine for more than 15 years, since childhood, and he’s part of the reason I decided to start this blog and point out how important a good financial education is right from the start.
According to Pedro, two of the books that changed his life were Rich Dad, Poor Dad and Cashflow Quadrant, both by Robert Kiyosaki. I certainly recommend reading both. They won’t give you any miracle keys to financial freedom, but they will open your mind to achieving it.
See also: Which financial education books should you read?
Featured image: Brian Ironside, CC BY-SA 2.0, via Wikimedia Commons.
