Whether we put it on a credit card or deplete our checking or savings accounts to purchase something, we are financing the things we buy. We are trained to hand over most of the money that passes through our hands. We spend it and give away our ability to earn interest with it. How does that work and is there a better way? I think there is.
Cost of Capital
One concept I like to work on with clients is the cost of capital. Economic Value Added (EVA) is a financial performance measure that examines your cost of capital. Hang with me here – this is basically just a way of looking at the rate of return on how you use your money. You can either earn interest on it or spend it.
Let’s look at a monthly budget. What do we keep and what passes through our hands? Now, not everything that passes through our hands goes to waste. For instance, you might be familiar with the biblical principle of tithing. The idea of tithing is to give away 10% of your earnings for the work of a local church or other charities. This desire and practice of giving, of course, happens regardless of your faith tradition. But the ideal of 10% usually does not match what actually happens. The national average for giving right now is about 2.8% of income.
Then there is personal savings, another ideal. Currently, the national average is a 2.4% savings rate, the ratio of personal saving to disposable personal income. This is down from 10.8% in 1960.
Pay as you go is one option to consider, but I like to think beyond that. Let’s look at a pay-as-you-go scenario that we can all relate to, and then let’s look at ways to think beyond pay-as-you-go.
Most people these days purchase a car using a loan instrument, with 48-72 months to make the payments. Using pay-as-you-go, in other words, saving up until you have the cash to purchase a car outright, is the method that Phillip’s “uncle”, Dave Ramsey, advocates. You save a ton on interest when you save up and pay-as-you-go. But no matter what, that money is – poof – gone and you need to start over filling up a pay-as-you-go envelope for the next car purchase.
A Better Way
What if there was an even better way? What if you were not stuck in the cycle of either owing interest on a lot of debt, or losing the ability to accumulate interest? Here are three strategies that we look to in order to increase your EVA – which means you have an economic engine working for you and your financial goals.
- Increase Your Savings Rate – This is the most obvious one. Where do you stack up compared with the national average in the 2 – 3% range? After you pay down debt, increasing savings rate should be the next item on your financial to-do list.
- Compound Interest – if you are familiar at all with us at UWP, you know we love our compound interest. This is where your money really starts working for you.
- Your money doing more than one thing – Sitting in a traditional bank, your money won’t be doing much for you. Money is more agile than you give it credit for. It can earn compound interest in tools like cash value life insurance, tax-deferred dividends, or compounding death benefits. With all those tools, your money will earn interest even when you borrow against it.
Your money can have that agility in real estate too. With rental income, somebody else is paying that mortgage, or if you own the property free and clear, that’s just more cash flow for your economic engine. There is also the potential for capital appreciation in a primary residence or income property.
Your money can also work for you on multiple levels through a business you own. There’s the income, of course, and capital appreciation if the business grows. You also have tax advantages through deductions you can take on business expenses. With the right lending instruments, you are leveraging other people’s money to create more wealth through your business.
You finance everything you buy, but with the right strategies, you can make your Economic Value Added (EVA) equation something to be proud of. You can rev up your economic engine, increase your savings rate, and get your money doing more for you. And as always, we’re here to help any way we can.