What is the best use of "spare" money?

Question

Here are some cliff notes about me:

• 30 years old immigrant (came to the US late 2009), so no established credit (got a $900 credit card with my bank finally last year)
• No spouse, no children. Just me, myself and I.
• I opened a 401k in January 2014 (yeah, I kinda wasted 4 years. I was scared since it's not FDIC insured and I came in the middle of the big crash)
• 12% of my salary goes into that 401k, split 6% into Roth and Employee 401k
  • I'm not sure what the balance should be. On one hand, I believe that taxes will always be higher later on (so Roth is what I want since I pay the taxes on it now?), on the other hand, I do not know if there is a drought coming (so the deferred taxes of the Employee 401k might come in handy later)
• Of the remaining salary (the money that actually hits my pay check), about 42% go out for my rent - yeah, I live in a really expensive area :(
• The other running costs (Utilities, Groceries etc.) make up another ~10-15%
• I have no debt whatsoever, not even an ongoing car payment (in fact, I don't even own or need a car)
• Since my tax situation is very simple, Income tax isn't a huge factor as well, my yearly tax return is more or less a zero sum game

So I have about 40% of my monthly salary that is simply there, usually I waste it on nonsense and now I actually want to do something better with it - but I'm not sure what.

Basically, what is the best use of "spare" money to build up a bigger pool of money that I can use later, be it through actual savings or through a credit score that allows me to make big purchases, for example a home but without putting in to much risk (so no "get rich quick" schemes or stock picking)

• Max out my 401k - from what I understand, I can put 17500$ aside each year, and that money includes my employers part
• Open a savings account with a bank that doesn't have completely abysmal savings rates (e.g., Ally)
• Get a second credit card from an issuer that's not my bank (I have a Visa card - does it make sense to get a Master Card or Amex?)
• Something obvious that I'm missing? (Lowering rent costs isn't really an option sadly)

Answer 1

• For the really long term (retirement), maxing out your 401k is a good idea, but that money would not be available to you at favorable conditions before you actually retire, so doesn't fit your requirements.
• Generally, the best balance between risk and return in the medium to long term is low-cost index funds (mutual or ETF) bought continuously to get a cost averaging effect. The downside is that if you want to spend the money at the wrong time (i.e. in the middle of a recession), you'll take losses. You won't lose everything but a 30% loss is certainly possible. But on the long run, you'll have good returns.
• If you are really risk averse, a savings account is probably the best option - but savings rates will be abysmal and any bank that offers substantially above-market rates should be investigated with great skepticism (see Kaupthing).
• Don't forget to insure yourself against crippling risks (liability and disability mainly, and of course general health insurance).
• Finally, don't hesitate to keep "wasting on nonsense" (i.e. stuff you enjoy) a smaller portion of your money. Consider it insurance against burnout.

Answer 2

Congratulations! You're making enough money to invest. There are two easy places to start:

1. Roth IRA. This is an Individual Retirement Account you add your (post-tax) money to; when you retire, all of the interest it's accumulated is tax-free. Until you retire, you can withdraw the money you've added, but taking away any of the interest it's earned will hit you with a penalty. So it will store the money you've put into it, and be a nice bonus when you retire. Note that an IRA isn't a specific stock, bond, mutual fund, ETF, or other asset: it's more of a bucket to organize your investing. You'll still need to pick what assets to buy with our IRA money. You can only add $5500 per year to an IRA; once you hit that limit, it's time to move on to...
2. Index fund(s). This is simpler than a Roth IRA: there are no exceptions around taxes and taking money out, but there also aren't any tax advantages. Find a stock index you want to follow (such as the Dow Jones Industrial Average, Nasdaq, S&P 500, etc.), and buy the relevant fund. I recommend Vanguard index funds because they have fewer administrative fees than other funds.
   1. If you're risk-averse, go for a bond index fund instead of a stock index fund. Bonds are lower-risk, but they also have lower rewards.

I recommend against savings accounts because they will quite safely lose your money: the inflation rate is usually higher than the interest rate on a savings account. You may have twice as much money after 50 years, but if everything costs four times as much, then you've lost buying power.

If, in the course of learning about investing, you'd like to try buying individual stocks, do it only with money you wouldn't mind losing. Index funds will go down slightly if one of the companies in that index fails entirely, but the stock of a failed company is worthless.

Answer 3

With 40% of your take-home available, you have a golden opportunity here. Actually two, and the second builds out easily from the first.

Golden Opportunity # 1: Layoff Immunity
Ok, not really immunity. Most people don't think of themselves getting laid off, and don't prepare. Of course it may not happen to you, but it can. It's happened to me twice. The layoff itself is an emotional burden (getting rejected is hard), but then you're suddenly faced with a gut-wrenching, "how am I gonna pay the rent????" If you have no savings, it's terrifying.

Put yourself in that spot. Imagine that tomorrow, you're out of a job. For how many months could you pay your expenses with the money you have? Three months? One? Not even that?

How about shooting for 12 months? It's really, really comforting to be able to say: "I don't have to worry about it for a year". 12 months saved up gives you emotional and financial stability, and it gives you options -- you don't have to take the first job that comes along.

Now, saving 12 months of expenses is huge. But, you're in the wonderful spot where you can save 40% of your income. It would only take 2.5 years to save up a year's worth of income! But, actually, it's better than that. Because your 12-month Layoff Immunity fund doesn't have to include the amount for retirement, or taxes, or that 40% we're talking about. Your expenses are less than 60% of take-home -- you'd only need 12 months of that. So, you could have a fully funded 12-Month Layoff Immunity Fund only in a year and a half!

Golden Opportunity #2: Freedom Fund
Do you like your Job? Would you still do it, if you didn't need the money? If so, great. But if not, why not get yourself into a position where you don't need it? That is, build up enough money from saving and investing to where you can pay your expenses - forever - from your investments. The number to keep in mind is 25. Figure out your annual expenses, and multiply it by 25. That's the amount you'd need to never need a job again. (That works out to a 4% withdrawal rate, adjusting for inflation every year, with a low risk of running out of money. It's a rule of thumb, but smart people doing a lot of math worked it out.)

Here you keep saving and investing that 40% in solid mutual funds in a regular, taxable account. Between your savings and the compounding returns off the investments, you could easily have a fully funded "Freedom Fund" by the time you're 50. In fact, by 45 isn't unreasonable.

It could be even better. If you live in that high-rent area because of the job, and wouldn't mind living were the rents are lower once you quit, your target amount would be lower. Between that, working dedicatedly toward this goal, and maybe a little luck, you might even be able to do this by age 40.

Final Thoughts
There are other things you could put that money toward, like a house, of course. The key take-away here, is to save it, and invest it.

You're in a unique position of being able to do that with 40% of your income. That's fabulous! But don't think it's the norm. Most people can't save that much, and, once you lose the ability to save that much, it's very difficult to get it back. Expenses creep in, lifestyle "wants" become "needs", and so on. If you get into the habit of spending it, it's very difficult to shrink your lifestyle back down - down to what right now you're perfectly comfortable with.

So, spend some time figuring out what you want out of life -- and in the mean time, sock that 40% away.

Answer 4

You may also want to consider short term, low risk investments. Rolling Certificate of Deposits can be good for this. They don't grow like an Index Fund but there's 0 risk and they will grow faster than your bank.

For my bank as an example today's rates on my Money Market is 0.10% APY while the lowest CD (90 days) is 0.20% APY with a 5 year going up to 0.90% APY. It's not substantial by any stretch but its secure and the money would just be sitting in my bank otherwise.

For more information look at: What is CD laddering and what are its pros and cons?

Answer 5

There's a hellova lot to be said for investing in real estate (simple residential real estate), even though it's grandma's advice. The two critical elements are

1) it's the only realistic way for a civilian to get leverage. this is why it almost always blows away "tinkering in the stock markets" in the 10-year frame.

2) but perhaps more importantly - it's a really "enforced" saving plan. you just have to pay it off every month.

There are other huge advantages like, it's the best possible equity for a civilian, so you can get loans in the future to start your dotcom, etc.

Try to buy yourself a very modest little flat (perhaps to rent out?) or even something like a garage or storeroom. Real estate can crash, but it's very unlikely; it only happens in end of the world situations where it won't matter anyway. When real estate drops say 30% everyone yells about that being a "crash" - I've never, ever owned a stock that hasn't had 30% down times.

Food for thought!

Answer 6

Investing in mutual funds, ETF, etc. won't build a large pool of money. Be an active investor if your nature aligns. For e.g. Invest in buying out a commercial space (on bank finance) like a office space and then rent it out. That would give you better return than a savings account. In few years time, you may be able to pay back your financing and then the total return is your net return. Look for options like this for a multiple growth in your worth.