FOOL'S EYE VIEW
How To Become An Automatic Millionaire

By Cliff D'Arcy
December 2, 2004

I've recently finished reading The Automatic Millionaire by American author David Bach, which was recommended to me by a Foolish reader. (By the way, this book costs $19.95, but you should find it for less than £8 by shopping around online. Its ISBN is 0767914104).

The Automatic Millionaire is written for an American audience, hence its colourful title! However, even though my knowledge of personal finance in the US is fairly limited, I found this book very easy to absorb. In fact, its common-sense approach and effortless writing style makes it a very Foolish read – so I hereby nominate David Bach as an honorary Fool!

You can get rich in several ways: by winning a lottery, marrying into money, inheriting wealth, suing, or careful scrimping and saving over a lifetime. However, this book isn't a guide to getting rich quick. In fact, it's quite the opposite. Bach's sure and steady approach almost guarantees that you will get rich slowly and retire comfortably. This is a plan for tortoises, not hares!

The 'Automatic Millionaire' couple

The Automatic Millionaire starts with the tale of an apparently ordinary American couple who have a modest joint income, which has never been higher than $55,000 a year (under £28,700). However, they own two homes outright, have put their two children through college, and have decided to retire early with almost $2 million (£1,042,000) in savings and other assets!

Bach - a young financial planner at that time - couldn't understand how they got so rich. Essentially, this couple's no-nonsense, no-budget, no-discipline system is the foundation of the book. And their core message is "Pay yourself first". Forget about budgets and living expenses, set up a monthly payment into a long-term savings scheme – and stick to it.

Save for the long term: pay yourself first

Bach recommends that, on average, would-be Automatic Millionaires put aside a tenth (10%) of their gross (pre-tax) earnings, using payroll deductions or automated monthly payments to whisk this money away before it can be spent! If you think that you can only start with 1%, start instead with, say, 3%, because it's better than nothing and you honestly won't miss it. However, over time, as your confidence grows, keep hiking your percentage – some people are comfortable with saving up to a quarter (25%) of their pre-tax income!

Bach argues that financial plans that aren't automatic will fail, because they require too much effort, self-discipline and monitoring. That's why you must pay yourself a percentage of your income, instead of a fixed monthly amount. This way, your monthly savings amount grows in line with your income – and you don't need to get involved unless you decide to up your percentage!

Think about it: if you're an employee, the government doesn't let you have your take your pay without deductions and then hit you with a tax bill at the end of the year. The taxman collects his share as you go, under the PAYE (Pay As You Earn) scheme. So, the government takes its cut automatically each month – and so should you!

So, instead of saving what's left over after paying your bills, the smart approach is to do your investing and saving first, then spend what's left. You'd be surprised how quickly you learn to live without this money, which starts growing, earning you money and building your future.

We Fools are huge fans of compound interest, as is Bach. Over time, your savings grow, thanks to interest on your capital, plus interest on your interest. Over long periods, your money grows hugely. For example, £1,000 growing at 10% a year for forty years turns into a juicy £45,259.

Put money in a tax-efficient investment

Bach's first suggestion is to put the money into your pension. That's because contributions into your pension attract tax relief. In the UK, this means that every 78p turns into £1 on day one (for higher-rate taxpayers, 60p becomes £1). This extra boost to your savings from the government means pensions get a big head start on other investments.

If you have a company scheme into which your employer contributes, or offer to match some or all of your contributions, become a member and start paying in extra money. If you don't, set up a low-cost personal pension, such as a Stakeholder plan, and pay in, say, a tenth of your gross salary (before tax). In time, you may hit the contribution ceiling for pensions and decide to save more another tax-efficient vehicle, such as a shares ISA.

Spread your risk

Bach suggests that investors spread their risk through diversification (allocating their savings to a mixture of stocks, bonds and cash), in order to avoid a crash in any particular asset class. As you approach retirement, many funds switch to "lifestyle" options, putting more and more of your money into safer investments, so that a crash just before you retire won't leave you high and dry. Bach recommends that you go for this safety-first tactic.

Tackle your Latte Factor

It's not how much you earn, it's how much you spend that's the problem! If you need to track your spending for a while to see where you're splurging money, do so – but this isn't vital. Another trick that Bach introduces is the Latte Factor, or "Don't be dumb with your money" approach. This involves cutting out some wasteful habits that you don't need – that morning coffee, muffin or pack of cigarettes – and using this £5 a day or so to help you to build a better future.

Sleep well at night

Another suggestion that Bach offers is the "Sleep well at night" factor. In other words, make automatic payments into a high-interest savings account, in order to build up an emergency fund. Many people find that transferring this money by standing order on payday is a good approach. Depending on how much you worry, build a fund of between three and 24 months' living expenses. And, of course, as this is an emergency fund, you don't dip into it to buy a new gadget or pair of shoes. Keep your hands off it, because it's for emergencies, silly!

Stay clear of debt, but buy a home

Bach also warns readers to stay out of debt. If you have credit cards, pay them off in full. If you can't, put as much spare cash as you can afford towards paying off these balances ASAP. And, other than getting a mortgage to buy your home, aim to pay cash for all your major purchases.

The Automatic Millionaire also urges readers to buy a home in order to build wealth through long-term increases in property values. However, Bach urges homeowners to overpay their mortgages, in order to reduce their interest bill and shorten the life of their mortgage.

In the US, many people do this by making 26 fortnightly payments of half their mortgage repayment, instead of twelve monthly payments. This extra payment each year (26 x ½ equals thirteen monthly payments) turns a thirty-year mortgage into a 23-year home loan. Here's another way that I devised that does something similar.

Give to charity

Finally, Bach asks readers to give to charity, again through automatic payments. In the UK, Gift Aid and Payroll Giving allow you to do this in an automatic, tax-efficient way, turning every £1 into a donation of £1.28.

How much time do you work for yourself?

If you work forty hours a week for 240 days a year for 45 years, your working life totals 86,400 hours, or roughly 2,000 hours a year. In contrast, most of us spend very little time on financial planning or paying ourselves.

If you can pay yourself the equivalent of just one hour a day – an eighth (12.5%) of your income – you will become seriously well off. All it takes it patience and a few automated payments. What could be simpler than that?

More: David Bach's website | Find a better credit card, ISA, pension and savings account.