Four Personal Finance Fundamentals that You Should Know
“Do one thing every day that scares you.” ― Eleanor Roosevelt
Finance is scary. It is a discipline and industry that seems to scare off everyday people with overcomplicated jargon. Yet, personal finance and personal growth go hand-in-hand. I mean, how can we invest time (as well as money) in ourselves, if our fundamental financial needs are not met?
But if we should do one thing daily that scares us for the sake of personal growth, then let these four personal finance terms be that for you today. As with many things that scare us, after facing it, we realize the fear was not based in reality, but simply chatter in the skull that distorted our mindset.
Personal finance should not be seen as a set of strict rules defined by complicated terminology, but instead a lifestyle. What follows are not instructions on what to do, but digestible insights into why you should do it.
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The root of all good…and evil—good for our investments, bad for our debt. How we earn interest on our investments and pay interest on our debt is the make it or break it factor in our personal finances.
If earning compounding interest on your investments seems foreign, then think about it in terms of credit card debt. Credit card debt is also compounding, that’s why it feels so out of control. That $5,000 of debt that you’re making the minimum monthly payments on will amount to over $2,300 in interest and take 6 soul-sucking years to pay in full. So that $5,000 of stuff, cost you over $7,300. That’s assuming a 15.91% annual percentage rate (APR), which is the national average—yours could be higher.
During the same 6-year time span, if that $5,000 was invested and earning 10% interest compounding annually, it would generate over $3,850 in interest resulting in a total of over $8,850 earned. And each year, it gets better: you’ll earn interest on interest on interest. Think about a snowball rolling down a hill becoming larger and larger until it becomes an avalanche—that’s compounding.
This snowball effect, makes compounding interest even more powerful for young investors—Why? Because young investors have the advantage of time. If you can invest $5,000 a year from your 20th birthday up until your 30th birthday, and don’t add a single cent after, you’ll have more than $600,000 by the time you hit the big 6-0. If you wait to start investing until your 30, but then set aside the same $5,000 a year for the next 30 years, you will have about $540,000 by the time you’re 60. This is assuming 7% annual compounding returns.
The point: avoid paying compound interest on debt at all costs (no pun intended), and start investing as soon as possible.
That’s kind of an oxymoron, and, yes, I still stand tall on the soapbox when it comes to paying compound interest on debt. Compounding interest aside, to distinguish between good debt and bad debt, you should consider the return generated from the investment you make with the borrowed money and whether this return allows you to pay off your loan quickly to avoid the crazy compounding interest.
If you are purchasing an appreciating asset like your home, then each month’s mortgage payment brings you closer to outright ownership of an asset whose value will continue to appreciate indefinitely, according to historical trends. To address the whole compounding conundrum, if you make payments on your mortgage every other week or one additional payment a year, then you are dwindling that balance on which you are paying interest; therefore, reducing the amount of interest paid over the lifespan of the loan.
Student loans or any other form of investing in yourself to increase your earning potential can also be considered good debt. This is, only if you would be able to land a job after graduating that pays enough to make significant contributions to your student loans, so to pay this debt rapidly—again, because of compounding interest. Of course, taking into account that some added value in self investment goes beyond a monetary equivalent.
The point: Look at debt, like you would any other investment—what’s your ROI?
Saving money is hard, but needing money when you don’t have any saved is harder. This is where PYF becomes the North Star in our financial wellness journey! PYF or pay yourself first is referring to the practice of putting money aside for savings (or to pay off debt) first and foremost when you receive your monthly or bi-monthly paycheck. The PYF gold standard?—20% of your monthly income. But, something is better than nothing.
If you have debt, first things first, pay it off. Once your debt is conquered or at least under control, you should save until you have an emergency fund. That means three months income liquid—which means cash ready for those unpredictable financial burdens.
Once your debt is under control or non-existent and your emergency fund ready, PYF means start investing. Take the money that you were contributing to your savings monthly and invest it in a secured diversified portfolio, whether that be real estate crowdfunding, REITs, an index or a mutual fund. Saving beyond your three-month emergency fund, or any other short-term goals, is just hoarding money that is growing at a rate slower than inflation.
The point: Always PYF whether it be for debt, savings or investing. Oh, and pro tip: automate this payment, so you can set it and forget it.
Your FICO score is a three-digit number, from 300-850, that is based on 1.) how promptly you pay bills and 2.) how much of your available credit you use, also known as credit utilization rate. Maybe you already knew what a FICO score is, but do you know how to play the game? Maintaining an excellent credit score is, in fact, a game that involves some know-how beyond paying your bills on time.
First, you should almost never cancel a credit card. Unless this credit card has insanely high annual fees, your best bet is taking some scissors to it, instead of cancelling it. If you do cancel a credit card, your FICO score will likely plummet. Why? Well because your available credit just went down significantly, which raises your credit-utilization rate significantly. According to Experian, 30% of your FICO score is determined by this metric alone because it is an indication of excellent budgeting and not overspending.
You can calculate your credit utilization rate by adding up your balances on your credit cards and dividing this sum by your total credit limit; multiply this by 100 and the percentage is your utilization rate. Your ideal credit card utilization rate is 30%. So, if you have $10,000 available of credit, you should only carry a $3,000 balance and the lower the better. Even if you pay your balance off in full each month, going beyond the 30% benchmark could be affecting your credit.
The beauty of having an excellent FICO score is that you have access to better credit card offers, many of which offer 0% interest, sometimes for as long as 15 months, as well as 0% on balance transfer. This gives you the ability to consolidate debt, avoid the evil of paying compounding interest, and make a plan to pay off that debt within the 0% APR timeframe. So, you can start saving!
The point: How much credit you use is just as important as paying your bills on time.
Financial jargon can seem scary. But do you know what’s even scarier? Not having the tools and knowledge necessary to help yourself attain financial security. By conquering this scary thing today, you are laying the necessary foundation to generate wealth and personal prosperity so that your future “scary” challenges can be more self-enriching.