Here's a quick math question from Fortune Magazine: If you take out a $1,000 loan that has a 20% interest rate, how much will you owe each year in interest? The answer: $200. Did you get that right? Nearly two thirds of Americans wouldn't have.
According to a study by the FINRA Investment Education Foundation, about a third of Americans say they don't know how to calculate an interest rate at all. The same study found that 18% of respondents actually spent more than their entire income in the previous year and that 21% of them had overdue medical bills.
FINRA points out that the lion's share of financial capability is the ability to make ends meet through savings. The one in five people who are not balancing their monthly incomes and expenses are struggling to survive—and overdue medical debt only makes things worse on a monthly basis.
While the study reports that many Americans recovered from the financial crisis of 2008, that they've increased their emergency fund savings, and that more than half of credit card users pay off their balance every month, the fact remains that major chunks of the population are still worse off than before the recession.
These hardest-hit segments include African Americans, women, Hispanics, Millennials, and people without a high school diploma. Financial illiteracy is obviously a major problem—and it's time to level the playing field. Let's clear this $#it up.
When it comes to finance questions, people usually get confused about:
- What counts as an "asset"
- Whether or not registered retirement savings are actually tax free
- What's more important—saving or investing?
- Whether renting (vs. buying) is a terrible waste of money; and,
- How to use credit cards properly (and not get into a mountain of debt)
Without further ado, here are some essential finance facts for your easy reading and educating pleasure:
1. What counts as an "asset"?
Finance people talk about "assets" all the time, but this can be a confusing term. Simply put, an asset is anything you own that has value. This can be your fridge, your DVDs, etc.
But the main thing to note is that your assets only have value if you sell them for cash.
Investors focus on owning assets that will make them more money in the future because they will increase in value. This is a great way to view the situation because it puts you in a growth mindset.
So, let's rate a few commonly-owned items to see if they're investment-worthy assets:
If someone refers to their car as an asset, then they are usually dead wrong. Once you buy a new car and start using it, it immediately begins losing value. This means your "asset" is worth less and less every day.
On the other hand, if you buy a used car to drive to a job that makes you a lot of money, then this car has a greater value to your financial well-being. Saving or investing that extra money you're making is super savvy, too. The important point here is to avoid spending too much on something that looks pretty but will not make you money.
And what about your house? Well, if you bought the house for very little money and plan to renovate it and increase its value, then perhaps it can be an asset. If you buy an extra property and rent it out so it pays off its own mortgage and then continues to pay you rent each month (free money!), then that house is definitely an asset. However, on their own houses do not actually increase in value. You can read more about this below in renting vs. buying.
A savings account is in fact an asset because you earn interest on it—and the more you can earn, the better. So, shop around and find the savings account with the highest interest rate!
2. Are registered retirement savings tax free?
Are registered retirement savings accounts, such as a 401(k) in the United States, or an RRSP in Canada, actually tax free?
The short answer is no.
Then, should you even bother to have a registered retirement savings account?
Simply put: Hell, yes!
The money you put into a registered retirement savings account is not taxed during your working years. When you start making contributions, your money is not taxed.
The taxing happens when you retire and withdraw money from the account. So, in effect, it is more like a delayed tax saving account.
While this is not as sexy as "tax free," it is a still great idea.
It's especially awesome if your employer matches your contributions to your account.
Also, a mountain of research shows that the earlier you start saving, the more you can save and the less you have to put aside each month later in life.
While investing is essential to ensuring a happy retirement down the road, no matter what stock or investment property you buy into, you can't discount the value of a retirement nest egg.
3. What's more important—saving or investing?
The answer is that saving and investing are both great ways to help you reach different goals.
Saving is perfect for short term goals like planning a vacation or having funds set aside in case of an emergency. Having an emergency fund is essential because it prepares you to deal with unpleasant surprises (like your car's broken anything).
Putting money aside in a savings account gives you immediate access to money when you need it. Plus, government-backed savings accounts keep your money safe so there's no risk of losing it. Still, interest earned on savings accounts is tiny. In most cases, less than the rate of inflation.
Investing can help you achieve major goals at least four or five years away, such as saving for your kid's college degree or buying a home. Investing your money can make it grow faster in less time than if you put it in a savings account.
Keep in mind that it's harder to access your invested funds than if you have cash sitting in your bank. It might take a week to sell stocks and have the money show up in your account. Investing also comes with more risk because you might lose some or all of it if the stock market suffers.
Mutual funds typically aren't as risky as other types of investments: a professional invests your money across different stocks, bonds, and other products, so there's less risk if the value of one stock drops. This is a perfect solution if you're nervous about the stock market or you don't want to worry about which stocks to invest in.
Of course, you can always buy stocks (shares) in a company you think will succeed in the future. An ideal stock also pays investors regularly (these are called dividends) based on their profits.
4. Is renting (vs. buying) a terrible waste of money?
Real estate brokers will tell you that it’s better to pay yourself (that is, your mortgage) instead of funneling your money into a landlord’s pocket. This may be true to an extent, but only if you buy property wisely.
The main issue today is that people look at purchasing a home as an asset that will grow in value. However, historically, the value of residential real estate has increased pretty much in step with inflation. This means your house will be worth the same in 20 years as when you bought it!
When you add the realities of local transfer taxes (when you buy or sell the house), bursting housing bubbles that lose value on your home, and yearly maintenance costs, buying your own place starts to seem like a pretty big gamble.
A renter doesn’t have to worry about any of these things and is probably paying less money per month to boot.
Still, you can buy a home wisely—if you don't overspend by choosing a home outside your budget. If you find a house where you can just make the minimum payments for the next 30 years, then that house or condo is out of your price range.
One of the issues leading to the 2007-2008 mortgage and credit crisis in the U.S. was that people overextended themselves and took up very large loans at very low interest rates. They could just comfortably make the monthly payments on their white picket fenced yards. Then, when the interest rates returned to normal, they couldn't afford the monthly payments and ended up losing their homes.
Unfortunately, this is not an isolated incident. Real estate bubbles and artificially low interest rates are back and ready to ensnare new victims across North America. As with all other forms of spending, when it comes to housing, you should take a realistic look at your budget and stick within it.
5. How do I use credit cards properly?
Credit is essential to life in the modern world. Most people don't realize that their credit score is the single most important factor to getting a mortgage, car loan, or a new credit card.
Becoming eligible for these purchases takes only one year of credit history showing that you made your monthly payments on time. But just as easily, having bad credit or no credit at all can shut the door on your home ownership dreams. What's even crazier is that when your credit score is higher, you are offered lower interest rates so you actually have to pay less money for your purchase compared to someone with a lower credit score!
In short, having a good credit rating is super important—so cutting up all your credit cards is not an option. Instead, you've got to know how to use credit to your advantage.
To make sure you don't get hit with killer interest fees or a low credit score, avoid these common credit mistakes:
Spending more than you can repay each month, then having to pay a mountain of interest on your balance
Having a high credit limit on your cards, which encourages you to spend more money
Using credit cards to make ends meet or to pay off other debts
Making all your purchases on only one card and then not being able to pay it off
Instead, make sure to maximize your repayments to lower (or eliminate!) interest. Making your minimum payments on time each month is critical to keeping control of your credit score. If you don't already have online banking set up, then get this done ASAP. It makes tracking your spending and paying on time much easier. You can also set up automatic payments every month to ensure you make minimum payments on time.
Keep in mind that even a few thousand dollars of credit card debt can take decades to pay off, and you'll end up paying three or four times the original amount due to interest.
To avoid these lethal interest rates and keep your score looking peachy, aim to pay off more of your balance than just the minimum each month. Clearing your entire balance every month is ideal. The bank can’t charge interest when you owe them nothing at the end of the month.
Lower your credit limit
If you can't afford to pay off your credit balance every month, then don’t increase your credit limit—even if your bank calls and offers to raise it. Having a high credit limit drives you to spend more and makes it far too easy to get into debt you can’t pay off.
It's in your bank's interest to encourage you to spend, but don't take the bait. Opt out of receiving these offers. You can always call them up at a later date and ask for a credit increase. They'll probably be more than happy to give it to you.
Don't do all your shopping on ONE credit card
Forbes' finance experts point out a little-known factor that affects your credit score: your level of credit "utilization." This term refers to how much of your available credit you're actually using.
For example, if you had a credit limit of $100 and a statement balance of $20, your utilization would be fairly low at 20%. But if you had a credit limit of $100 and a statement balance of $70, then you'd be using 70% of your available credit, which is too high.
According to Experian Decision Analytics, people with credit scores above 780 (excellent) have an average utilization of 5.6%. On the other hand, people with credit scores below 600 (not good) have an average utilization of 77.2%. When you rack up a lot of credit card utilization like this, you might have trouble paying it off right away and then the interest hits you right where it hurts.
Here's an example:
To figure out your current credit utilization, divide your bill amount (ex. $1,200) by your credit card's limit (ex. $1,500) to get a result (0.8, in this case). Then multiply that amount by 100 to get your utilization (ex. 80%).
In a situation like this, you might be better off using your single credit card LESS FREQUENTLY and making the rest of your purchases in cash or with a bank card. This is an especially good idea if you are trying to cut down on your spending in general.
The other option is to split your purchases between two credit cards so you’re using less of the credit on each card. Do not go this route unless you are a disciplined spender! It’s easy to get carried away with multiple credit cards and to lose track of your daily spending.
That’s it! If you’ve read this far, then congrats. You're on your way to taking control of your finances and getting onto a better, more profitable track!
Here are the major takeaways and strategies that you can begin applying to your finances this very moment:
Spend only as much credit as you can afford to pay off at the end of the month. If this means cooking at home instead of eating out or waiting a few weeks to buy new duds, then so be it! A little restraint goes a long way.
Lower your credit limit if you can and opt out of receiving offers from your bank.
Set up online banking with automatic payments so you always make your minimum payments on time. This will keep your credit score in great shape.
Start a high interest savings account and get in the habit of making regular deposits.
The decisions we make every day have great impacts over time. Spending the right way is essential to having a good credit score and avoiding vicious payday loan cycles and the black hole of long-term debt.
Take these tools and use them. We wish you all the best on your journey to riches.