6 Things You Should Understand About Money (But Honestly, Probably Don't)
Your financial beliefs and attitudes can shift throughout the course of your life. But there are some financial truths that hold true no matter what your age or situation. Factor these six into how you approach your finances, and it can help you make more of the money you have now and eliminate costly missteps in the future.
1. Compound Interest Can Either Be Your Friend or Your Enemy
Compound interest—basically, when your interest earns interest—can be a powerful way to multiply your savings over time.
Make even a one-time, $5,500 contribution to an IRA (Individual Retirement Account) when you’re 25, for example, and if you earn an average 7% per year (which is in line with historical stock market returns) for the next 40 years, your initial investment could be worth more than $80,000 by the time you’re 65, says Ed Snyder, a Certified Financial Planner at Oaktree Financial Advisors in Carmel, Ind.
On the other hand, when it comes to debt—especially credit card debt—compound interest can be a major wealth blocker. That’s because many issuers calculate compound interest on balances owed daily, says Snyder. “If you have $10,000 in credit card debt with an annual interest rate of 15%, your daily interest rate is .041%, and you pay $4.10 in interest on day one,” he explains. “Your balance then becomes $10,004.10, and the interest will compound on that amount.”
The lesson? Reap the benefits of compound interest by investing as early as possible, so your savings has the chance to experience exponential growth. And when it comes to debt, pay off your credit cards in full each month; if you can’t, make a plan to get to zero as soon as possible. Apply only the minimum payment each month, and you could be paying down a small balance for years.
2. Calculating Your Hourly Rate Can Help You Determine if a Purchase Is Worth It
It’s one thing to decide whether to buy something based on whether it fits in your budget. But if you really want to know if that Game of Thrones-themed flash drive will bring you lasting joy—or if it’s an impulse buy you’ll quickly lose interest in—figure out how many hours you’d have to work to pay for it.
To calculate your hourly rate, divide your take-home pay by the number of hours you work each pay period. (Note that while your salary is likely based on a traditional 40-hour week, Gallup research found Americans work an average of 47.)
If you make $20 an hour, for example, you might reconsider the $50 sale sweater you’d typically throw into your cart without a second thought. After all, you’d have to devote 2.5 hours’ worth of earnings to pay for it. What you’ll likely learn is that many items you’d usually view as bargains no longer seem worth it when you weigh them against the value of your time.
3. If You Want to Make Smarter Money Choices, Invest in Upping Your Financial IQ
Do you spend as many hours managing your finances as you do planning your next vacation or scrolling through social media? The average American doesn’t. While iPhone users spend about a half hour each day on social media, more than one survey has found Americans spend more time planning a vacation—even selecting a restaurant—than planning for their retirement. (And the Bureau of Labor Statistic’s most recent time-use study found US adults spend about 13 minutes a day on all household management, a category that includes managing your finances.)
Ruth Hayden, financial educator and author of several books including Your Money Life: The Make-It-Work Workbook, suggests taking baby steps to build up your financial knowledge base. Maybe that’s (ahem) reading more articles on Grow, or looking up basic investing term definitions and concepts.
“Financial language is just like any other. You need to know some basic vocabulary in order to be able to communicate about finances and investments,” Hayden says. “When you can communicate about your money, you’ll feel more competent and confident with your money decisions.”
4. The Impact of Fees Shouldn’t Be the Only Factor to Consider When Selecting Investments—But It’s a Big One
The potential effect that fees can have on your investment portfolio has been widely documented. But it’s tough to assess whether an investment is worth it, based solely on how big the fee is.
“As an investor, I could choose the funds in my 401K with [the lowest] expenses… but that does not guarantee that it will provide me a higher return,” Snyder says. Rather, he says your best bet is to look at the long-term returns—over three, five, and 10 years. “If fund A and fund B are both large growth funds, with fund A having lower expenses but also lower returns, fund A may not be the best choice just because the expenses are lower,” Snyder says.
Bottom line: If you’re investing in exchange-traded funds (ETFs) or mutual funds, look at how different ones stack up to one another with both historical returns and fees in mind.
5. Buying a Home Isn’t Always the Right Move Financially
You’ve probably heard, or even said yourself, that renting is throwing money down the drain every month. But know this: Owning a home isn’t a guarantee that you’ll save (or make) any money—especially if you haven’t saved enough for a substantial down payment.
“If you can’t pull together the 20% down payment and still have six months of expenses in reserves, you shouldn’t be buying yet,” says David Rae, a Certified Financial Planner in Los Angeles. “The less money you put down, and the less you have in your savings, the higher risk you run of being house poor.”
Why’s that? For starters, the more you put down, the lower your monthly mortgage payments will be. (And ideally, your housing costs won’t exceed 30% of your income.) “Not putting down 20% makes the same house cost more money, which decreases the net benefits of owning that home: You may be subject to private mortgage insurance (PMI), or you may be taking on a loan with higher interest rates,” says Rae. “All of these factors really add up over the life of the loan.”
6. You Should Own Things—They Shouldn’t Own You
Cars, homes, and other material items may make you feel successful and accomplished, but accumulating things shouldn’t come at the expense of financial freedom—that is, the ability to make decisions that support the life you want to live today and in the future.
Not sure you’re prioritizing freedom over keeping up with the Joneses? One way to get back on track is to start paying yourself first. “That means contributing to your 401K or other retirement plan at work, to your IRA, and to your emergency fund or other short-term savings goals before you do anything else,” Snyder says.
Pro tip: Automatically transferring cash to each of these accounts from your paycheck can be a simple way to help ensure you stick with it.
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