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Personal Finance Made Simple
Most people don’t handle their finances well. Money management often causes stress. One third of those in relationships argue with their partners about money. About 69% of people don’t balance their checkbooks; many fear outliving their retirement funds. They become passive and let experts handle their money, even when it isn’t in their best interest, but those aren’t your best – or only – choices.
You can condense the core financial rules most people should follow into 10 simple statements that fit on a small card. If you follow these rules, you will be in better financial shape than most people, with less money-related stress and a better future outlook. The 10 “index card” rules are:
1. Save “10% to 20% of Your Gross Income”
Saving is hard. New expenses always crop up. The median US income dropped $3,000 between 1998 and 2013. Costs keep rising in basic categories, like education, housing and medical care. Most income increases went to wealthy people whose spending distorts the economy, creates markets for luxury items and raises expectations. America doesn’t encourage living moderately. Saving takes discipline and demands sharp focus in a nation that encourages consumption.
Examine how you spend money to see where you can cut expenses. Track every penny you spend for three months. Software like Quicken can help you record and categorize your expenses. At the end of the first month, review your spending. Once you know where your money goes, you can manage your spending more actively and create a plan to guide your future financial activity.
In case of an emergency, set aside enough money to cover your expenses for three months. As you work to gain control of your finances, stop using credit cards. People spend up to 20% more if they use credit cards instead of cash. If your job lets you “set up an automatic savings plan” to deposit funds directly into your savings account, join in. Don’t expect to jump straight to saving 20% of your wages. Take realistic steps to sustain your progress.
2. Pay the Balance on Your Credit Card
As recently as two generations ago, people had far less access to credit. If you wanted to buy something you couldn’t afford, you could borrow from friends and family or you could ask for credit from a local merchant. Businesses gave credit only if their proprietors knew you. Your social circle might help you in a real emergency, but friends were less likely to help you buy a luxury item. Loan sharks might advance money to you, but at high interest rates and risk. Things have changed. Newer laws governing lending let companies offer a lot more credit. Credit card companies make money from people who don’t pay their full balance due each month.
That’s when your credit card shifts from being a short-term, interest-free loan to being a bill with high interest rates. Paying off that debt is the best thing you can do to gain financial control. If you can’t pay off your cards now, try to pay more than the minimum each month. If you have more than one card, first pay the one with the highest interest. Don’t try to make this change alone. Find an “accountability pal” and support each other as you change your credit card habits.
If you have a card with a high interest rate, try negotiating for a lower rate: Some companies will reduce your interest rate rather than lose you as a client. Or transfer your debt to a card with lower interest. Be careful: Some cards charge higher interest rates on any new purchases made after a balance transfer. Be careful about using “debt consolidators”; they charge fees. They might secure a lower monthly debt total for you by having you pay over a longer time. If you must, declare bankruptcy to get out from under excessive debt. Declaring bankruptcy isn’t easy and will limit your access to credit for years, but it can give you a fighting chance and “peace of mind.”
3. Utilize “Tax-Advantaged Savings Accounts”
Throughout the 20th century, more firms offered pensions and government offered programs like Medicare and Social Security. Fewer companies now offer pensions, and Social Security covers fewer of people’s expenses. In the 1980s, the Social Security “replacement rate” covered 50% of pre-retirement salary; it fell to 40% by 2016 and may drop to 36% in another decade.
To supplement the gap, maximize your use of any retirement accounts for which you may be eligible. Start as young as you can to get the most benefit from compound interest. If your employer offers a 401(k) or for nonprofit organization employees, a 403(b), sign up. That investment will be immune from taxation until you withdraw it during retirement when your tax rate is lower. Many employers match part of your investment – usually 3% to 6% of your income. This is like getting a raise for saving, so never pass up an “employer match.”
Depending on your income and contribution limits, invest in an IRA. Use “college savings accounts.” When you put money in your retirement account, don’t take it out early except in a genuine emergency. Penalties will apply for early withdrawal, and the money won’t be there when you retire. Don’t change retirement accounts when you change jobs.
4. Avoid “Individual Stocks”
Everyone has heard stories about people who made a fortune after buying Microsoft or Amazon when they were just starting out. Those stories are not typical. For every person who got rich buying a great stock early, more people lost money investing in companies that seemed like sure things. Imagine that you bought Kodak back before digital cameras. It would have seemed like a sure thing – until almost everyone stopped using film.
Some rare individuals like Warren Buffett earn profits from buying and selling stocks. But nobody else is Warren Buffett. No one, including Buffett, can be certain about what a single stock will do. That includes all the big names giving advice in the media. Buying individual stocks can generate a lot of “transaction costs,” like brokerage fees for buying and selling. Some people praise “alternative investments” like gold or collectibles like art. Treat these as hobbies. Don’t regard them as investments. Prices in these areas change erratically, and you can’t depend on them.
5. Buy the Right Kind of Funds
The market offers a variety of funds which pool investors’ money to buy a range of investments. Investing in the right kind of fund is less risky than buying individual stocks.
With a fund, the idea is that dedicated professionals actively manage pooled assets with the goal of beating the stock market. You may picture informed experts investing your money for a higher return. In practice, that’s almost never the case. Most actively managed funds (more than 80% of them) underperform “the market index.” Instead of investing in actively managed funds, find index funds. These funds vary widely by fees. Look for a fund with as low a fee as possible, because fee costs add up over time. Or opt for an “exchange-traded fund” if it is an index fund.
Diversify your investments to reduce risk. Do you research to decide which type of diversity works best for you. If you prefer a simple rule of thumb, subtract your age from 100 and invest that percentage in stocks and the rest in bonds. A 20-year-old would, therefore, invest 80% in stocks and 20% in bonds. If you want a more targeted set of guidelines, put 70% in an “S&P 500 index fund,” 15% in a “small-cap index fund” and 15% in an international fund with a broad range of investments. An even simpler plan is to take your money out of the S&P 500 fund and the small-cap fund and invest in “one total stock market index fund.”
6. Follow the “Fiduciary Standard”
Financial advisers have many different qualifications and certifications. Only one criteria matters: the fiduciary standard. A fiduciary agent is bound by law to “put your interests ahead of his or her own.” Instead, most financial advisers operate according to “suitability standards.” This means they give you basically good advice, but with the understanding that the advice is geared toward investments that maximize the agent’s commissions. Most advisers who reach out to you probably won’t follow fiduciary standards, and you’ll pay for their free advice in other ways.
Ask potential agents directly if they follow fiduciary standards. Consult organizations that represent such professionals, like the National Association of Personal Financial Advisors. Look for specific credentials, like “certified financial planner” or “registered investment adviser.” Some companies use computers to apply investment algorithms and generate advice. These services can be cheaper than a human adviser, but even a “robo-adviser” must be a fiduciary.
7. Buy a House Only When You’re Ready
Before the 1930s Great Depression, more Americans rented their domicile than owned their homes. Most people had limited access to mortgage loans. They had to put down at least half the price and pay the rest in five to ten years. To help stabilize the volatile real estate market, the federal government promoted 30-year mortgages requiring only 20% down payment. Most Americans could hope to own a home, and many did. But putting down only 20% of the cost increases the lure of buying more house than you can afford.
Most Americans’ homes are their “largest financial asset.” Many people erroneously assume the value of their homes will always go up. But a home is a “highly leveraged asset,” which makes it a risky investment. Ideally, your home should function as “an automatic savings plan”: Find a house, put 20% down, get a fixed-rate mortgage, and pay it off a month at a time. However, owning a home is an expensive way to save money. In the early years, most of your payment goes toward the interest on your home mortgage loan.
Between 1890 and the end of 2014, the S&P composite stock index “outperformed housing by roughly a factor of eight.” You earn less putting your money into a home than into stocks. Like stocks, a house purchase is a “long-term proposition.” When your debt is under control, you’ve secured your emergency account and you’re ready to buy a house, don’t buy the first house you fall in love with. Put at least 20% down, or you’ll have to pay mortgage insurance. Shop for mortgages. A fixed-rate mortgage is best. It protects you if rates go up, and you know what you owe. Consider taking a 15-year mortgage: You can pay off your home much faster.
8. “Insurance: Make Sure You’re Protected”
What will your family do if you can’t work or if you die? Most families need insurance to weather such situations. The best type is “term insurance,” which means you pay fees for a set period of time (a term), usually between one and thirty years.
Choose a “level term” life insurance policy – the cost stays stable throughout the entire term. This protects you from sudden increases in expenses. Get one that covers 30 years, because a shorter-term policy means you pay more at the end of that term to buy more coverage. Many insurance agents work on commission and may steer you toward a specific purchase. Insurance companies make more money from “whole life or universal life insurance” and will push those hardest.
Get homeowner or rental insurance, car insurance and health insurance “to protect your net worth.” Review your policies carefully so you know what is and isn’t covered. Buy collision auto insurance coverage and liability. Liability insurance pays for expenses in cases of accidents and injuries. Buy at least double the minimum. Comparison shop annually for health insurance. Make sure your plan includes the hospitals you want to use and double-check with each. For retirement insurance, buy a low-cost “fixed annuity.”
9. “The Social Safety Net”
No matter how well you manage your finances, sometimes you need help. Fully 96% of the US population receives financial support from the government at some point, be it from Social Security, a government college loan or some other program. Almost half of elderly Americans would live in poverty without Social Security. Support such social safety nets. Vote to protect these programs, so they will be there when you need them.
10. “Remember the Index Card”
“Hang the card on your fridge” so you always follow the other nine rules.[/text_block]