What Is A Current Ratio And Why Does It Matters

What Is A Current Ratio And Why Does It Matters

Running out of cash can be a frightening experience. It is one thing when you are in a restaurant, and you leave your wallet at home. However, it can be quite stressful to realize you have a potential cash flow problem coming down the pike.

By exercising financial discipline, you can avoid some everyday stresses. Having a large emergency fund when unforeseen events happen can soften the blow of sudden but necessary expenses. And yet, many Americans have not put enough savings aside for life’s uncertainties. Having liquidity has become even more apparent during the pandemic. High job losses, business closures, and medical needs have put financial strains on many of us.

Finding financial happiness is more than just making money. To achieve your short-term and longer-term financial goals, you need to know and understand your financial position. Preparing financial statements, as businesses do, will help you evaluate strengths and weaknesses.

Think of your family household as a business. The family balance sheet is your net worth statement, providing you a snapshot of your financial condition. To avoid liquidity problems in good or bad times, the current ratio is among the best ways to measure your family’s ability to pay debt obligations within a year.

Personal Net Worth As A Key Benchmark

Net worth is a great way to review your personal financial data accounts at a point in time. It is calculated using your total assets: what you own less total liabilities, or what you owe. Hopefully, what you own is over what you owe.

Using data from your net worth, you can analyze many different key personal financial ratios to develop better habits. We have written about various financial benchmarks in money management: savings, retirement, spending, investing, debt accumulation, and reduction. These ratios can be easily calculated and give you a better sense of your financial health and progress relative to your goals.

Liquid Net Worth As A More Realistic View

Liquid net worth is an even better and more realistic benchmark because it focuses on your assets’ liquid nature. That means those assets that can be quickly converted into cash with little or no loss of value. Although net worth remains a helpful gauge, it doesn’t differentiate your assets from their liquidating value.

As such, liquid net worth gives you a better understanding of your assets and your future needs, whether running out of cash or even exploring an opportunity. Drilling further down, the current ratio is among the best financial ratios. This ratio is easy to calculate and measures your liquidity position. Having financial flexibility allows you to react to and adapt to changing financial conditions like a recession and losing your livelihood.

What Is The Current Ratio?

When measuring your current ratio, your focus is on existing assets. You can convert into cash within a year and current liabilities due within the year. The current ratio is sometimes referred to as the working capital ratio. Businesses, analysts, and investors have used these formulas seeking strong balance sheets that predict which companies can best pay their short-term debt obligations. Similarly, a family household can use the ratio to know whether they can rely on having enough short-term assets readily available to pay your short-term debts.

Who Evaluates Your Current Ratio

This ratio is essential to avoid money shortfalls but may highlight your liquid position to maximize your business growth or family wealth. Investors use the current formula to search for companies with strong balance sheets to weather economic downturns. Lenders review your financial statements, crunching numbers to judge their risk exposure by your ability to pay your loans. Financial advisors use your data to help you develop your goals and strategies to achieve your financial plan.

Our Focus

  • Define and calculate the current ratio.
  • Understand the ratio and its limitations.
  • Strategies to improve our financial position.

The Current Ratio Definition

The current ratio relates current assets to current liabilities and is easy to calculate. It helps you to understand your liquidity position within the short term period of one year. Liquidity refers to the ability to convert your assets into cash with little or no loss of value. The quick ratio is a close cousin to the current ratio but uses a shorter time frame of 90 days or less and uses receivables. As such, the quick ratio is more attuned to the liquidity of businesses as opposed to households.

Certain assets, particularly financial assets, tend to be easier to convert as marketable securities with values. What other holdings can you sell quickly to convert into cash?

Not All Assets Are Equal

Before we had kids, we enjoyed collecting art and antiques. We happened to make these purchases at the peak of that market. Once we had kids, our tastes dramatically changed. So did the art and antique market, which collapsed around the Great Recession. Try selling those items in a hurry! We sold many pieces well below the price we paid and learned a valuable lesson. Asset categories matter. A current ratio measures the household’s ability to liquidate those assets to meet their short-term obligations without additional borrowing.

Although there may be differences in assets and liabilities of a household or business, the calculation is pretty much the same. Cash inflows and cash outflows are often a trade-off between having liquidity and using your surplus cash for growth.

Current Ratio Formula = Short term Assets/ Short Term Liabilities.

Current liabilities reflect the debt payments owed in the current year. That would be your monthly credit card balances, and other debt payments owed that year. A ratio of one or higher indicates you have more short term assets than debt, a sign of good financial health.

Current Assets In The Household Balance Sheet

Your family may own various assets, ranging from monetary assets (or financial and more liquid assets), tangible assets (e.g., cars, houses, or furniture), and diverse investment assets. The current ratio relies on liquid assets able to quickly convert into cash with minimal loss in value. You can sell your car but at a depreciated rate and potentially below its fair market value depending on condition, mileage, and use.

A typical example of current assets your family household may have:

  • Cash On Hand $500
  • Savings Accounts $1,500
  • Emergency Savings Account $1,200
  • Checking Accounts $1000
  • Tax Refund Due $400
  • Money Market Accounts $3,000
  • Marketable Securities (eg. stocks, bonds) $45,000, includes $4,500* in cash
  • CDs $1,000
  • Cash Value of Life Insurance Policies $15,000
  • *Cash portion only.
  • Total Current Assets $28,100

Summing up the amounts of $500 +$1,500 +$1,200 + $1,000 + $400 + $3,000 + $4,500 + $1,000 + $15,000 equals $28,100 in total current assets.

Notice that I only added 10% of the marketable securities, or $4,500. You don’t want to inflate current assets. It is best not to count on your investments. Instead, add only the cash portion. Markets can be volatile, often impacting values in the short-term, but you want to opportunity for the securities to bounce back.

Use Caution When Determining Your Current Assets

As a long-term investor, I have experienced declining stock values in my portfolio many times. A range of factors causes market turbulence, such as an unstable economy. Although tempting, it may not be wise to sell your marketable securities like stocks and bonds.

As we saw with the pandemic in the spring of 2020, stocks tumbled but returned reasonably quickly to acceptable values. Panicking is never a good time to sell stocks in a plummeting stock market, only to sell some of your winners. Don’t rely on your investments as current assets if you have a long term perspective. It would be best if you considered a small portion, say 5%-10% of your investment accounts as cash in the short term.

Don’t Count On Retirement Or College Savings

Retirement or college savings accounts are long term assets designed for your financial future. When you set up 529 College Savings accounts for your children, you build a fund for tuition and other costs. Likewise, when you are saving for your retirement through your company-sponsored 401K and IRA plans.

These accounts are the last places you should withdraw money and should not be considered liquid assets. They provide tax-deferred benefits as well as compounding growth as long as you leave the money in place. Besides, withdrawing money from these funds usually causes potential tax liabilities and penalties on these long term assets. Generally, this is usually a costly move. It is better to look elsewhere first for cash.

Some families have side hustles or start-up businesses, which may add some current assets such as customer accounts receivables, inventories, prepaid expenses, and notes receivable expected within the year. If you do include existing business assets, make sure to add your business’s current liabilities as well.

Current Liabilities In The Household Balance Sheet

This category is for current obligations that you owe within the current year. Managing your debt is critical to a good current ratio and having financial flexibility. It can mean the difference between financial success or strain for you and your family. Typical accounts that are due within the year:

Outstanding credit card balances of $6,000

Line of credit balances, associated with a flexible loan that you may access as needed and repay immediately or over time with interest. $1,000

Auto loans or leases due $5,400

Student loans $4,500

A mortgage loan, maintenance, or rent payments due $12,000

House Equity Line of Credit (HELOC) if you borrowed money., unused.

Installment Loans for household appliances, electronics, furniture $1,000

Any other short term loans coming due.

Total Current Liabilities $28,900

Total current liabilities are the sum of the amounts of $6,000 +$5,400 +$4,500+ $12,000 + $1,000= $28,900

What A Current Ratio Reveals

To calculate your current ratio, you divide total current assets by total current liabilities. Looking at the current ratio, we divide $28,100 by $28,900, equaling a current ratio of 0.97, very close to 1.0.

A score of 1 means that your current assets match your current liabilities. However, you may want to target a more desirable rate of 2, indicating better asset coverage of the household’s debt obligations due within a year. A 2 current ratio means for every dollar of liability; you have $2 in existing assets.

What stands out in current liabilities is $6,000 in outstanding credit card balances weighing on current liabilities. This amount grows faster, given the high-interest rates charged by credit card issuers. A year from now, that amount will increase to $7,000 (assuming no other borrowing on your card), possibly outpacing current asset growth, bringing your current ratio down.

Limitations Of The Current Ratio

Be honest about what you include for this analysis. Don’t inflate your current assets or understate your current liabilities. Consider any trade-offs like paying off fast-growing card balances, even if that means current assets will go down from using your cash. While “cash is king,” too much cash may mean you need to allocate more to growing your retirement or investment assets.

That can mean an opportunity cost to you and your family by not maximizing your wealth generation potential. The opportunity cost of any decision is the cost of the next best alternative that must be foregone. Keeping cash in your savings account instead of a retirement amount shortchanges your nest egg in the long run.

Strategies To Increase Your Current Ratio And Overall Financial Position

Spend Less

To improve your current asset position relative to liabilities, evaluate your spending patterns. Overspending or impulse buying can lead us to buy things we can’t afford or need. For example, when we are looking at our favorite sites, we come across a beautiful coat. We don’t look away even though it is out of our price range and we just bought a lovely coat a few weeks ago. Present bias is a bias that stimulates our need for immediate gratification at the expense of our need to save. Rather than saving, we will be increasing the balance on our credit card. When we shop, we are often subject to marketers exploiting our biases, as we discuss here.

Track Your Spending

If you are susceptible to overspending, try tracking your monthly bills. You may be surprised at how many things you thought you needed but haven’t even used. Return those items or learn how to control your spending better. Review your budget for places where you may reduce some obvious costs. You may be binge-watching more than ever as you sign up for all the new streaming options.

Last year, I found that Craig had downloaded hundreds of dollars worth of Kindle books over two weeks. I was surprised, but when I brought it to his attention, he was even more shocked.

Due to the pandemic, we have spent less on entertainment, vacations, and other typical places before social distancing. As a result, we may have even picked up some good habits like cooking more, engaging in DIY projects, and even doing without some luxuries. We all want to get back to our everyday lives, see friends and family, but that shouldn’t mean losing any financial discipline we gained.

Consider your financial goals when accumulating assets. Be mindful of their potential appreciation value and the respective market. Our arts, rare books, and antiques served their purpose for many years. However, we took a significant loss when we transitioned to a different lifestyle and a growing family. Falling in love with the art on the wall and the furniture are nice but were not suitable investments.

Boost Income

Many people are struggling due to the coronavirus-related economic downturn. You may have lost your job, had your hours reduced, or want to boost your income. Think about what solutions suit you best. If you like your firm and want to advance there, consider expanding your skills and knowledge. Talk to your boss about ways you to increase your training to be helpful to your department.

Even if you are delighted with your current situation, always consider ways to invest in yourself throughout your career. Many people worked remotely due to social distancing. You want to continue to do so as a work/life balance or cost-savings measure and ready to do it long term. Another way to earn more is to take on a part-time job or do some freelancing. Consider options that fit with your current family lifestyle and can be financially beneficial.

Allocate Some Savings To Investments

Even if you only have a small amount of savings, begin to invest as early as you. However, before taking that step, make sure you have first set aside an emergency fund for unforeseen events. When you are young, you have a long-term horizon that allows you to take on more risk and handle the volatility.

Manage Your Debt Properly

Pay your credit card balances on time and in full, so your debt doesn’t grow on a compound basis. Carrying card balances is a big weight on your current ratio and hard to manage when you pay on average 16% APR. Your debt may continue to grow faster than your current assets. This is an untenable situation. Eventually, it will difficult to find liquidity when you need to.

Don’t buy a bigger home than you can afford or need. Consider a shorter mortgage, such as 15 years, to pay less total interest on the price of your home. Yes, your monthly mortgage will be bigger, but for a shorter time and less cumulative interest. Refinance your mortgage if you are paying a higher mortgage rate than currently offered.

Final Thoughts

Using financial benchmarks, notably the current ratio, are useful as a starting point to understanding your financial health. Evaluating your financial strength and position can move you towards meeting your goals and achieving success. Having sufficient liquidity to deal with potential struggles in the future may be the difference between financially comfortable or strained. Preparedness and financial discipline are essential for you and your family.

This article originally appeared on Your Money Geek and has been republished with permission.

 

 

 

 

 

 

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Investing Rules For Success: It’s Not Rocket Science

Investing Rules For Success: It’s Not Rocket Science

Investing is not rocket science! Anyone interested in learning fundamental rules and recommendations for making long term investments can become a successful investor. Over time and with experience, you will develop your investment strategies based on your short-term and long-term goals. As the saying goes, “You’ve got to be it to win it.”

Saving is not investing. Although leaving your money in a savings account may be safest, investing in stocks provides appreciably higher returns over the long term. Their returns typically exceed the inflation rate. Make your money work for you by saving it and deploying it into investments.

Key Reasons To Invest Money

  • Help to achieve your financial goals.
  • Make your money work for you.
  • Compound your growth, particularly if you start early.
  • Provide an emergency cushion for unpredictable costs.
  • Set aside funds for your children’s college tuition and your retirement.
  • Make investments to build wealth and be financially secure.

Investing Rules For Success:

1. Set Investment Goals

If you have never invested before, you may become overwhelmed by the choices, the jargon, and how to begin. Set your investment goals so you can achieve them. You should align these goals with what you want out of life. Investing, at least here, is not about getting rich quick. There are no legitimate schemes to get there swiftly. Instead, think about your financial plan for you and your family and the respective timeframe for achieving specific goals.

Once you understand your goals, you need to establish investment strategies that work best for you. Saving is not investing, but you have to start somewhere.

Typical Goals:

Money set aside for an emergency fund is an essential “must-have” tool for unexpected costs. Automate your savings as soon as you can and invest these funds in short-term liquid assets readily accessible when needed.

Buying a home means you need to have money for a down payment in the next five years. Here, you would want to invest your money so that you don’t blow these funds away. You want to preserve this money by investing in securities without taking on high risks. Such a vehicle could be a mix of stocks with growth and stable dividends.

529 College Savings tax-deferred plans are savings you invest in your children’s college tuition needs in the next 10-20 years. These 529 plans have various options. If you have a longer-term horizon before needing the money for school, you can use Vanguard target-date funds or aggressive funds for the first few years.

Investing for retirement should be done as early as possible. Retirement accounts have tax-advantages like 529 accounts. You should automate your contributions for your company-sponsored 401K plans, especially if they offer matching contributions. Establish your Roth IRA early as well. Having as much as 25-40 years to build your retirement nest while taking advantage of tax benefits and compounding works its magic. Like college savings plans, there are many investment options to choose from that allow you to invest in higher growth, higher risk securities until you get closer to retirement.

FIRE On!

To reach financial independence by a certain age, you will need to save money aggressively for investing. While pursuing this track, you will probably be working hard early in life. Once financially independent and debt-free, you can retire early while pursuing other goals. That may mean continuing to do a job but at fewer hours, pursuing passive income streams, living more simply and entirely but financially secure. You can complement capital preservation for funds needed to pay for necessary living costs with various investments designed for income.

2. Get Your Financial House In Order – Set Up A Large Emergency Fund

Before investing, establishing an emergency fund is a prudent strategy for unforeseen events. Life happens, and being prepared is good financial discipline.  When you lose a job or face a medical need, you still have monthly bills like your rent or mortgage. You don’t want to encounter late charges, fees, hits to your credit score, or worse, eviction amid disaster. Putting big bills on your credit card, adding to your balance is the last resort.

If you don’t have an emergency cushion, start saving now so that you can pay for necessary living expenses for a reasonable time,  Use an automatic savings plan to withdraw money from your paycheck to funnel into an emergency fund. Invest your emergency money in a readily accessible account such as a high yield savings bank account, a money market mutual fund, or an FDIC-insured money market deposit account. Although you will only earn a small amount of interest now, such a fund should remain liquid.

The Need For Emergency Savings Became More Apparent

The pandemic has caught many people unaware as it wreaked havoc on our health and economy. As a result, those with more significant emergency savings to cover a year’s worth of living costs are in better shape. Having readily accessible funds in liquid accounts such as money market securities helps you avoid borrowing money.

Once the emergency cushion is in place, you are better positioned for financial security. Then, you have less pressure to sell any of your long term investments to take care of necessary living costs.

3. Buy And Hold For Long Term Mentality

It is probably apparent that we favor a long-term mentality when it comes to making investments. Staying the course when financial markets get volatile can be difficult.

The bear market in March 2020 is a prime example of trying to avoid panicking and selling stocks at the bottom. It can be costly to investors. I recognize the tendency to sell stocks when it seems like the world is ending.

2020: An Extraordinary Year

This year has been particularly extraordinary for many reasons. We began 2020 in great economic shape with the longest bull market. Its abrupt end when the S&P 500 price peaked at $3,386.15 on February 19th, up a fair climb of 4.8% year-to-date.  As the coronavirus appeared on our shores, the market became volatile, reaching its S&P 500 price bottomed at $2,237.40 on March 23rd. From peak to trough, there was a 33.9% drop in about four weeks.

Unlike other bear markets, the market proved its resilience even in substantially higher unemployment than we have experienced since the Great Recession. As a result, the S&P 500 reflects the most significant stock reversal in history. Thus far, the S&P 500 is up 59% since it bottomed in March!

Imagine if you sold your stocks on that day? Had you held on to your shares through the turbulence, you would be up over 10% year-to-date. Don’t panic when the market gets volatile as you may cause regrettable errors you will regret. I am sure some people were on the sidelines in March who was opportunistic and jumped into the market in those dark days of March.

The quick market recovery was helped by unprecedented financial support through The CARES Act by the Fed, the Treasury, and Congress. As such, the relief was given to the unemployed, small businesses, and those with a mortgage or student loans. The lesson learned is to think long term, not to panic, and sell your stocks during volatility as markets tend to recover over time.

4. Diversify Your Portfolio

Concentration in two or three stocks or one type of asset is risky. Diversification in investments is the process of reducing risk by spreading your money across a mix of various investment choices. Although you may realize lower returns in a diversified portfolio than the potential return of a single alternative (e.g. Amazon shares), your risk of loss is lower.

The risk associated with owning only one investment of a particular type (e.g. Countrywide Mutual) is called random risk. Random risk can pop up when a specific company does very poorly apart from the rest of the market. These days there are so many ways to diversify your portfolio to reduce risk with various asset classes.

They can range from money market securities, bonds, individual stocks, mutual funds, real estate, precious metals, and high-risk collectibles. Within stocks, consider growth stocks, blue-chip stocks, and value stocks.  You need to find out what is suitable for you. I have had very good (and some bad) experiences with some of these categories.

5. Asset Allocation With Rebalancing Annually

Asset allocation is a form of diversification among different classes of assets. The average investor will predominantly have various stocks either bought individually or through mutual funds.

It is prudent to diversify by considering a mix of money markets funds, stocks, bonds, and real estate investments.  Age, risk tolerance, life cycle, and preference often determine your proportion of stock exposure.

There is a common rule of thumb for stock allocation of subtracting your age from 100. A  person of 35 years should allocate 65% of their investments to stocks, while a 75-year-old person should hold no more than 25%. Some suggest using 110 rather than 100, which would allow for higher stock proportions in your portfolio.

Review your portfolio annually to rebalance these assets if you have too much exposure to stocks, for example. Automatic portfolio rebalancing is often available to employees as a valuable feature when they participate in employer-sponsored retirement plans.

6. Gauging Your Risk Tolerance

There are trade-offs between risk and return. Investments come with risks that may vary significantly. Risks and returns are positively correlated. That is, returns tend to go in the same direction as risks. Someone seeking potentially high returns on their securities will need to take more significant risks. For example, a high return opportunity with little risk may be paying off high-interest credit card balances if you have the money to pay it off. I digress on purpose.

If you are averse to risk and want a completely safe investment without having to worry about losses, your best bet will be to invest your money in US Treasury securities. The full faith and credit back these AAA securities.

T-bills have the shortest maturities of all Treasuries and are considered risk-free investments. But, they pay a very low return, especially nowadays.

Being too ultra-conservative will shortchange your potential for acceptable returns.  Find the right balance by factoring your tolerance for risk into your investment approach. Generally, the younger you are, the better you should handle greater risk in your portfolio. As long as you are working, can pay your monthly bills, have an emergency cushion, you should take on risk.

7. Compound Interest Is Far Better In Building Your Wealth

When investing for college savings, retirement, or investment accounts, compounding plays a magical role. Assuming you don’t withdraw any money, compounding allows you to earn interest on interest on your balance in these accounts. That is, your principal continues to rise with earned interest. Compound interests work to benefit from added interest to your principal. 

Understanding compound interest fuels the urgency to invest your money as early as possible. Your balance grows at its interest rate so long as you aren’t tempted or have a need to withdraw money.  By adopting good financial habits of investing money, compounding over time is what builds wealth.

How Compounding Works On Retirement Accounts

Saving for retirement is a form of investing for the long term. Using a simple example and a compound interest calculator, Maria, age 25, initially investing $2,000 in her employer-sponsor 401K plan (ignoring tax benefits and employer-matching) and automates $1,000 per month from her paycheck to be deposited in her account. Based on an 8% average annual return, her retirement fund would be close to $1.4 million by the time she is age 55.

Maria changes her mind, decides to increase her monthly contribution to $2,000, and will leave her money in the plan longer until age 60. Maria’s retirement fund will grow to $4.154 million. Using a compound interest calculator, you can change the initial investment and monthly contributions, annual return, and the number of years to calculate a targeted amount for you. The effect of compounding has significant positive ramifications on your money, particularly when you start to invest early in your life. 

8. Don’t Gamble When Investing

Many people consider investing as a form of gambling. While some forms of investing are like gambling, they are different. According to Merriam-Webster, “Gambling is the practice or activity of betting: the practice of risky money or other stakes in a game or a bet.”

Casinos, poker, greyhound, and horse races are fun entertainment sources but not a reliable investment choice. Chances are very likely you will lose more than you gain. The games are designed for the “house” to have high returns, while yours will be in the negative column.

Investing is not gambling. The big difference between investors and gamblers is that investors have substantially more publicly available resources to rely on to make their decisions. Investors can reduce their losses by diversifying their portfolios, not panicking during market turbulence, and doing their due diligence.

On the other hand, investors can be more like gamblers when they trade on anonymous tips, buy penny stocks, or speculate on securities they don’t understand or engage in day trading.

Day trading is not investing. Day traders require different skills, more capital, huge time commitment, and understanding the market forces. Day trading has various risks. By definition,  its profits are short term and taxed as ordinary income. Investors’ holdings of more than a year benefit from the lower capital gains rate.

9. Avoid Short Selling

I am also uncomfortable with the practice of short selling. Short selling is a speculative strategy that can be dangerous if you don’t know what you are doing. When a trader or investor short a stock, they sell the shares on the expectation they will profit if the stock goes down because they believe the stock is overpriced. It’s legal, but it seems to go against the philosophy of investing. Company management runs their companies for future growth, so they are particularly hostile to short sellers. Just ask Elon Musk, CEO of Tesla, about short sellers.

The danger to short-sellers is that they are wrong, and they could be facing unlimited losses if the stock continues to rise. That particular security could be anointed a favorite among the street, misunderstood, or getting a generous buyout offer.

10. Don’t Buy On Margin

When buying shares in a company, you may use some of your own money and borrow the rest from your broker. Margin calls are an extension of credit, with the securities acting as collateral. When the company’s shares decline in price, your broker will ask you to put up more money towards the borrowed amount or to sell the shares. The broker uses margin interest to protect themselves from losses on the loan to you. Both the Fed and FINRA set industry rules for investing in the market. Your broker usually sets the minimum margin requirement. They could be stricter than federal guidelines.

Margin buying offers higher profits and higher risk through the added leverage. By paying only a small portion of the total amount, investors amplify their purchasing power. However, when financial markets are volatile, brokers make margin calls. These calls boost the losses suffered as well. The higher the amount borrowed, the greater the risk. Given these risks, I have always avoided using margin to buy stocks.

11. Don’t Be Greedy – Some Discipline Is Needed

Wall Street saying, “Bulls make money, bears make money, pigs get slaughtered.” The market is the wrong place to get greedy by overstaying your welcome with a particular stock. Even the best companies stumble once in a while. Stocks do rise over the long term, but they often pause or decline based on a range of factors, including an economic downturn, industry problems, or internal issues with the company.

Trim your stock positions that have appreciated 20% -25% after your purchase. You can sell a small portion to lock-in some profits. I have done this regularly for years. My reason for doing so is that awful experience of thinking that a rising stock will continue to do so. That euphoria can fade quickly. Stocks will pause, reverse, and sometimes fail over time. After a few of these experiences, where my gains disappeared, to be replaced by eventual losses, I changed gears to take small profits at a time.

12. Don’t Chase IPOs Right After Its Pricing

Many individual investors want to participate in hot IPOs but aren’t typically able to buy at the IPO price. Instead, many investors buy after the new issue is trading in the secondary market. They see the excitement surrounding this stock, which more than likely rose 20% on its first day of trading. Enthusiasm happens as the new stock name attracts all investors. Typically, institutional investors add to their IPO allocated positions as part of their participation.

Don’t chase these stocks after their initial pricing for a while. Statistics show that in the long run, IPOs tend to underperform. There are several reasons for these stocks to do poorly one year after the IPO.

13. Why IPOs Perform Poorly In The Long Run

Often, company management is young and inexperienced with communicating with their new shareholders publicly. As part of the deal for taking the company public, the underwriters will support the newly issued shares and discourage flipping shares (selling the shares after the initial rise) from those investors who received stock at IPO price.

The underwriters will solicit lockup provisions from previous private owners of the stock for 90 days or longer.  The private owners are usually the founders who own many shares, their management, and key employees. When those provisions expire, some of these earlier investors will want to sell shares, putting pressure on the stock.

Along with these impacts on the stock, the company may miss some revenue or earnings results compared to expectations. Analysts may revise forecasts. The company may experience delayed product rollouts. As a former analyst, I had substantial experience with newly issued shares that can’t cope with potential issues in the first year of their public debut. Facebook, Groupon, Lyft, and Uber all had problems and underperformed significantly within their first year. After a stock’s immediate rise, there often is a better price you can pay. Learn from other people’s mistakes, mine included.

14. Learn As Much As You Can

There are so many ways to learn about investing in building up your knowledge, skills, and experience. Never stop learning. There are so many opportunities to learn about different kinds of investments, philosophies, and strategies. Resources are readily available.

I have recommended simulated stock games to many who want to learn about investing. They are fun, have resources, and do give you “hands-on” experience without losing money.  I have played with my kids and college business students to great success. My college students have told me that they regularly invest in the market on their own after playing the game.

To learn how to invest, consider watching CNBC Squawk Box in the AM and Mad Money with Jim Cramer in the evening. Read articles from thestreet.com, Investors Business Daily, and SeekingAlpha. I read everything possible, written by Warren Buffett. Annually, I read Buffett’s annual letter to shareholders for its golden nuggets.

Investing Classics Worth Exploring:

The Intelligent Investor by Benjamin Graham

Security Analysis by Benjamin Graham and David Dodd

One Up On Wall Street by Peter Lynch

Common Sense Investing by John C. Bogle

A Random Walk Down by Burton Malkiel

I could fill a page on books I could recommend. I read all or parts of these books when I became a security analyst. However, having your own experience as an investor will speak volumes to you. If you are going to doing your own investing, you have to research companies, listen to conference calls or read transcripts, SEC documents, and understand what others are thinking.

One way to begin investing is by buying low-cost index funds that provide immediate diversification.  I highly recommend going in this direction.

15. Be Humble

Anyone who tells you that they never made a mistake while investing is probably lying. Investors make lots of mistakes and hopefully learn from them. Expect to eat humble pie on occasion. Otherwise, it may mean that you are not taking enough risks. The smartest investors I know personally or from a reading of their experience know the impact of feeling wrong from losing money on an investment.

16. Be Patient

Learning how to be patient about an investment you made is essential. Sometimes you buy a stock too early, and it is not moving the way you like. Be patient and try to learn more about it. As we said earlier, there are no get-rich-schemes.

I have learned patience by purchasing small amounts of stock, such as an eighth of the expected larger position. This way, I can benefit from dollar-averaging if the stock continues to decrease my share cost. At times, you may not get a chance because the stock took off and got expensive. I may kick myself for not buying more initially and be opportunistic should there be a chance the price declines in the future.

Alternatively, there will be times when you realize you were wrong about your expectations. You made a mistake and decide it is better to sell now and move on. It could be that it was a surprise to all holders or didn’t fully understand its kind of company. As much as I try to do my research, I was wrong. Mistakes, I have made a few.

Final Thoughts

By following our investing rules, you can become a successful investor. Investing is the best way to build wealth and become financially secure. Start as early as possible so you can take advantage of the long-term horizon and compounding growth. There are many ways to learn how to invest, but the best way is through experience.

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8 Financial Lessons Learned During The Pandemic

8 Financial Lessons Learned During The Pandemic

“The meaning of intelligence is the ability to change.”

Albert Einstein

According to studies, it takes 21 to 66 days on average to change your habits in regular times. As a result of the pandemic, which continues, we needed to change our lifestyles. To stay healthy, we made significant concessions. Lockdowns required masks, social distancing, and grocery shortages. As a result, it led to an economic downturn with massive unemployment. This became our new norm.

We formed new habits and learned many lessons with financial implications to cope with COVID-19. Optimism is in the air as potential vaccines may provide a path to resuming our lives. Still, the pandemic has left an indelible mark on all of us in a variety of ways.

If we can point to a silver lining from the pandemic, several surveys have consistently pointed to the following trends that show people are:

  • saving more money.
  • spending less.
  • reevaluating their priorities.

If these are permanent changes, they are good financial habits and favorable outcomes for Americans—improved financial literacy yields long-term benefits.

Saving More

The US Personal Savings rate–the percentage of people’s disposal income after taxes and spending–exhibited substantial rises during the pandemic. From 7.2% at the end of 2019, this savings rate peaked at 33.6% in April 2020, before settling down to a still-high 14.3% level in September.

A Harris Poll and CIT Bank reflected a strong disposition towards saving more money during the pandemic. This study showed 53% of consumers (including unemployed) saved more than they typically do in the last 3 months.

As a result of the pandemic, many consumers plan to continue to save more and spend less on nonessential items (egNerdWallet, The Harris Poll). Whether this a permanent shift in priorities or a hopeful aspiration remains to be seen post-pandemic.

Less Spending

According to a recent Bank of America survey, roughly two-thirds of Americans say their spending habits have changed since the start of the pandemic. Respondents pointed to reduced costs from commuting, dining out, paused gym memberships, and vacation travel.

While these costs decreased as many people stayed home, working or otherwise, other spending increased. Most notably, we spent more on online shopping, especially for groceries, higher pet expenses as families adopted more pets, and online education courses. Grocery spending was up 54% from panic buying in March compared to February.

People also formed some bad habits–overeating, too much alcohol, and a lot more binge-watching as “too many subscriptions” with new streaming services were readily available.

Reevaluating Priorities

More people participated in the market, putting more of their money into stocks after the sharp decline in March. TD Ameritrade reports that they had more visits to its website by people wanting to learn how to do day trading. Robinhood, a fintech company with an advanced trading platform, has reported that it scaled up to 13 million accounts by early October.

Day trading can be dangerous for new and inexperienced investors in volatile markets. My preference is for people to learn how to invest for the long term.

The need for saving money for emergencies became a far greater priority.

Frugality, an admired trait for some people, became more accepted. Two in three Americans report in a Slickdeals survey that the pandemic has turned them into frugal persons. Being called frugal is a compliment to many. Let’s value our collective experiences and pack them into financial lessons we learned during the pandemic.

Financial Lessons Learned During The Pandemic

 

 

1. An Emergency Fund Is Vital

The mantra of having an emergency fund to pay for your living essentials became more apparent during these times. The amount to save for this fund is less obvious. As a rule of thumb, common recommendations start with saving of $1,000 or having a goal of establishing a fund to pay for 3-to-6 months of living expenses.  Dave Ramsey calls for 3-6 months funds. Suze Orman has recommended having 8 months of savings for your living expenses.

I admire these leaders in the money management space but for this event at least that may not be enough. For many, the pandemic caused high medical and other costs AND high unemployment. Savings of 6-8 months may just a starting point and a national average.

Set Aside More Savings If You Are In A High-Cost Area

Remember that there is a significant portion of our country who live in high-cost cities like NYC and San Francisco. Lose your job there and you are still paying high-cost rent. That’s the problem with the rule of thumb. You may get the tip bitten off.

The Lesson

When determining how much to save, consider your economics and family situation.  Many learned this year that a more significant amount of savings is needed when something as unpredictable as coronavirus rolls in, dramatically hurting our economy. To better protect yourself, coverage of a year of your basic living needs will allow you to sleep better at night. Sleeping well is a better rule of thumb.

Aim high, so you don’t feel low. Reduce some of your spendings on non-essentials so you can have an abundance of financial flexibility when times are difficult.

Invest Your Emergency Funds In A Liquid And Accessible Account

Your emergency money should be in a separate account where it is safe and accessible for liquidity purposes. Such a place may be a high yield saving account or a money market deposit account, both of which are FDIC-insured.  Check whether rules limit your ability to withdraw money. While you won’t earn much in the way of income now in our low yield environment, liquidity to cash-equivalents is virtually king. Here are some other places you invest your emergency fund.

2. Investing In Stocks For The Long Term

Triggered by the reality of COVID 19, the S&P 500 index sharply declined 33.9% from February 19 peak to its bottom on March 23. This decline ended the long bull market from the 2009 recovery. Many investors, fearful of this breathtaking decline, sold their stocks into the market weakness. Even the normally optimistic investment guru Warren Buffett, was selling more stocks than actively buying in March, according to his 13F filing.

Sure, it was difficult not to be tempted to sell stocks, especially if you lost a job or lacked liquidity. I felt enormous pressure to stay the course and not sell as stocks went to the bottom.

The market’s bottom is only clear in hindsight.  I held on to my stock positions with some difficulty by having faith in my experience and listening to market experts I respect. Was I worried at all? Only a liar would say no. Having a long-term horizon that is shorter than those in their 20s and 30s means I am closer to retirement now than I was in the Great Recession. However, I sold my stocks closer to the 2009 bottom, a costly lesson I keep close to me now.

The Lesson: Don’t Sell Stocks Out Of Panic

Here’s the lesson: in my newbie years as an investor, many times, I actively sold a lot of my stocks and went over to the sidelines. There, I would watch good stocks recover over time.

Don’t sell stocks out of panic. Markets come back in time. Indeed, the S&P 500 index is up nearly 57% since its bottom, registering an 8.6% gain year-to-date. Few predicted the March collapse or the rapid stock market recovery in 2020. How did it happen? It took a little bit of luck, recovering corporate earnings, stimulus money, and, most of all, aggressive action by the Powell-led Fed all contributed to stimulating the economy and the markets.

Don’t Be Greedy

Keep a long-term perspective while maintaining diversification in your portfolio. Determine whether you have too much or too little risk for your tolerance and lifestyle. I trim stocks that have done well. I do this sell a bit as certain stocks have grown 20-25% or are too large compared to my total stock portfolio.

There is nothing wrong with selling part of your stock position into cash. Instead, it is opportunistic and financially disciplined. It helps you to avoid being greedy.  As the old Wall Street saying goes, “Bulls make money, bears make money, pigs get slaughtered.”

3. Working Remotely Became A Bigger Benefit

Before the pandemic, remote working was trending upwards in many organizations as an extension of telecommuting. However, many companies, indeed, whole industries (eg. investment banks, brokerage firms), that did not believe in the virtues of remote working were forced to consider this as a viable option.

Many companies have successfully switched to long term remote work. For many employees who kept their jobs during the pandemic, this is a meaningful perk in company benefit plans in the future.

This is a grave lesson for employees who were furloughed or laid off because of jobs that weren’t as amenable to remote work or lacked skills to do so.  Remote working jobs will remain in demand. Employees will want to equip themselves for such jobs by learning skills to allow them to do so.

As many employers took this route, allowing their people to work remotely, many credit the impact of COVID-19 for their accomplishments.

Achievement highlights show:

  • 15%-40% in increased productivity;
  • 10%-15% less turnover;
  • 40% reduction in absenteeism; and,
  • 20%+ potential cost reduction in real estate and resource usage.

Sources: Forbes, Global Workplace Analytics; BCG Analytics.

The Downside of Working Remotely

Remote working is not without its downsides. Not everyone liked working remotely, missing the interaction, collaboration, and socialization of the work environment. New employees, in particular,  may find it challenging to learn their way around the company when working remotely.

To counter that feeling of being lost, employees may need to assert themselves with their colleagues and managers with active participation. Take more initiative as you gain more confidence at the new firm. It is also the responsibility of companies and more experienced employees to establish ways to build a virtual bridge and integrate new employees. Mentoring programs may be the best way to do this with frequent check-ins.

When in need of guidance, new and young employees should be encouraged to ask potential mentors who are readily available.  As the new people on the block, frequent zoom communications should allow them to ask what skills they should add, and offer to help others.

Related Post: Remote Working As The New Normal: Advantages And Disadvantages

The Lesson

Remote working is a trend likely to stay. It provides cost benefits to both employers and employees. The opportunity to work from home is increasing. If this is a desirable benefit for you, make it a priority in your training and how you choose your job.

4. Telemedicine Became More Essential

The telemedicine industry was growing before the pandemic. However, as the government called for widespread lockdowns,  telemedicine’s need became essential for the medical field to adapt quickly. Physicians wanted to remain engaged with their patients during COVID though not every medical office was set up to implement the practice.

Big Technology Needs

Many physicians, who may have scorned the movement to provide remote medical care, took steps to implement telemedicine. To a great extent, the complexities–technology, regulatory, legal, and patient acceptance-are greater for physicians to do so.

A certain level of advanced technology is needed to provide real-time audio-video two-way communications.  Physicians want to be able to smoothly connect from their offices with their patients living in diverse locations. Many were in different places than their homes, as COVID may have hampered people’s ability to travel home from vacations or visiting family. Conversations are not enough when there are serious or chronic ailments requiring remote monitoring or MRIs.

For Example

I needed a particular recording device for monitoring my heart after an ablation procedure. To gauge its success, my cardiologist sent a special monitor to record my heart rhythms for about 10 days which I then sent back for his analysis. Fortunately, tracking reflected good results. Was it ideal? No, but it was better than waiting for the pandemic to disappear.

I didn’t need medical images or other care. However, telemedicine is not suitable for patients in need of urgent care requiring in-person attention.

 

Legal And Regulatory Compliance

Besides technology, the healthcare field requires compliance with a range of strict HIPAA privacy, insurance, and other guidelines while COVID poses threats for in-person diagnosis and treatment.

States granted temporary licensing waivers as emergency needs persisted and telemedicine became widespread during COVID. Existing telemedicine providers, like the publicly traded Teladoc, a major telemedicine provider, has had a jumpstart in treating non-emergency medical problems. It is already in compliance with relevant state, national, and international laws and regulations, including HIPAA.

The Lesson

As patience acceptance grows and there is strict compliance, telemedicine is likely to continue to grow for a garden variety of non-emergency ailments. However, the practice of distance medicine can not fully replace the “hands-on” attention for emergency needs even with the use of robotics and other technologies. Telemedicine is valuable as an interim measure or for regular visits.

5. Online Learning

Back in March, as the spread of the coronavirus caused lockdowns, schools across the country adopted remote learning measures in a hurry. For the most part, people–students, parents, teachers, and administrators–adapted as well as possible. This Fall, schools, colleges, and universities modified classed into an in-person, hybrid, and fully online model. As COVID cases increased in schools, colleges, and universities, there was a greater shift to online teaching.

The jury is out as to the success of remote learning in K-12 grades, colleges, and universities. The younger your child is, the more essential in-person learning is for instruction, emotion, and socialization benefits in order for them to thrive in our society.

Public education is the best way to raise responsible citizens, forge a common culture among our diverse population. That was constitutionally accepted after the Brown vs Board of Education.1954   Until then, public education was unequal for blacks who were discriminated against by having to go out of their neighborhoods to separate schools.

Lack Of Broadband Internet For Some

With hybrid or fully online education in place for most communities in the US since March 2020, we have learned of the disparity of broadband Internet technology. Those who reside in rural or poor neighborhoods do not have the same high-speed Internet facilities as urban areas. There has to be a level playing field for education. We must build the high-speed data transmission facilities needed for teaching.

As a replacement for in-person learning, there is a recognition that remote learning is not an equal replacement. Even Sal Khan, the founder of Khan Academy, admitted that distance learning is a less than perfect substitute for in-person schooling.

The Lesson

Distance learning is not a replacement for the classroom. Improvements should be made so remote learning works as an option for many people who have subscribed to online classes before the pandemic. As an educator myself, I am hyper-sensitive to the challenges of my students who may be sharing laptops with another family member or simply enjoy being in a class with their peers.

6. The Benefits Of Lifelong Learning

My mother always told my brother and me, “So long as you are able to learn something and can read a book, you will never be lost or bored.” It sounds corny, but my mom was right. We were never allowed to say we were bored when we couldn’t find something to do. We didn’t grow up with the Wide World of the Web (www or the  Internet) like the Gen Z digital natives. Somehow, I was able to entertain myself pretty well.

My love of reading and learning came in real handy as we were in lockdown at home. The way we read and learn may be different but once an appreciation, always one now. Sure, I was distracted by the news, little binge-watching, and too many visits to certain apps on my phone (Candy Crush, if you are wondering).

Expand Your Skills

Many people turned to pick up new or expand skills to improve their work profile or pleasure during the pandemic. People learned new languages, AI, machine learning, robotics,  how to excel on DIY projects, do exercises, experiment with cooking, and Zumba dances remotely with streaming classes of all sorts.

In a recent Gartner analysis, only 16% of new hires possess the skills needed for their current and future jobs. They found existing roles may require up to 10 new skills by 2021. That’s a lot of learning to do. Companies can accelerate training for their employees.

The Lesson

Learning skills can make your job more secure, help you earn more, and position you as a more attractive candidate to other organizations.  Take the initiative to look into where you do some of this training on your own. Learn and update your knowledge in your field so you can be a more valuable employee now and in the future.  Expanding your knowledge in areas of interest adds new dimensions to you as an employee and to your life.

Related Post: The Benefits of Lifelong Learning With No Downsides

7. More Family Time To Talk

Family time with two teens at home can be quite emotional. It doesn’t help that we also have a new puppy in our home. Hormones are raging like a “tempest in a teapot.” That said, I have had some of my best conversations with both kids or individually, learning about their interests, academics, and their good friends.

My daughter, Alex is a planner. She is organized, loves criminal forensics, enjoys working, and is very interested in diverse topics. As an avid reader of this blog and others, she is interested in learning how to handle money better and learn how to earn interest. My son, Tyler, is interested in cash usually borrows from Alex without paying her back.

The Lesson

Jokes aside, we have increased our discussions with our finances, stock market, and skill-building during this time. I have learned from their viewpoints. They are both young adults who remind me every day how hard this pandemic has been on them. It is hard not going to school with their friends, playing sports, and socializing like typical teens.

8. We Owe A Debt A Gratitude

 

Be Thankful For Your Job

Being grateful for what you have and to others provides good feelings all around. You are fortunate if you kept your job unscathed by reduced hours. By May 2020, 20.5 million were unemployed, an increase of 14 million people since February. This is a higher level than in the Great Recession.

Yes, there were higher unemployment checks and stimulus money at the start. That helped many a temporary relief. But it is stressful to be dependent on government aid held up by political maneuvers.

Health Care Workers And Many Others

During the pandemic, it was hard not to be touched by essential and non-essential workers who were in harm’s way when doing their jobs. Those efforts continue while the pandemic is still rising in the number of cases, hospitalizations, and death. So many people are working tirelessly behind the scenes in stressful jobs. Healthcare works became visible but what about security guards, food servers, janitors, transportation workers, and many more?

We may have passed these people in the past without thinking about them. I am grateful for their help and for being there for us. Thank them more often.

Family And Friends

COVID exposed a lot of vulnerabilities in our society. Our elderly population, black communities, and those with pre-existing conditions paid a higher price, many the ultimate and others who are chronically suffering from having the coronavirus.

Cancer patients had difficulties getting the essential treatments they needed. We lost two cousins and a dear friend. They may still be with us, if not for.. Not a typo but I just can’t finish that thought that is in common with so many people.

Related Post: Gratitude Can Help Your Finances

 

Final Thoughts

The tragic coronavirus pandemic has affected us all. We were forced to change our lives dramatically to cope with the dangers of the virus. Some trends are emerging that have provided some favorable outcomes. We addressed 8 financial lessons learned during the pandemic. Each financial lesson offers benefits that may help us earn and save more, spend less, invest for the long term, and help us enjoy our lives more.

Thank you for reading! Stay healthy! If you found some value in this post, can we ask you to share it with someone? Consider joining by subscribing to The Cents of Money and getting some freebies and our weekly newsletter.

 

 

 

Common Credit Mistakes And How To Avoid Them

Common Credit Mistakes And How To Avoid Them

“No man’s credit is as good as his money.”

E.W. Howe, novelist

What is credit? Credit is defined as the ability to borrow money or something of value now with the understanding you will repay the lender later with interest. Managing credit well is one of the essential disciplines in your financial life. Developing good credit habits can enhance your financial health.

Unfortunately, there are many ways to make common mistakes that can be costly by lowering your credit score. A reduced credit score can make it difficult for you to borrow at a more affordable interest rate, fall behind in paying debt, or turn off landlords from renting to you.

You are not born with good credit, but you can earn it by handling your debt reasonably well. Understanding your FICO credit score may help you to raise it a few points to a better level. By doing so, you may get lower interest rates when you take out loans, shaving your interest costs meaningfully.

Determining What’s Important To Your Credit Score

Calculating the FICO Scores formula involves five different criteria:

Payment History: 35%

Payment history carries the most significant weight in your score. Payment history picks up on patterns of making consistent payments on time for the length of your credit. Having a more extended credit history is a better gauge than someone who has just received their first loan. Having a good track record of not missing payments and being on time works in your favor.

For example, making a late credit card payment, that is, a payment past the due date will hurt your score.

Those who are new to getting credit have to build up a practice of paying what they owe on time. Any occurrences of past-due accounts or delinquencies, especially for current amounts, are red flags. This component looks at different account types such as credit cards, retail or store accounts, installment loans, mortgages, and finance company accounts.

Credit Utilization: 30%

As a significant influence on your credit score, credit utilization is the ratio of your total outstanding revolving credit balances divided by full available credit. Revolving credit refers to your credit cards and credit lines you may have but does not include your car loan (unless on your credit card) or your mortgage.

The utilization ratio is also known as the balance of debt to available credit or debt-to-credit ratio. It measures how much credit you have used for the total amount available to you. You don’t want to “max out” your cards. You should not be above a 30% ratio as it will impact your score. Stay in the mid-20s range to be assured of not hitting the 30% level. Think twice before closing a credit card as it will have a negative impact on this factor.

Credit History: 15%

Lenders look at your credit history and your experience with credit matters. The length of time of your oldest credit account and the average age of all of your accounts determine your credit history. The longer you have an account, the better your credit score. If you are new to obtaining credit, it will take time to benefit from showing up in your score. Don’t close your old credit cards because they count positively in your credit history. 

Credit Mix: 10%

Lenders favor some variety of borrowing in your mix of credit. A borrower handling different kinds of debt products may reflect less risk to lenders. A person without a credit card tends to be seen as a higher risk. That said, don’t go out and get different kinds of loans for the sake of improving your mix.

New Credit: 10%

Your inquiry will be reflected on your credit report for up to two years when you apply for credit. That is called a hard inquiry. As such, it can negatively impact your credit score, particularly if you are making multiple inquiries. However, don’t let it stop you from doing comparison shopping for the same type of loan.

A soft inquiry occurs when you are checking your credit score or report. Someone other than yourself may make a soft inquiry by accessing your credit background for something different than a loan such as an employer. Soft inquiries do not generate negative hits.

11 Common Credit Mistakes To Avoid

Avoid making common credit mistakes. Becoming informed and determined to avoid these mistakes may yield great returns for you and your family. I will refer to the score criteria when relevant to a specific mistake you may be making.

 

1. Not Paying Your Credit Card On Time

You are required to pay the minimum amount by the due date on your bill as a credit cardholder. If your household is like ours, you probably lead busy lives. You probably are responsible for many monthly bills, not just your credit card bills. If you are late paying a card bill, you will likely incur $25 the first time you are late, but the amount will rise the next time.

Depending on the terms of your credit card agreement, you may face a hike in your APR on any balance you carry along with future charges. Lateness is pretty consequential to your credit score as payment history at 35% of the FICO score calculation is the largest component.

To avoid being late in paying the required minimum, you should automate payments of all your bills, including your credit cards, through your bank account. When it comes to paying your card bills, automate and don’t procrastinate. The penalty charges are punitive for a reason.

2. Carrying A Large Balance On Your Credit Card

Paying the minimum on your credit card bill on time is an easy fix and makes the card issuers happy. They stand to make a tidy sum on interest income at the high APR rate they charge their average customer. Roughly 58% of cardholders carry an average balance of $6,354 per person at the current average APR of 16.03%.

Of course, card issuers are happy because it is highly profitable. The problem for cardholders is those carrying balances result in paying extra costs on their purchases. Instead, pay your credit card balances in full. Otherwise, it takes years to pay off your current payments while piling on more debt as you continue to use your cards.

An Example

Let’s say you have a current balance of $4,000, and your APR is 16%. Typically, your minimum payment as a percentage of your balance, around 2.5%, or $96 that you owe. If you pay the minimum rate going forward, it will take you 18 years and four months, costing you $4,148.86 in extra interest charges to pay that balance. And, that assumes you never make additional purchases with that card in the future.

Carrying high balances is dangerous for your pocket, and it also has implications for your credit score. After payment history, amounts owed (accounting for 30% of your FICO score) is your credit utilization rate. If you are using too much of your available credit on your card, it may signal to the banks that you are overextended or a potential risk.

Stay Well Below The 30% Credit Utilization Rate

Using more than 30% of your credit utilization can negatively impact your credit score and future borrowing ability. Stay well below that 30% threshold. It is essential to tackle your high balances by making a plan to pay off your card debt, usually the most expensive debt you hold at the double-digit APR. Become disciplined about your spending wisely. Credit cards are convenient, too convenient if you tend to overspend. Cut your spending drastically if you want to have a chance to reduce a large balance.

How To Raise Your Score By Lowering Your Utilization Rate

Most of us don’t pay a lot of attention to our credit card bill, but we should. Your due date is when the payment is due on your statement and reflects the previous billing cycle charges. The last day of the billing cycle is your statement’s closing date. The due date is the grace period, typically 21-25 days, and falls between the closing date and payment. The credit card companies are required to give you this period, not because they are friendly folks.

You are required to pay by the due date to avoid penalties. However, you can benefit by paying your bill on or before the statement closing date, the last day of the billing cycle. By doing so, you can improve your credit utilization rate and, therefore, your credit score. For example, if you have a $3,000 credit limit, spend $2,500 but pay off $1,900 before the closing date, it will appear as if you spent only $600, or 20% of your credit available on that card.

Related Post: 6 Ways To Raise Your Credit Scores

3. Don’t Close Any Credit Cards

Even if you don’t use certain credit cards, don’t close these accounts. Often we have several credit cards that were once appealing because of certain features or through a favorite store. However, over time, you have lost interest and decide to close the account to worry about theft or temptation to use it.

Don’t do this—the length of your credit history matters for 15% of your credit score. The longer you hold open cards, the better, even if you aren’t actively using them.

My Mistake

I made this mistake with a Saks Fifth Avenue card I applied for and got 10% off a large purchase I happened to make for a special occasion. While I liked to browse their stores, I realized I didn’t want to have their card. So, I closed the card. Perusing my credit report months later, I got a ding on my report, which translated into a lower score. To avoid this mistake, simply throw unused cards in a drawer and say goodbye.

4. Not Reviewing Your Credit Report Periodically

According to an FTC study, one out of five people has found errors on their credit report. The sooner you find the mistakes, the easier it is to fix them.

Current and future creditors use your credit report and review its potential impact on your credit score. Others that may want or need access to your credit report are landlords, utility companies, insurance companies, prospective employers. Also, legitimate access to your credit report may be required by collection agencies and if you are a party of court orders.

Fixing Errors On A Credit Report

Fixing errors on a credit report is not difficult, but you don’t want to delay doing so. Delaying a review of your credit report may result in you having to pay a higher interest rate than you should when you apply for credit. Don’t wait for those needs to arise. The best way to fix errors, disputes, or possible fraud is to follow these instructions.

Besides looking for errors, you may be dismayed at some notations on your credit report. Your report may shine a light on poor judgment or reflection of your impulse spending habits. Additionally, it may help you to pinpoint potential fraud when someone has made unauthorized inquiries or purchases.

Fear of fraud may motivate you to make essential changes to get the information in good shape before shopping for a home or a car. We once found a tax lien for a small amount that was burdensome in applying for a car loan. Be timely when you encounter these issues. It is easy to forget when something is a small amount but remains a nuisance to do.

5. Not Reading The Fine Print On Your Credit Agreements

Fewer than 1 in 1,000 people take the time to read the fine print online, spelling out the terms and conditions in financial contracts like credit cards, insurance policies, car, or mortgage loans.  Not doing so may have long-term financial implications for you and your family.

Credit card agreements have incredibly complex terms and conditions. You should understand the particulars of the APR, penalty structure, the benefits from cashback, rewards, discounts, and other perks they are providing.

Terms of Your Mortgage

When you are buying a home, it is typically, for most people, your largest asset. True, your attorney plays a significant role in helping you through the home-buying process. However, you should understand the key elements of the mortgage loan and its interest rate, fixed or variable, prepayment penalties, and length of the term. How owed mortgage interest compounds (semi-annually or monthly) can make a difference in the total cost of your home.

To avoid problems later, become familiar with the typical terms and conditions for the respective agreements you are shopping for. Certain laws have been passed in recent years to protect consumers from providers. These laws, like the Credit CARD Act of 2009, recognize the imbalance that often exists between parties. However, you are responsible for understanding what you are signing. Yes, these documents can be boring and hard to understand, so ask questions.

6. Paying A Loan Off Early Can Hurt Your Credit

If you suddenly received an incredible amount like a bonus or an inheritance, you may want to pay off your loan. Be aware that there may be negative consequences. Some loans, if paid ahead of time, incur pre-payment penalties. These are usually relatively small and worth getting rid of the debt burden. While there may be a temporary hit to your credit score, it is probably beneficial in the long term.

You would want to weigh the value of saving interest over the time remaining on the loan. Usually, there is a relatively small ding to your credit score. Unless you seek a bigger loan and need the best rate possible, paying off a loan should not be a big deal.

How It May Hurt Your Score

When you do not have much payment history (35% of score) may not be a good idea to pay off a car loan. An installment loan is a type of contract involving a loan to be repaid through scheduled payments like for cars and homes. As long as they are paid on a responsible basis, these loans are reflected positively on credit score according to Experian. A good credit mix means there are different types of credit being used. Credit mix accounts for 10% of your credit score, so paying off a car loan may negatively impact your score.

7. Don’t Make Excessive Hard Inquiries For A Loan

Creditors get worried about people making too many “hard inquiries” that occur when applied to a lender of some sort. Lenders see this as a sign of risk that you may be overextending your debt. As we mentioned earlier, hard inquiries may hurt your credit score.

On the other hand, “soft inquiries” occur when someone is accessing your credit report for reasons having nothing to do with a loan. Instead, it is someone such as a landlord considering whether to rent their house to you. That inquiry is for reasons better to understand your creditworthiness as a reflection of your character.

Hard inquiries to your debt burden is often a big problem. These kinds of consequential inquiries come from those who apply for loans or have too many credit cards that they max out. If you have too much debt, applying for debt will worsen your situation. Instead, you should consider working with a financial debt counselor that can provide strategies to reduce what you owe.

8. Avoid Cards With Annual Fees Unless They Have Important Features You Will Use

Generally, there are so many credit cards to choose from without an annual fee that paying one seems like a waste of money. That, at least, is the conventional thinking. Some yearly payments of $550 or over are outrageous but appeal to those who enjoy the card less for the numerous benefits than the status symbol they provide.

If you have the time and desire, you likely can find credit cards with annual fees below $100. There is enough competition in the industry for you to find appealing rewards and money-saving perks that pay for the yearly fee. Just make sure that you will use these benefits. For most people, finding a competitive card with good perks and avoiding the annual fee is the better way to go.

9. Overspending For Rewards

Studies show that credit cardholders spend more when they use their card as compared to paying with cash. As such, this has been referred to as “the credit card premium.” Rewards offered by issuers are designed to encourage more spending in order to get more points or some other perk. Ever sit next to another table where the diners are actively comparing the points and rewards they have earned? I have, and often wish I could get a dollar for every time I did!

According to a recent survey from Coupon Chief, one in five consumers say the rewards are the best perk, ahead of 16% who responded that building credit was the most valuable benefit. More concerning, 52% of Americans don’t actively track their credit card points. Holders are attracted to getting something for free; however, they may be more costly to those shoppers who are tempted to impulse buys.

10. Fear Of Getting A Credit Card

You don’t have to get a credit card. A third of Americans don’t have one for a variety of reasons. They could be fearful of temptation to overspend, poor credit, or prefer an alternative to a credit card. I didn’t have a credit card for many years, and then I used it sparingly when I did. My parents never had a credit card and never accepted cards in their retail store.

Credit cards have many benefits, but ONLY if you use it responsibly as we discuss here. Don’t fear getting a credit card. Instead, learn how to pay balances in full and on time. Building credit is important as a means of borrowing money for buying a car or a house.

11. Don’t Get A Retail Store Card

The temptation of getting a store card often comes right at the point of purchase when the store clerk waves an application at you. “If you sign up today, you will get 10% off today’s purchase, Ma’am?” And, you say, “Sure, why not?”

Okay, let’s rewind that conversation so that you understand that retail store cards may be a mistake. A store card has limited use because you can only use it at that specific store or enterprise. That’s great for the specific merchant because they collect a lot of information to market daily offers to you.

Other merchants do not accept retail credit cards. On average, store cards charge higher APRs than credit cards, which are already high enough. The average APR for store-only credit cards was 24.06% in 2Q 2020 versus 16.03% for traditional credit cards, according to WalletHub.

They usually provide low credit limits, so you won’t get a big bang in credit availability to improve your utilization rate to hike your credit score. At the end of the day, retail credit cards have fewer benefits than traditional cards.

 

Final Thoughts

Creditworthiness is a valuable trait when you need to borrow money, or someone wants a good read of your character. Take steps to avoid common credit mistakes that will put you in good standing and help you raise your score. To be in good financial health, managing credit well is an important discipline. Develop and maintain good credit habits and keep your debt levels from overwhelming your life.

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