The Pros And Cons of Credit Cards

The Pros And Cons of Credit Cards

“Once you get into debt, it’s hell to get out. Don’t let credit card debt carry over. You can’t get ahead paying eighteen percent.”

Charlie Munger, Vice-Chairman, Berkshire Hathaway

 

For me, credit cards have always been a double-edged sword, a fight between good and evil, or in Biblical terms, a blessing and a curse. Growing up, my parents predominantly used cash, using their retail business’s checking account to pay bills. I was the first in my family to go to college and the first to have a credit card. My parents celebrated the former and not so much the latter. They only accepted cash from their customers, refusing to believe in the benefits of the credit card. That’s where I probably get my reluctance to use credit cards instead of cash at times.

They may have been onto something though it may have been something else altogether. My mom, I still believe, may have been irked by the fact that women, on their own, could not get their cards until the passage of the Equal Credit Opportunity Act of 1974. Before that, women needed to have a man (husband or father) cosign for a credit card. How was it fair that my Dad, not my Mom, the brains behind all our finances, could get a credit card? Just saying why I think my Mom, until the day she died in 2000, never had any interest in a credit card (pardon the pun!).

The Credit Card Landscape

Credit cards are a financial tool. But like buying a new buzz saw, you need to use it with care. Some people collected credit cards like baseball cards when I was growing up. That seems like a formula for disaster to me. Clearly, we are not yet a cashless society with nearly 1 in 4 people unable to get approval for a credit card due to lack of credit history or discipline. Roughly 33 million people in the US are unbanked or underbanked, meaning they largely use financial products outside the banking system.

When COVID hit our shores in March 2020, new card applications dropped 40%. Inquiries for all kinds of loans–auto and mortgages–dropped substantially as our priorities changed during the pandemic.  The irony is that the use of credit cards increased out of necessity due to fear of touching cash on the risk of getting a coronavirus-related infection. That behavior is just another example of the strange happenings in 2020. Growth in new card applications should resume in 2021. 

Credit Card Statistics:

  • About 176 million or  67% of Americans have a credit card with about 3.1 cards per person.
  • The average card balance is $5,897 per person end of 2020.
  • Roughly 58% of cardholders carry some kind of balance.
  • The average FICO score for credit cardholders was 735.
  • The current credit card interest rate averages were 14.58%, but for those with fair credit scores, the rates rise to 23.13%For new credit cards.
  • The average rate was 17.87%.

 

Advantages of Credit Cards

 

1. Convenience

Compared to cash, credit cards are a suitable financial product. Before COVID, retail businesses were increasingly not accepting cash from customers. Credit cards provide fast payments, transfers between accounts, and withdrawals.

There are far more shopping options with a card. It is easier to make, change, and cancel travel, hotel, and car rental arrangements.  When traveling overseas, credit cards allow you to realize currency conversions automatically.  Let’s face it, carrying a lot of cash is hard –bills and change– around in your pockets, jingling around. That said, I do like window shopping without my wallet, so I don’t feel tempted to spend money unnecessarily.

2. Build Up Your Credit

For those who lack credit history, like young people, becoming an authorized user on your parents’ credit card is a rite of passage. This is an excellent way to build up a credit history so long as your parents’ credit scores are strong. Otherwise, it won’t help your credit situation at all.  Most states do not have minimum ages for your child to become an authorized user. I’d suggest you teach your kids about the responsibility of using a card safely and responsibly first.

Getting a new card may be a second chance to improve your credit score. You have missed payments, hurting your credit score in the past. If you are ready to be responsible, you should consider getting a secured card, putting some cash on account. You don’t need a massive number of cards to strengthen your payment history and length of credit history. Understand common credit mistakes and how to avoid them.

Related Post: 6 Ways To Raise Your Credit Score

3. Easy To Track Spending

You should regularly review your credit card bills helps you track your spending. It is easy to do (except when you know you spent a lot of money) and an excellent way to improve your financial discipline. Although spending cash is the best way to feel pain immediately, regular examination of the amounts you are consuming is a realistic way to correct yourself. The credit bills provide a purchase record when making returns.

One particular month, I recall seeing a very high bill with several items that seemed uncharacteristic of me. It was a posh store with a great salesperson.  Looking around,  I realized that the dress  “I had to have” was still in the bag with the tags on along with new shoes. Who did I buy that for? Not me, apparently so I returned those things and stayed clear of that salesperson.

4. Automate Your Payments

Paying your bills, especially credit cards, are so much easier when you use the automation feature. Most cards have this feature that you can set on or before the due date so you are not late on your bill payments. Also, consider paying more than once a month if the lower amounts feel better to digest. As payment history accounts for 35% of your credit scores, automating payments is one way to help you not miss the due date.

5. So Many Perks

Having a credit card may entitle you to perks. Typically, the card use may provide perks such as cashbacks, rewards, airline points, merchant discounts, hotels, travel insurance, welcome bonuses, access to tough-to-get tickets, and free museum passes. Before signing up a specific perk, make sure it aligns with your needs. One time I ordered four tickets for Hamilton on Broadway for my family, only to realize they were preview tickets for the opening in LA, 3000 miles away. The issuer reimbursed us and waived the fees.

6. Protections For Consumers, Not Necessarily For Businesses

Credit cards offer several features for consumers. When you lose cash, it is gone forever. The good news is that money is typically not attached to your personal information, like the loss or theft of your credit cards. Some cards provide zero-liability fraud protection. In a fraud situation, just notify your issuer to cancel your card. Alternatively, the issuer can get you a new account number at no charge. Safety is important.

Typically, when you lose your credit card, your losses are capped at $50 so long as you let the issuer know promptly. There may be a higher fee and responsibility for any charges that aren’t yours if you delay reporting them. I once thought I lost my card, I called the card company quickly to find that my card fell out of my wallet into a nook in my bag. Paying the fee was a fine for a lesson learned to at least look for your card first.

Cards often have spending limits. Occasionally, you may want to lift the limit if you know you may be spending more for an overseas trip, for example, where you plan to shop for jewelry. A cardholder can let their issuer know that they want to “opt-in” to allow for transactions that may put you over your credit limit. You can let them know the specific dates you’ll be traveling. Spending limits are a good feature, especially if you’re prone to overspending.

The Credit CARD Act of 2009 enhanced more protections for consumers that do no apply to businesses. With this law, issuers need to notify consumers of significant interest rate hikes at least 45 days beforehand. Also, fees, previously hidden, must be better disclosed clearly. There are some other practices that improved with the CARD Act discussed here. Still, it is always important to read the tiny fine print, especially when it comes to credit cards.

Disadvantages of Credit Cards

 

 

1. Overspending Leads To Higher Debt

Spending beyond your means can be the root of all evil related to your finances. Credit cards enable people to shop impulsively.  Having a card rather than a finite amount of cash gives you the ability to borrow more than you should. Overuse of your card leads to carrying high-cost debt on your balances. Paying double-digit interest rates on these balances can be overwhelming.

The convenience of using credit cards as compared to cash may encourage higher spending, according to studies. In the now-classic MIT study by Drazen Prelec and Duncan Simester, MBA students held an auction for tickets to sporting events. One event was a desirable basketball playoff game, and the other was a regularly scheduled baseball game. Those participants were encouraged to buy tickets using credit cards spent up to 100% more than those paid in cash. They called this the credit card premium.

Other studies seem to validate the MIT findings that we tend to spend more with a credit card than cash. For me, spending cash for purchases gives me an immediate pain instead of a nearly month delay of having to pay my credit card balance.  to me, mental accounting bias and overspending

2. Irresponsible Use of Your Credit Card

When you pay your card bill in full every month, you don’t pay any interest. Your credit card provides a lot of benefits without the pain of paying high interest costs. Unfortunately, many people just pay the minimum amount due at the end of the month, carrying a balance forward. The issuers prefer cardholders to carry balances as it is a lucrative income stream for the companies. 

At an average balance of $3,000 with an average interest rate of 16%, it can take 16 years to pay off that balance at the monthly minimum rate, roughly 3%-4% using a credit card interest calculator. That assumes that you haven’t used a credit card during those years. It is a vicious cycle. The magical powers of compounding that work so well when investing or saving for retirement works against you when you are paying interest charges on interest accumulated. If you cannot use your card responsibly, you should work hard to reduce your spending. Some people have too many credit cards, maxing out their limits, losing control of their spending.

Watch out for the particularly punitive penalty interest charge when you are late on your credit card payment. The penalty interest rate could be as high as 29.99%, above your regular interest rate, and may stay in place for some time.

3. Lower Your Credit Score

Just as you may raise your credit score, misuse of your credit cards can destroy your score. Missing payments, applying for credit too many times, and using more than the 30% limit of your available credit all can hurt your scores. Even closing a credit card account, you don’t use will result in a decline in your score. Your credit score reflects your creditworthiness to lenders, landlords, and other professionals and could negatively impact you.

4. Read The Fine Print

Just like any contract you sign, make sure to read the terms and conditions of the credit cards you are considering. Despite legislation to protect consumers, issuers are well known for hiding information about their perks, fees, charges, and other liabilities from consumers. In recent years, consumers have been able to compare credit cards more quickly. Among my favorite sites are WalletHub, NerdWallet, and CreditCards.com, which have a ton of good information on credit card features.

Be aware that you are usually subject to mandatory arbitration if you have a dispute with your card issuer. This has been relaxed in recent years but is still in the terms and conditions. It is one of my pet peeves and a project I assign my law students to look at the fine print. The average consumer can’t fight the legions of arbitration attorneys that support card issuers.

Exercise Financial Discipline By Using These Rules:

  1. Shop wisely for a credit card, finding the perks that most suit you.
  2. Read the terms and conditions carefully even after you made your selection.
  3. Pay your credit card bill in full, so you don’t carry a  balance.
  4. Have an ample emergency fund, so you don’t put high unforeseen costs on your card.
  5. Spend below your means always and make savings and investing a priority.
  6. Don’t close any credit card. Instead, cut your card in a million pieces or simply put it in a drawer.
  7. If you have multiple cards, decide how to use them for different categories and don’t max out their limits.
  8. Avoid cards with annual fees unless they have essential features you will use.
  9. Don’t get addicted to credit cards. Limit the number of cards you have.
  10. When it comes to paying your card bills, automate and don’t procrastinate. The penalty rate is punitive for a reason.
  11. If your child is an authorized user of your credit card, teach them how to use the card wisely and safely.
  12. Be aware of behavioral biases of spending more when using your credit card instead of cash.
  13. Review your credit card bills for errors, poor judgment on your part, or correct impulsive spending.
  14.   Use cash for some of your discretionary spending.

 

Final Thoughts

Credit cards serve an essential purpose as a financial tool in an increasingly cashless society. Used wisely, the advantages of credit cards will outweigh their disadvantages. Practice financial discipline in all aspects of money management. We have had our druthers about using credit cards, learned a hard lesson or two.

Thank you for reading! If you found some value in this article, please share it with friends, family, and colleagues. Consider subscribing to our growing community at The Cents of Money!

 

 

 

 

6 Ways To Raise Your Credit Score

6 Ways To Raise Your Credit Score

Our financial lives depend on our creditworthiness. When we go for a loan, lenders review our credit report and our FICO credit scores to determine our annual percentage rate (APR). Generally, the higher our score on a 300-850 score, the lower the borrowing rate we will pay on our loans for our car, mortgage, or college tuition.

7 Reasons Why You Need To Review Your Credit Report And Score:

 

  • People want to know where you stand before making important financial decisions.
  • I am borrowing for a home purchase.
  • Car loan or lease.
  • Student loan.
  • She is hecking for inaccuracies, identity theft, and fraud.
  • He was getting a job.
  • We are renting an apartment.

 

Can You Improve Your Credit Score?

The short answer is yes, you can!  We will go over tips to increase your scores. First, let’s talk about how the FICO Scores formula is calculated with its five different criteria of the total:

Payment History: 35%

This category carries the most significant weight in your score and is the most critical factor. The longer the credit history, the better. Having a sound track of not missing payments and being on time works in your favor.

So those who are new to being approved for their credit cards need to show a consistently positive pattern.  These are 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 known as the balance of debt to available credit or debt-to-credit. It measures how much credit you have used for the 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. I would stay in the mid-20s range so as not hitting the 30% level.

Credit History: 15%

How you handle credit is essential to lenders. The length of time of your oldest credit account and the average age of all of your accounts determine your credit history. The older the 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.

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. When you don’t yet have a credit card, you may be at higher risk. That said, don’t go out and get different kinds of loans for the sake of improving your mix.

New Credit: 10%

When you apply for new credit, that inquiry is reported on your credit report for up to two years. That is called a hard inquiry and 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. Soft inquiries do not generate negative hits.

Related Post: Common Credit Mistakes And How To Avoid Them

6 Ways To Increase Your Credit Score:

 

1. Check Your Credit Report For Errors

Reviewing your report for inaccuracies and missing information may be the fastest and easiest way to improve the score. An FTC study reports that 5% of consumers had errors that may carry enough weight to result in getting a lesser favorable loan. One in four consumers had errors in one of three credit reports.

If you find an error, contact each of the credit bureaus (Experian, Equifax, and TransUnion). You will need to give them specific information as to what you believe is incorrect. They must investigate the item(s) you have raised, usually within 30 days. You can do all of this online, but it is a good idea to follow up if you don’t hear back from them.

Fix Errors As Quickly As Possible

Initiate your inquiry as soon as you spot the error by following these steps. The credit bureaus may back burner your issue if they deem it frivolous, so be specific and provide the needed information as part of your inquiry.

Sometimes what appear to be errors are fraudulent charges and scams.

Read our related post: 9 Ways To Better Protect Your Privacy Against Fraud And Scams

2. Pay Bills On Time

The credit bureaus require you to pay the minimum amount required on time. They are looking at your payment history, which counts a lot towards your overall credit score. Missed or late payments are harder to repair and can lead to delinquent payments that take seven years to get rid of on your report.

Automate Payments

Consider automating payments online through your bank portals for credit card companies. Set up online payments with your other loan providers. Stick to a monthly schedule or pay these bills every two weeks to lessen the burden.

If you have missed payments, get current as quickly as possible. Be consistent after that as the creditors look for a clear pattern of timely payments before you see score improvements.

You do not want a collection account to appear on your credit report. Even if you pay that account, it has long-lasting adverse effects. It puts a 7-year stain on your report. Don’t let that be a disincentive from paying off the collection debt as it will stay on longer. You might want to check with the creditor to see if it was “charged off” as lousy debt before making a payment.

Pay Credit Card Balances In Full

Although the strategy of making the minimum payment on your credit balance is good for your score, it will keep you in debt longer. It is far better to pay off your monthly debt balances in full. Otherwise, you are paying those card balances at mid-high teen interest rates.

That makes the credit card companies happy, but, of course, that is not your goal.

3. Reduce Your Debt

The credit utilization ratio is an essential contributor to your overall credit score. Being disciplined about your debt levels is vital for the financial future. This ratio reflects how much of your available credit has been used. Lenders look at debt usage on a per-card basis and total debt relative to total credit available.

Creditors look at a 30% threshold. Ratios above that level may provide negative consequences to your score. Consider targeting a lower percentage in the mid 20’s if you must carry month-to-month balances at all. You may not realize that making sizable purchases such as moving to a new home caused you violated the 30% ratio.

Raising Credit Limits Too Tempting For Some

I have read others recommend that you seek higher limits on your credit cards to lower the ratio. That may work mathematically, but it is too tempting to have more credit available to spend more for some of us. It sort of reminds me of how our elected officials thrash out at each other, then raise our nation’s debt ceiling rather than reducing our borrowings.

Rather than raise limits on your credit cards, make a plan to zero out your debt balances to gain financial flexibility or stop using your cards and spend less.

If you are having trouble making ends meet because of exigent circumstances (e.g., job loss, death in the family), contact your creditors to see if there is something they can do, such as modify your credit terms temporarily. Another recommendation is to go to a financial counselor for some strategies to reduce your debt significantly.

Related Post: How To Pay Down Your Debt For Better Financial Health

4. Little To No Credit History

When you have a relatively “thin credit file,” it means you don’t have much in the way of showing that you are responsible with credit yet. Minimal credit history accounts for about 15% of your credit score. There are a couple of things for you to do.

You can become an authorized user on someone else’s account like a parent. Make sure that they use their credit responsibly, or it won’t be beneficial to you.

Related Post: A Guide To Your Child’s Credit Report: Pros And Cons

Strengthen Your Credit File

You can apply for a secured credit card where approvals are easier to get than unsecured credit cards. Your credit limits will be far lower, usually capped at around $500. You will need to post a refundable deposit as security. Secured credit cards are suitable for those with lousy history and those with little or no track record.

You may want to consider Experian’s recently launched free product, Experian Boost. It allows consumers to include utility and cellphone payments into their credit score calculations using this tool. It may provide an incremental boost for those with thin or poor credit history files. You are connecting your online bank account to your Experian credit report.

5. Don’t Close Any Unused Credit Accounts

If you have credit cards, you no longer use or need it, it is better to cut them up and put those cards in a drawer and forget about them. The exceptions to de-classing them to your sock drawer are you will be too tempted to spend or pay annual fees.

Otherwise, if you call the company to close the account, you will likely lose a few points off your score. Closed accounts, even if they have zero balances, stay on your credit report for ten years.

Keeping the account open and unused benefit your scores at least two ways:

  • your credit utilization ratio will rise because you have removed available credit.
  • Eliminating an account might hurt your credit history if it is an older account.

The impact of closing an unused account may be tougher on young people or someone trying to build up their credit file. I made this rookie mistake by closing a retail store’s account when I was younger. It was an expensive store and not one I found myself shopping at anymore.

I thought I was making a smart move when I closed the account and had my score dinged. I recommend the “scissors approach” and cutting the cards and put it away.

6. Apply For New Credit Sparingly And Only If Needed

Credit mix is a factor in your score, though not as influential as credit utilization. Think carefully before applying for more credit than necessary. It may result in counting as a hard inquiry on your credit report and, therefore, a harmful point reduction in your score.

 

How Long Does It Take To Rebuild Your Credit Card:

 

  • Credit errors or repairs  3-6 months
  • Closing accounts           three months
  • Hard inquiries                two years
  • Missed Payments         18-24 months
  • Car Repossess              seven years
  • Delinquencies                seven years
  • Bankruptcies                  7-10 years

 

Credit Score Ranges Per Experian:

  • 800-850 Exceptional
  • 740-799 Very Good
  • 670-739 Good
  • 580-669 Fair
  • 300-579 Very Poor

 

How Much Of A Difference Does A Credit Score Make On Your Loan?

Using myFICO Loan Savings Calculator,  here are national 30 year fixed mortgage rates with a 400,000 on April 16, 2021, according to the following scores:

Scores      APR                  Monthly Payment

  • 760-850    2.676%                 $1,617
  • 700-759    2.898%                 $1,664
  • 680-699    3.075%                 $1,703
  • 660-679    3.289%                 $1,749
  • 640-659    3.719%                 $1.845
  • 620-639    4.265%                 $1.971

 

If your score is currently at the low end, you can save up to $127,421 in total interest paid over the life of the loan by improving your credit to the 760-850 level. Becoming more creditworthy helps you save money.

 

Final Thoughts

Most of us are in the 620-719 score range. We have several ways we can raise our credit scores incrementally and produce meaningful savings. A better credit score improves our ability to borrow and satisfy those like our landlord who want us to be creditworthy.

We should be more financially responsible by reducing debt, paying our bills on time and zeroing out our costly credit card balances. We need to have greater financial flexibility and make better decisions for our  fulfilling our needs and wants in our lives.

If you are new here, welcome! Subscriber and join our growing community, get our free newsletter, freebies and free Personal finance email course.

Related post: Are You Creditworthy? All About Your Scores And The Five C’s

Have you checked your credit report recently? It is important to review to do so for errors and ways to improve before core ahead of your needs to borrow. Do you have any experience you can share that you dealt with repairing credit errors  or increasing your score?

We would like to hear from you!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

How To Become A Millionaire -16 Dos And Don’ts

How To Become A Millionaire -16 Dos And Don’ts

It’s no longer “Who Wants to Be a Millionaire” but how to become a millionaire. You don’t have to be a contestant on a game show, win the lottery, or receive a windfall from a relative. Just follow the 16 Do’s and Don’t in this article, and you’ll be on the road to becoming a millionaire.

Four Money Mindsets Used by Millionaires

While it might be easy to think that millionaires are just lucky, they think about how their money can work for them, not just how they can work for money.

1. Use Time to Your Advantage

Most people look for concrete paths to becoming a millionaire. But the essential ingredient to becoming a millionaire is intangible. It’s time. The majority of millionaires utilize the compounding nature of time, where growth builds on itself over time.

My favorite imagery to describe compounding is to imagine the growth of a tree. In the first five years of a tree’s life, it will only grow a few feet. Its shrubbery is the size of a basketball. It’s a small, weak plant. In the next five years, will the tree double in size? No! It’s more likely to quadruple (or more) in size. It’s growing in all three dimensions—height, depth, width. It’s not a simple doubling.

We’ve all seen the social media megastar who goes from broke to millionaire in less than ten years. But they are exceptions, not the rule. Most millionaires grow their wealth at a slow pace. Over time, they utilize an explosion of compound growth—like a tree—to become a millionaire.

2. Create Financial Goals

Millionaires develop written financial plans that serve as roadmaps to reach their destination. These plans allow them to make financial decisions based on their goals. A good financial plan means that to reach millionaire status isn’t an if; it’s a when. They know where they are going to get there because their personal finance is all planned out.

If you’re unsure how to create a financial plan, then a certified financial planner (CFP) might be an excellent place to start. They might suggest you start investing or open a Roth IRA retirement account or first fill up your emergency fund. A financial advisor is there to share millionaire wisdom with you.

Becoming a millionaire goes hand-in-hand with retirement planning and retirement savings. For some, reaching the millionaire club will enable their financial freedom or the ability never to work again. Saving money allows a high net worth, and financial independence is the reward.

Big financial success requires big financial goals. A written financial plan sets those goals.

3. Millionaires Increase Earnings

There are a few ways to go about increasing your earnings on your path to becoming a millionaire.

The fact is that most millionaires have a full-time job. And they might work it for a full 40 years. If routine work is how you make money, you could ask for a raise. Easier said than done, sure. But there are sure-fire ways to speak with your management about increasing your base salary. The best part? An increased salary affects your income every year from now until retirement. You aren’t just doing it for your current self, but for your future self too.

You could switch jobs. Self-made millionaire Steve Adcock attributes changing jobs (and getting raises each time) to be one of the critical factors in becoming a millionaire. Steve also focuses on the need to work hard and start investing as early as you can. Or you could find sources of passive income or secure a second job. Surprisingly there are easy ways to generate passive income, tons of side hustles to start, real estate ventures, and other easy ways to earn money and build wealth.

Increased earnings can be invested and grow into future millionaire wealth. A simple rule of thumb is that a dollar invested today will grow into $10 in 30 years. Using this fact, one can quickly see how a few thousand dollars in extra earnings can make significant headway on your path to future millionaire status. The bottom line: increasing your earnings is how to become a millionaire. There’s no “best way” to do this, but it’s critically important to reach your millionaire financial goals.

4. Millionaires Also Decrease Their Spending

Many financial writers point out that the stereotypical “millionaire lifestyle” is antithetical to becoming a millionaire. Why? We think of millionaires as having a big house, a fancy car, the nicest clothes. But if you spend all your money, then you aren’t a millionaire anymore. The truth is that most millionaires find ways to decrease their spending. They don’t buy dumb crap.

This behavior—spend less, save more—is how to become a millionaire. It’s counterintuitive to our traditional thoughts. The people who don’t look like millionaires are the ones who frequently are millionaires. It’s the adage of the “millionaire next door.” The authors of “The Millionaire Next Door,” a worthwhile read, have a target net worth ratio with age added as a factor.

They might drive used or old cars. They wear non-designer clothes. They enjoy low-cost or free activities. They don’t dine out too much. They vacation economically. These are all ways that millionaires decrease their spending without feeling deprived.

There are plenty of counter-examples. We all see millionaires on T.V. who genuinely live the millionaire lifestyle. But for the average reader, the simple path to wealth involves decreasing your spending, not increasing it.

Five Ways to Invest Like a Millionaire

Did you know that millionaires put 44% of their investable assets in stocks? And that 2/3 of millionaires lean on experts by consulting with advisors? Let’s take a look at the most common path to Millionaire Road.

1. Millionaires Do Simple Stock Investing

The stock market is one of the most common methods for people to become millionaires. One investing strategy is simple to describe. Invest a regular percentage of every paycheck into a low-cost index fund. Rinse and repeat for ~35 years. Boom—that’s how to become a millionaire. But let’s take some time to break down those terms and that math.

First, what’s a low-cost index fund? Many people mistakenly believe that successful stock investing involves picking individual winners and losers. But that’s not true, and an index fund helps explain why. An index fund owns every stock in a given stock index. It doesn’t pick winners and losers but buys entire swaths of the market instead.

You’ve heard of some indexes—like the S&P 500 or the Dow Jones. An S&P 500 index fund chooses to own every stock in the S&P 500, regardless of its recent success or failure. Other indexes and index funds are less well-known. For example, some indexes track the energy industry, the automotive industry, or precious metals.

History shows that index fund investing is very successful. One of the key reasons is that index funds charge meager fees. Since there is less expertise required—no “skilled” picking of winners and losers—there is no need to charge high fees.

2. Millionaire Investors Leverage Time

Next, let’s discuss the long-term aspect of stock investing. Many people see the most expensive stocks—like Tesla—and think it’s typical for stocks to grow by 10x in five years. “If only,” they ponder, “I can discover the next Tesla.” Index investing circumvents that wishful thinking. Since brokerages design index funds to be average (they own everything), index funds return average profits.

Over the history of the stock market, that return has been about 10% per year. Once inflation is accounted for, the stock market has a “real return” of about 7% per year. 7% is not a lot until it starts compounding. One year of 7% turns $1000 into $1070. But what do 30 years of compounding do? The average person might think 7% times 30 years equals 210%…turning those $1000 into $1000+$2100 = $3100.

But the truth is that stock market returns compound over time, just like our tree from before! A 7% return compounded over 30 years equates to (1.07)^30 = 761%. Your $1000 investment turns into $8610. But $8610 doesn’t make you a millionaire.

3. Regular Investment, Regular Frequency Is the Path To Millionaire Status

That’s why many experts suggest the average person invest using a regular frequency and a uniform amount. That’s how you reach $1 million net worth. For example, Americans could choose to utilize their 401(k) account. They’d be investing a consistent fraction of their paycheck (uniform amount) each time they are paid (regular frequency). Some people call this “dollar-cost averaging,” although the exact definition of dollar-cost averaging is up for debate.

Let’s look at an example of dollar-cost averaging using a 401(k). Mikey invests $400 out of each of his paychecks. He does this from age 22 until he retires at age 60. Some quick math tells us that Mikey’s contribution is $400 per check * 26 checks per year * 38 years = $395,200. The technical term for this contribution is principal.

But once we account for investing growth (again, using the 7% per year historical average), Mikey ends up with a whopping $2.07 million. Remember, our 7% is the “real return,” meaning that Mikey has $2 million in today’s dollars. He hits 1 million dollars at age 51. That’s the power of consistent stock market investing over decades. In this case, 30 years of simple investing is how to become a millionaire.

4. Millionaires Invest in What They Know

Cryptocurrency has undoubtedly created many millionaires (and even some billionaires). Whereas stocks return an average of 10% per year, Bitcoin has grown by 196% per year since its invention in 2008. Crazy! But your correspondents here suggest the following when it comes to cryptocurrency: invest in what you know.

If you understand how Bitcoin works and feel confident in its long-term growth, then you likely have the constitution to withstand any ups and downs it sees in the future. But if you invest in crypto ignorantly, simply hoping to make a quick buck, then you might be in it for the wrong reasons. If prices dive quickly—which we know can occur—it will scare you into selling after a significant loss.

Investing in stocks—which represent ownership in the companies comprising our economy—is much more tangible for the average investor than the boom in digital currencies.

5. Millionaires Invest in Themselves

While a smaller percentage, another path for millionaires is to “invest in themselves” via starting a business. Most business owners will tell you how this is a high-stress, high-risk, high-reward path.

First, there is stress. Business owners typically work long hours. They often take a little-to-no salary during the early years of the business. Instead, they opt to invest any earning to allow the company to grow. They are responsible to their employees (and those their employees care for) and responsibly for their customers to provide the best service possible. These responsibilities contribute to high stress.

And then there is the risk. Businesses frequently use debt (or borrowed money) to get started. This debt creates financial risk associated with the business failing. Some businesses utilize outside investment capital. In this case, the outside investors trade a share of the risk for a company’s percentage. This trade decreases the business owner’s risk but increases their stress (they now must answer to their investors) and reduces the owner’s reward (they share it with the investors).

After the risk and the stress comes the reward! Perhaps the most satisfying aspect of capitalism is that those who invest their capital (money and time) can later reap huge rewards. Business owners certainly fall into this category. Let’s go over a few quick examples of those rewards.

Bill Gates founded Microsoft with, essentially, zero start-up dollars. The company is worth $1.7 trillion today (though Gates is no longer close to being a majority or plurality shareholder). Elon Musk contributed $6.5 million to Tesla in 2004—yes, he was already a millionaire. But Musk earned his millions from cash-strapped start-ups, most notably PayPal. Jeff Bezos founded Amazon using “a few hundred thousand dollars” as a loan from his parents. The company is now worth $1.5 trillion.

Yes, this data set was cherry-picked in the “worst” way. These are possibly the three most successful entrepreneurs in the past 50 years. But it serves to drive the point home. A business can filter risk and stress to create an asymmetric reward.

Four Personality Traits of a Millionaire

Millionaires and other successful people tend to share similar personality traits. You might already have some guesses as to what those are. Authors Chris Hogan and Tom Corley identified the following characteristics the millionaires share.

1. Millionaires Seek Feedback and Have Mentors

Millionaires don’t exist in a silo. They often seek out external feedback to improve. In particular, millionaires frequently utilize experienced mentorship to help them stay on the path to wealth. Sure, some people strike gold by doing things their own way. But those people are exceptions to the rule.

2. Millionaires Persevere

The road of life is never smooth, whether you’re a millionaire or not. But one character trait that sets successful people apart is their ability to persevere through thick and thin. This perseverance might mean overcoming hardships. It might equate to ignoring critics. They keep pushing on, no matter the obstacle. It’s not guaranteed to make you millions. Plenty of hard-working people don’t end up as millionaires. But it’s even rarer for a lazy quitter to end up a millionaire.

3. Millionaires Are Consistent

Millionaires know that the tortoise beats the hare. Its slow and steady strategy wins the race. In other words, consistency wins in the long run. Consistency can take many forms. It can show up as hard work. It manifests as daily responsibility and intentional thinking. When these behaviors are practice day after week after month after year—consistently—then good results are sure to follow.

4. Millionaires Are Conscientious

Millionaires tend to be responsible and thorough. They follow through. They complete their duties to the best of their abilities. In other words, they are conscientious. Their inner conscience guides them.

Three Things Millionaires Don’t Do

On your journey to becoming a millionaire, it’s important to avoid some behaviors, or you’ll sink your efforts. You’ll be trying to fill your bank account with a leaky bucket. Let’s now discuss the actions that millionaires don’t do.

1.Don’t Accrue Dumb Debt

Debt is a double-edged sword. You can spend more money than you have and achieve wild growth. Or you can stumble into a pit of misery, stuck in debt for decades. Student loans, for example, are one of the most common debt vehicles today. Many current and future millionaires have suffered student debt. Why? Because education kickstarted their growth as nothing else could.

While some student loan debt is dumb, most people find their student loans manageable and worthwhile. Trading education for some debt was a good deal. But credit card debt is rarely worth it. It’s dumb debt. Purchasing consumer products using credit card debt is not a millionaire behavior.

2. Don’t Make Rushed Decisions

Remember when we said that “time is on your side.” That idea applies to more than just long-term investments. Millionaires realize that big decisions require significant time commitments. And how to become a millionaire is a big question to answer! It’s not something to rush.

Millionaires rely on well-researched decisions, rarely succumbing to hasty, irrational choices. What’s one example of a foolish choice? Millionaires don’t follow the crowd. According to author Tom Corely, the millionaires he has interviewed tend to separate themselves from “the crowd.” They don’t make decisions based on popular choices. Why? Because the popular opinion is often wrong!

3. Don’t Be Stagnant

Millionaires seek growth in both their personal and financial lives. They aren’t stagnant. Millionaires are constantly seeking to learn new skills and expand their knowledge set. They don’t settle for the status quo. And in their finances, millionaires understand the balance between risk and reward. They don’t use a savings account other than for their emergency funds.

In general, the most impactful rewards come from the highest risks. But there’s a “risk-adjusted” way to measure those rewards. Millionaires often strike a healthy balance between risk and rewards.

Final Thoughts

Even if (somehow) this advice doesn’t land you in the millionaire club, think of where you’ll end up. You’ll be a reasonably wealthy, high-earning, low-spending, self-invested, self-improving, perseverent, consistent, and conscientious person who avoids debt, doesn’t rush decisions, and never settles.

Not bad, right?

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

Being Frugal When Saving Time And Money

Being Frugal When Saving Time And Money

“Price is what you pay; value is what you get.”

Warren Buffett

I bristled when they called me a cheapskate when I was a young kid. It cast a dark shadow over me. We lived in a modest neighborhood in the Bronx, so it wasn’t like some of us were from the upper class. Still, our lifestyle was far more humble than others. I was laughed at for getting an ice cream without sprinkles or wearing ratty clothes. My parents were more frugal for a good reason. They struggled with their small business and needed to save money for our basic needs. For many people, frugality is a necessity. For others, it may be a choice.

Cheap Vs. Frugal

Nowadays, calling someone frugal is more of a virtue, like giving a badge of honor to that person. Being frugal or cheap is sometimes used interchangeably, but the terms have different meanings. According to Merriam-Webster, frugal is characterized by or reflecting economy in the use of resources. On the other hand, cheap has a range of definitions. Cheap has two or more meanings: charging or obtainable at a low price and inferior quality or worth.

While both terms are about saving money, being cheap is usually motivated by price and paying less. On the other hand, being frugal considers price along with quality and value in evaluating the purchase. There is a gray area but considering if a person is cheap or frugal, you’ll know the difference by their actions or words. Cheap people are penny-pinchers who will mostly pick the lowest price option even if the quality is suspect, regift presents, and are poor tippers. Many will engage in D-I-Y projects like plumbing and electrician work just for the sake of not spending the money.

When Frugality Can Go Too Far

Being overly cheap or extreme frugality without reason and lack of generosity is a symptom of obsessive-compulsive personality disorder (OCPD) by the International OCD Foundation. The American Psychiatric Association has pointed to this symptom as when “a person adopts a miserly spending style toward both self and others.” Growing up, my Uncle Harry lived with us for many years. He was a Holocaust survivor of the death camp Auschwitz. As a teen, he suffered from the camp’s traumatic effects. He lost his family, except for my mom, and married late in life. Unfortunately, he divorced soon after.

It was extreme frugality that killed his marriage. His wife, Doris would come home with a dozen eggs or too many groceries and he would have a breakdown over the potential for wasted food. His psychiatrist noted his anxiety about saving money or extreme frugality was a tragic symptom of his experience.

In contrast to being cheap, frugality is a strategy that saves money and considers the whole picture: quality, durability, value, and price of what you are buying. Those who are frugal are savvy about saving money for themselves and others. They will consider other variables like whether that purchase is good for the environment and other causes.

The Frugal Warren Buffett

Warren Buffett is as legendary for his frugality as he is for his investing acumen. He lives in the same Omaha home since 1958. Buffett frequents McDonald’s and his company’s cafeteria. He is a value-seeker when investing or in his lifestyle. Yet, for all of his frugalness, Warren Buffett has generously donated $37 billion since 2006.  One of my favorite Buffett quotes: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

6 Benefits To Being Frugal  

 

1. Having A Purposeful Mindset

Adopting a frugal mindset means being more thoughtful about your purchase decisions. It is not about having it all but about choosing your purchases carefully for you and your family.  Having a frugal attitude favors good money habits like saving money and better financial management overall. It is not about choosing the lowest price option basing your decision on price alone. Other factors are part of the value proposition.

Frugality is a lifestyle that people adopt for the simple pleasures of life. It is not new. Plato and Henry David Thoreau in Walden advocated modest or minimalist living. It contrasts with societal desires for materialistic possessions which often leads to overspending just to keep up with your peers. Being thrifty has its merits and can lead to sound well-being.

Related Post: 10 Ways To Better Manage Your Spending

2. Motivate Yourself By Knowing Your Goals

It is easier to save or manage money when you have a plan for your future. Determine your short and long-term goals. Those who plan to retire early,  work hard to set aside money for savings, retirement, and investments. Their plan will motivate them to be financially independent and retire early (FIRE). It is not for everyone, but it does give you a chance to develop good money habits for future financial flexibility. By adopting frugal ways to save more, spend less now so you can retire early in life. Spending within your means allows you to choose what you want to do later on at a still young age.

I left my job on Wall Street in 2001, before the FIRE movement became popular in the 2010s. My choice was to go to law school and practice for a few years, have kids, and teach at a college. For me, it has worked out fortunately though it was a big adjustment that could have been smoother. To be honest, I didn’t have a well-developed plan though I did want to return to school because I enjoyed learning new things. Goal setting is essential even if you finetune through the years.

The Frugal Millionaire

In The Millionaire Next Door, a favorite read of mine, millionaires were profiled in two groups. The Under Accumulators of Wealth (UAWs) were the more typical white-collar professional millionaire, devoting more of their high income to luxury goods to maintain their status. As a result, they had lower net wealth compared to their income by neglecting savings and investments.

The Prodigious Accumulator of Wealth (PAWs) were more frugal millionaires. They avoided a showy lifestyle, bought used cars, often living in blue-collar areas. Goal-oriented, they made intelligent buying decisions, using savings to invest more of their money in securities or in businesses for good returns. PAWs spent less on luxury, accumulating higher net wealth relative to income from less.

3. Prioritize Spending To Improve Your Financial Health

Although you don’t want to penny-pinch, prioritize your spending. Frugal spenders tend not to be compulsive shoppers, accumulating lots of material possessions to regret. That doesn’t mean you can’t travel, buy good things, or enjoy your life. Quite the contrary. It is about spending thoughtfully and moderately and not on a whim. Know the difference between your wants and needs or living essentials. Your needs–food, rent, clothes, medical, education– should be a priority. Yes, you can have that latte if it gives you a particular pleasure.

Being frugal means spending below your means so that you can save money to improve your financial health. Those who are frugal tend to:

  • Save money rather than spend;
  • Avoid debt rather than purchase on credit;
  • Pay their credit card balances in full;
  • Have an ample emergency fund invested in a money market deposit account;
  • Contribute at least the minimum amount into your employer-sponsored 401K plan to earn their match; and,
  • Set aside money to build up an investment account.

Related Post: 10 Commandments of Saving Money

4. Price Vs. Value

Buying solely on a price basis without regard to quality is a hallmark of cheapskates. Those who are frugal make economic rather than impulsive decisions. Price is important, but there are other factors to consider. When making purchases, economic people will evaluate the quality, usefulness, reliability, durability, style, convenience, experience, and trustworthiness of the company or the brand. In other words, they will look at the whole picture.

Of course, the price versus value equation depends on the product itself. Frugal shoppers are not going to evaluate many factors for convenience products bought frequently. Price plays a bigger role when buying toothpaste or laundry detergent. For these products and many others, you can save money by buying generic brands at a discount to name brands. The price will be lower for generic brands, as much 35% reductions compared to name brands but the quality is often the same.

Don’t Shop On Price Alone

On the other hand, shopping for appliances, furniture, clothing, and other items less frequently bought quality and other considerations matter. Buying furniture chiefly because it is inexpensive is a recipe for disaster. That is being penny-wise pound foolish. Robert Burton is credited with that British saying in 1621 and is in The Anatomy of Melancholy. I am not sure Burton had our cheap bookcases in mind. However, that is what Craig and I remember saying after we bought cheap bookcases at a “bargain price.” We regretted that purchase made in our early years together almost immediately. The bookcase crashed in the middle of the night. Cheaply made, it didn’t hold up our books for too long.

5. Frugalness Is Good For The Environment

Practicing frugality has become part of the minimalism cult and more acceptable in recent years.  Mindless consumption is being frugal and less wasteful, which is good for the environment. Even if you are not saving money, reusing bags at the grocery store, or not taxing our utilities makes economic and environmental sense. Turn over your lights when leaving your room or home. Wash your clothes on the cold setting and lower or raise your thermostat. You may have personal savings, but you are also helping a cause.

6. Be Frugal About Wasting Time

Time is money. Both are valuable resources, but time is more precious because it is finite. We cannot replenish time. Saving money is necessary, but not when it causes you to waste time. Time is an element that many of us use poorly. Examples of how we splurge on time when trying to save money are:

  • Driving around to get the best gas price;
  • DIY projects when you aren’t handy or don’t even like doing them; and,
  • Grocery shopping at different places to get the best price at each store

Being frugal with our time means being more focused on how we are spending it. To save money, I sometimes over-research things for the best product. Make a “to-do” list to organize your time more meaningfully. Don’t go shopping without a list.

When your time is short, consider spending money on time-saving services. Studies say it can promote happiness when time constraints are stressing you out. On the other hand, Some people work more efficiently under a tight timeframe. I find that I often accomplish more with time constraints which help me to be more focused. Balance your needs of saving money and saving time according to your abilities and preferences.

Related Post: The Relationship Between Time, Money, And Productivity

Final Thoughts

No one wants to be a cheapskate. On the other hand, being frugal is often a virtue that may lead to a happier lifestyle. Just be sure you are not becoming obsessive like my Uncle Harry. Saving time and money are valuable goals that can help to eliminate stress while strengthening your financial health. Maintain a balance to live a life you enjoy. You don’t need to stop pleasures just for the sake of being frugal. Instead, prioritize what is essential for you.

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Ten Commandments of Personal Finance

Ten Commandments of Personal Finance

We revisit ancient views of money on ten central tenets of personal finance from timeworn texts and stories. Surveying these words adds a different perspective on finances whether you are celebrating the upcoming holidays or not. There is a common thread across varying beliefs on handling money, saving, overspending, debt accumulation, and investing.

Ten Commandments of Personal Finance:

 

1. Financial Planning

A financial plan is essential to achieve your short-term and long-term goals. According to Proverbs 21:15, “The plans of the diligent lead to profit as surely haste leads to poverty.”

Understanding your priorities is an essential first step. With hard work, you can accomplish what you want so long as you know your preferences. Our goals are not always clear to us, especially when we are young. “Complete your outdoor work in order and prepare your field; after that, you may build your house.” (Proverbs 24:12).

Making a plan doesn’t happen overnight. Set reasonable priorities incrementally as you engage in deep thought and conversations with your partner. It is often hard to address many features of a sound financial plan on your own. Reduce some of the risks upfront, whether you are investing in stocks or starting a business.

 One of my favorite books, Richest Man In Babylon by George S. Clason provides some guidance. “Gold slippeth away from the man who invest it in businesses or purposes with which he is not familiar or which are not approved by those skilled in its keep.” Avoid recklessness when investing.

Consult A Fiduciary

Consider a financial advisor who as a fiduciary must act in your best interests rather than his or her own. Such an adviser can provide a framework to help you with your goals for retirement saving, investing and estate planning. “For by wise guidance you can wage your war. And in the abundance of counselors there is victory.” (Proverbs 24:6).

2. Saving More, Spending Less

Saving money is an essential financial habit. According to a CareerBuilder report, 78% of American workers were living paycheck-to-paycheck. The report found almost 1 out of 10 workers making $100,000 were having trouble making ends meet. When facing a weak economy, rising job losses cause financial stresses. For those reasons, having an emergency fund is necessary to pay for at least six months of basic living expenses. Having readily accessible funds in liquid funds such as money market securities helps you avoid increasing debt.

Joseph’s Emergency Funds

Emergency funds as a prudent strategy appear in Genesis 41:34-36.

In this passage, Joseph interprets Pharaoh’s dream about seven fat cows grazing by a river swallowed up by seven skinny cows. Joseph views the seven fat cows as seven prosperous years for Egypt, followed by seven famine years. As a result of planning for this disaster, Joseph advises Pharaoh to store grain during the good years for use in more challenging years. Save when you have more for those times you have less due to job loss, illness, or crisis.

Adopting a habit of saving more provides you with more flexibility to allocate into investment and retirement savings. Begin by setting aside small amounts of savings of $1,000 but don’t stop there. Tough times prove that amount is inadequate. Don’t think of these savings as wasteful assets. Instead, it is a means to avoid higher debt levels. As Proverbs 13:11 tells us, “Dishonest money dwindles away, but whoever gathers money little by little make it grow.”

3. Track Your Spending By Budgeting

Spending more than your means is a sour recipe that leads to borrowing more. It is far more profitable to save money and allocate to investments that yield 5% returns or more than having to borrow at mid-teen rates with credit cards to pay for your overspending habits. “Whoever works his land will have plenty of bread, but he who follows worthless pursuits will have plenty of poverty.” (Proverbs 28:19).

Track your spending carefully by budgeting according to your priorities. Bava Metzia 42a instructs us, “A person should always divide his money into three: one-third in the ground (for the future), one-third (invested) in business, and one-third in possession.”

That may be an old way of splitting your funds. There are several ways to budget, such as tracking your expenses, creating a monthly budget, or using the 50/30/20 rule. The latter budget is Elizabeth Warren’s rule of thumb using 50% of aftertax or net income for your needs, 30% of net income for your wants, leaving 20% for saving money and paying the debt. Budget in any reasonable way you can control your spending. Consider these budgeting methods.

Avoid Lifestyle Inflation

Overspending leads to materialism and lifestyle inflation that is hard to maintain. Mishlei Proverbs 13:7 tells us, “There is one who feigns riches but has nothing; one who feigns poverty but has great wealth.”  According to Psalms 128:2, “You shall eat the fruit of your effort–you shall be happy, and it shall be well with you.” This proverb reminds me of another favorite book, “The Millionaire Next Door: The Surprising Secrets of America’s Wealthy by Thomas J. Stanley and William D. Danko.

Stanley and Danko profiled and compared millionaires in two categories: those under accumulators of wealth (UAW) and the prodigious accumulator of wealth (PAW). The UAWs had a low net wealth compared to their high income because of spending to maintain their status. On the other hand, PAWs managed their wealth better, often living in blue-collar neighborhoods and buying used cars. It is an eye-opening account about the good and bad money habits of the wealthy.

4. Manage Your Debt Wisely

The successful millionaires practice budgeting and bargaining. They avoid debt accumulation to lower their risks.  According to Proverbs 22:7, “The rich rule the poor and the borrower is slave to the lender.” Manage your debt wisely. Pay your bills on time and in full. Don’t carry high credit card balances. You need to pay your card balances in full, not merely the minimum, or your debt will be accumulating quickly because of compounding growth.

Managing your debt and developing good credit habits are essential in your financial life. Learn how to avoid common credit mistakes in a recent post here.

Related Post: How To Pay Down Debt For Better Financial Health

5. Retirement Savings

Start saving for retirement in your 20s through your employer’s sponsored 401K plans. Deposits in small amounts in retirement accounts regularly benefit from tax advantages and compound growth over a long horizon. Automate your tax-deferred contributions to come out of your paychecks, and employers often match a portion of your contributions. The match contribution is like extra money you can earn from your employer. Separately, you can establish an IRA (Roth IRA) for further retirement savings. Target your contributions to amounts capped by the IRS for maximum growth for retirement.

One of my favorite quotes in The Richest Man is this: “It behooves a man to make preparation for a suitable income in the days to come when he is no longer young, and to make preparations for his family should he no longer be with them to comfort and support them.” Providing insurance should be arranged for your family to cover potential risks. “We cannot afford to be without adequate protection.”

6. Diversify Investments

Allocate some of your savings into investments. Whether you have a financial adviser to guide you, manage your assets, and diversify to reduce your risks. Don’t put all your eggs in a basket unless you are using Easter eggs for a holiday hunt. Ecclesiastes 11:2 says, “Put your investments in several places-because you never know what kind of bad luck you are going to have in this world.”

The financial markets go through turbulent times. Reducing risk by diversifying your assets into stocks, bonds, real estate (including home ownership), and money market securities is the best way to weather those stormy times. Diversify within each class of investments to avoid the pitfalls. That means having some stocks with growth portfolios and those with healthy dividend yields.

Bull Market To Bear Market In Record Time And Then…

Since the beginning of the pandemic, the stock market has been volatile. We saw severe moves,  going from a bull market to a short bear market. There has been fiscal support, sending out the third stimulus checks and extending federal unemployment. 

The Fed has stimulated the economy with lower interest rates and substantial liquidity. Fears of high inflation are now on the table concerning investors. Stock investing is always challenging to predict. It is even more challenging to time the market.

Stay the course rather than jumping in and out of the market. For long-term stockholders, staying the course rather than panic selling seems to be a better path. A more robust economy will likely fuel corporate earnings growth.

7. Don’t Obsess About Money

Maintain balance in your life without a focus on just wealth accumulation. According to Proverbs 21:20, “Precious treasure and oil are in a wise man’s dwellings, but a foolish man devours it.”  While no one seeks to become poor, there are dangers of solely wanting to be rich. “Keep your lives free from the love of money and be content with what you have.” Hebrews 13:5

Rev. Martin Luther King Jr. worried about the obsession with money in his famous speech called False God of Money. He said, “We attribute to the almighty dollar an omnipotence equal to that of the eternal God of the universe. We are always on the verge of rewriting the Scriptures to read, ‘Seek ye first money and its power and all these things will be added unto you,’ or ‘Money is my light and salvation, what shall I fear.”

King himself lived frugally, leaving little money for his family. However, he saw other goals like working hard, investing in education, and having faith as critical.

8. Add Knowledge And Skills 

Become a lifelong learner adding knowledge and skills. “Wisdom is a shelter as money is shelter but the advantage of knowledge is this: wisdom preserves those who have it.” (Ecclesiastes 7:12). By investing in yourself, whether learning a skill, a language or knowledge, you grow in confidence and are valuable to others. “Lazy hands make for poverty, but diligent hands bring wealth.” Proverbs 10:4

Work hard and persevere in your job, your career, and your profession. As a result of the coronavirus and social distancing, we see many people who do not have the luxury of working from home. I speak of doctors, healthcare workers, grocery store clerks, bus drivers, and untold heroes working hard to save lives or are engaged in essential jobs.

“The Street Sweeper”

Dr. King valued those who worked hard. Another favorite King quote, “If a man is called a street sweeper, he should sweep streets even as a Michaelangelo painted, or Beethoven composed music or Shakespeare wrote poetry. He should sweep streets sp well that all the hosts of heaven and earth will pause to say, ‘Here lived a great street sweeper who did his job well.”

9. Be Ethical

We have a responsibility to be ethical to others. That means not to scam, steal, or be dishonest. Respect others’ property. Wastefulness is shameful according to the Torah and should destroy any useful objects according to Deuteronomy 20-19. Destruction is only forbidden when it is without purpose. For example, only trees that you know do not yield food may be destroyed.   We should not borrow anything without permission. According to Leviticus 5:23, “He must return the stolen article, the withheld funds, the article is left for safekeeping, the found article.”

10. Be Charitable

According to Jewish law, it is forbidden to impoverish one’s wealth by the distribution of all of one’s wealth to charity. However, one can leave one-third of his estate to charity in his or her will. A minimum of one-tenth of one’s income belongs to God per measure handed down from the Patriarchs as Jacob himself said to God, “Of all that You give, I will set aside a tenth to You” (Genesis 28:22). Give 10% of your net income per year as a desirable goal. Those who can, should.

According to HW Charles in The Money Code: Become A Millionaire With The Ancient Code, “Those who love people acquire wealth so they can give generously, after all, money feeds, shelters and clothes people.” We should strive to be as generous as possible to those in need.

Final Thoughts

Ten commandments of personal finance come from timeless scriptures. Sometimes ancient words remind us that money management was always a challenge. That said, you can learn money lessons wherever you look. Choose financial success by your actions in dealing with money. Determine your priorities and set out to accomplish them. The building doesn’t happen overnight. Many have lost jobs and the means to pay bills. It will take time to get back to normal. In the meantime, stay healthy.

Thank you for reading our piece. Please visit The Cents of Money for more articles and consider subscribing to get regular updates.

 

How Do You Measure Your Financial Success?

How Do You Measure Your Financial Success?

 

I wanna be a billionaire so f**king bad

Buy all of the things I never had

Uh, I wanna be on the cover of Forbes magazine

Smiling next to Oprah and the Queen.

Billionaire, Lyrics By Travie McCoy

 

You Don’t Have To Be A Billionaire

You do not have to be a billionaire to consider yourself to be financially successful. If you have a roof over your head, food on your plate, loving family and friends, you are already in a good class. To measure financial success, use specific personal financial ratios and qualitative factors to evaluate your financial health. These benchmarks can help you develop better financial habits in savings, spending, retirement, investing, and debt payoffs.

 Limitations of Financial Metrics

Financial metrics have some limitations. For example, debt-to-income will be different for people of different ages. At 30 years old, when you are at the beginning of your working career, you are accumulating more debt and likely have a low savings amount. However, by age 60-65, as you enter retirement years, the balance shifts to high savings and low-to-zero debt levels. For those who have unpredictable income, ratios may be difficult to assess without normalizing for volatility.

We zero in on a few of the most important financial ratios. For our post on 18 personal financial ratios where we look at the array of money topics, please visit here.

We look at qualitative factors, those you can’t calculate, that can help you measure your financial success.

Having money is not the only factor in our attaining success and happiness, is it? Money isn’t everything

Have An Emergency Fund That Can Absorb A Financial Shock

Having liquidity on hand for emergency purposes provides much-needed peace of mind. Liquidity refers to your ability to easily convert assets into cash with little to no loss of principal. When you are liquid, you have the financial ability to pay for unexpected costs such as a loss of job, death in the family, or your roof is leaking.

According to a recent Charles Schwab survey, only 38% of Americans have an emergency fund, with 59% of American adults live paycheck-to-paycheck. It takes time to stash away money for unforeseen events such as a job loss. However, it should be a priority. Without it, you will have to borrow more.

Liquidity Ratio

Monetary assets are liquid investments. The average household can include cash, money markets, savings, and checking accounts. As such, they should be able to provide liquidity to pay your fixed monthly expenses. 

Liquidity Ratio = Monetary Assets/ Monthly Expenses

Fixed monthly expenses are basic living needs like groceries, rent or mortgage, utilities, and car loan for six months. A  ratio of six means that your monetary assets can pay for your basic needs of food, rent, utilities, and a car loan for the next six months, if necessary.

 Emergency Fund Ratio

The liquidity ratio is linked very closely to the emergency fund. This cushion is essentially a cash fund for emergencies in unforeseen events such as job loss, death in the family, unexpected surgery, or immediate house repair.

An emergency fund ratio works ample enough to support you through these unknowns for a targeted timeframe. If you are looking for six months or higher (and this is highly recommended) to set aside in one fund investing in a high yield savings account or a money market account, then:

Emergency Funds Ratio= 6*Monthly Expenses

This ratio will give you a targeted amount of monetary assets needed to be comfortable for the possible emergency. It takes time to accumulate money for these purposes. How long it will take depends on you and your ability to save.

Related Post: Why You Need An Emergency Fund

Net Worth Is A Key Benchmark

Your net worth, also known as net wealth, is a snapshot of your current financial position. How rich are you? You can calculate net worth as total assets, that is, what you own less total liabilities or what you owe. Hopefully, what you own is more than what you owe. I consider knowing what your net worth is to be an essential personal finance benchmark.

Net Worth Ratio

Net worth is your personal balance sheet measuring your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will be getting wealthier. Another financial measure is your liquid net worth which strips out non-liquid assets.

Net Worth Ratio= Total Assets Less Total Liabilities

Your total assets are what you own at its current market value. Like art and antiques, some assets are more difficult to calculate and may require a professional appraisal. Your total liabilities are what you owe based on your debt obligations, notably the balances on your credit card debt, mortgage, car loan, and any other loans you have. The higher the positive number you have, the better off you are financially.

 

Targeted Net Worth Ratio (The Millionaire Next Door)

One of my favorite personal finance books, The Millionaire Next Door, is an oldie but goodie. I have read it at least twice and refer to it often when teaching my college students about money habits.

The more successful millionaires are the prodigious accumulators of wealth (PAWs). They tend to be less extravagant, as most of us believe of millionaires. Instead, PAWs lived frugally, often buying used cars. As such, they accumulated and retained their wealth.

This ratio uses age as a factor in the calculation, as some other ratios do.

Targeted Net Worth Ratio= Age x (Pretax Income/10)

Your targeted net worth provides you with an indication of what you should be worth after liabilities.  As a 30-year old making $95,000 annually, your net worth should be $285,000. The calculation amount is 30 x (95000/10). It is a guidepost to help you reach your goals.  Although somewhat arbitrary, it gives you some context of what is achievable if your goal is financial flexibility.

These Ratios Consider Our Age

There is a fundamental relationship between our income, debt, and savings. These ratios (savings-to-income, debt-to-income, and savings-rate-to-income) consider our age. We make lower salaries in our early career years when we borrow for a house and a car and make debt payments. Keep your debt burden at manageable levels and save for 401 K retirement and Roth IRA.

Savings-To-Income Ratio

When looking at savings, add your assets, including cash and money markets, the current market value of retirement savings, notably 401K and IRA balances, brokerage investment accounts, real estate investments, and the present value of other business interests.

Don’t include less liquid assets to total savings like art, antiques, your car, or primary home. The monetization of these assets is less predictable in terms of time. It is also harder to peg a reasonable value as they are usually less liquid than securities.

Savings-To-Income Ratio= Market Value of Savings/ Gross Income

Your ratio will be minimal at age 25 or 30, growing to a multiple of 3 or better when you are 45 years, and continue to grow to 10x-15x your pre-retirement income, so you have a comfortable cushion for retirement.

Debt-To-Income Ratio

A better way to look at whether your debt burden is too high is to compare it to your gross income, that is, the amount you make.

Debt-To-Income Ratio = (Annual Debt Repayments/Gross Income) x 100

Typically, when you are age 30, when your salaries are at the low end of your career, you may be borrowing for a home or a car while still paying student loans. Your ratio should be no more than 36% of gross income. This ratio should decline as you command higher salaries and save more.

An alternative way to calculate the Debt-To-Income ratio is looking at your total debt balances compared to your income.

For example, you owe $175,000 on your mortgage and $25,000 on your car loan. Your salary is $110,000, or (175,000 +25,000)/ $110,000 = 1.81. This amount is a fairly normal ratio for a 30-year-old. As your salary rises and you pay off part of your loan, you should be at a ratio of 1 in your 40s. Target little to zero debt as you enter your 60s, so you are debt-free in retirement.

Savings Rate-To-Income Ratio

Savings should be one of the essential parts of your household’s financial goals. Adopt a “Pay Yourself First” attitude. Your monthly budget should call for savings to be at least 10% of gross income.

Savings Ratio = Savings/Gross Income

Savings refer to money in the bank, liquid funds, deposits, money markets, and other liquid funds, such as your emergency fund. Gross income is your total source of income on your budget and includes what you earn, side businesses, bonuses, dividends, and interest income.

Your savings rate should be at least 10% of gross income. Saving is difficult to do when you first start to work. As your salary or what you make rises, it should get easier to put money away for savings. A healthy savings ratio of 20% would be a good target and allow you to put some of this money to pay down debt.

 Personal Cost of Debt

Carrying too much debt relative to income is problematic. This ratio looks at your cost of debt influenced by your credit mix and FICO score.  If you have high monthly credit card balances, then you probably have a high price of debt. Card companies notoriously charge high-interest rates.

Also, your credit score matters. If you have a lower FICO score, that is, below 650, for example, lenders will see you as a risky borrower and charge higher interest rates. Reducing debt will help you to raise your credit score.

Pay Down High-Cost Debt

In debt reduction plans, there are two types: Snowball Method (tackles the smallest debt first) and Avalanche Method (gets rid of the highest cost first). I prefer the Avalanche Method so that you can get rid of the highest cost of debt first. Try eliminating your credit card balances altogether by paying your bills in full.

Related Post: How To Pay Down Your Debt For Better Financial Health

Personal Cost of Debt = (Loan 1/Total Debt)x(Interest Rate for Loan 1) + (Loan 2/Total Debt)x(Interest Rate for Loan 2)

Debt           Debt Amount             Interest Rate %            % of Total Debt              Interest Rate x Weighting

Loan 1           $25,000                          7.0%                            42%                                      2.9%

Loan 2           $35,000                          4.5%                            58%                                      2.6%

Total              $60,000                                                             100%                                      5.5%

Your goal would be to reduce your higher-cost debt, that is, loan 1. You would first target reducing the $25,000 loan outstanding. In considering net worth, you want your assets to be a more significant amount than your liabilities. Your investments should be ideally earning returns above your cost of interest.

For example, stocks generate higher pretax returns of 9% over the long term, or 6%-7% aftertax returns. Therefore, you should look to carry debt at lower costs than stock returns.

This calculation is very similar to how businesses look at borrowing capital for projects. Companies select projects expected to generate returns above their cost of capital. Your household is your business. You want to have higher returns in your investments than your borrowing.

Retirement Savings Ratio

There is a Chinese proverb: “Don’t wait until you’re thirsty to dig a well.” 

Saving for your retirement should begin as early as possible so your nest egg can benefit from compound growth. As soon as you start your first job, you should take advantage of your employer’s sponsored retirement plans, usually a 401K, and begin contributing to your account. Save enough to earn your employer’s matched contribution. Open a Roth IRA plan.

Retirement Savings Ratio = 25 x Primary Income

If you make $100,000, your retirement savings should amount to $2.5 million. This ratio is also called the 25X Rule.

This ratio complements the 4% Withdrawal Rule developed by William Bengen in his study, “Determining Withdrawal Rates Using Historical Data.” The 4% withdrawal rule means that you should be able to live during retirement by withdrawing 4% of $2.5 million in assets, or $100,000.  It is not a coincidence that 25 x 4% equals 100%. The math at least works perfectly.

Bengen was a financial planner from MIT. His study said that if you withdraw 4% of your assets annually (his analysis pegged the number closer to 4.15%), your retirement savings could last 35 years. Use this as a guideline rather than something etched in stone. Whether you can withdraw 3% or something closer to  5% depends on what kind of lifestyle you will have in retirement. 

The 80% Rule

Some experts use the 80% rule as a rule of thumb for estimating what your income at retirement would be. If your final income before your retirement is $100,000 x 80% = $80,000.

This rule means that you should be able to live on $80,000 comfortably in retirement. The assumption is you may be able to eliminate some expenses associated with work, such as work attire, transportation and can take public transit.

If you use this $80,000 amount in conjunction with the 4% withdrawal rule, then $80,000/ 4%= $2 million. This lower amount (than the $2.5 million above) reflects the reduced lifestyle needs of a retired person.

Related Post: Saving For Retirement In Your 20s

Qualitative Measures of Being Financially Successful

Sometimes number crunching is just not enough, especially for measuring your financial success. We embrace our lives differently. Making a million dollars a year may be a bad year for someone used to making eight figures in the past. Others may feel retiring by age 40 is their mark of success. Being a barber at the age of 108 years was a supreme achievement for Anthony Mancinelli.

What are the qualitative ways of being financially successful?

Being Financial Independent

You are having a target of being financially independent. As such, you have enough savings and income to pay for your living expenses without being employed in a job you don’t want to have or be dependent on others.

You may support yourself through alternative sources of income like dividends, passive income, part or full-time work you enjoy. It is an excellent mindset for those with many interests and who don’t want to work if you don’t like non-flexible hours.

Debt-Free And Financially Flexible

You have paid off all your debt. The only obligation you carry is monthly credit card payments, but not if you pay them in full. You have a financially flexible life, meaning you can meet your current and financial obligations and have savings. You are not living paycheck to paycheck. You have liquid savings in the event of an emergency.

Don’t Fight About Money With Your Spouse

You and your spouse are on the same page regarding your financial goals and communicate regularly to stay on track. You agree on the game plan for spending, savings, and debt. Being aligned is an ideal scenario but challenging to achieve regularly. It is up to both spouses to meet periodically to review their budget for the short term and assess long-term goals.

Couples often fight about money issues. It will happen for most of us. Being honest and transparent to each other is what counts. If you veer off track from your goals, review your plan together and make changes if needed. I don’t think shielding the other from potentially bad or embarrassing developments is the right thing to do.

Be open and proactive about financial problems that should be dealt with promptly. Avoid financial fidelity.

Passionate About Your Career Job

It is easier to increase your chances for financial success if you enjoy your job and career. Some people have had success in starting up several successful companies or even starting up one great one after several failures. Apoorva Mehta, the founder of Instacart, the online personal shopper, reportedly had 20 failed startups before he successfully built Instacart.

I have had success in very different career paths. When I worked as an equity analyst, I enjoyed the quick pace and satisfaction of meeting with senior company management and communicating my research with institutional investors. I was passionate about my job. It was an exciting time for the telecom industry as digital Internet technologies created new products and services.

As a professor, I love teaching and the “Aha” moment when students make connections in the classroom. When I feel I’ve made a difference, it is priceless.

Don’t Compare Your Financial Situation To Others

We often compare ourselves to others. It may give a point of reference to our peers, which may not be a complete picture. Obsessing over these comparisons is unproductive and may be stressful.

Social comparison bias is a human reaction. We allow ourselves to be influenced by comparing our financial achievements–income, net worth, status, job title—to others. We negate different paths, personality traits, and the possibility that some inflation has been taking place.

A better comparison is to look at you are currently against the person you were in the past. What have you accomplished relative to what you anticipated in your plans? How do your results fit with your long-term goals? That is a more accurate picture and will allow you to move forward with your next moves.

Enjoy Learning And Picking Up New Skills

To be successful, keep learning from your experiences and pick up new skills. Continue to challenge yourself with strengthening a weakness or adding competence. Continue to evolve in your career, expand your skills, manage people or learn a language. Not only will it keep you from being hampered, but you will also be more valuable at this job or elsewhere.

Final Thoughts

Financial ratios are proper as a starting point to understanding your financial health. They do not take the place of a sound financial plan. Although they have limitations, like age specificity, these metrics can move you to the next goal post. Consider qualitative measures of what being financial success is. What we all want is to be able to say that we had a life well spent.

Thank you for reading! Please find other articles of value on The Cents of Money where you can subscribe for freebies. 

How do you measure your financial success? How does it coincide with your financial goals? Look at your financial plan relative to your goals regularly. What works for you? We would like to hear from you!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

I wanna be a billionaire so f**king bad

Buy all of the things I never had

Uh, I wanna be on the cover of Forbes magazine

SmIiling next to Oprah and the Queen.

Billionaire, Lyrics By Travie McCoy

 

You Don’t Have To Be A Billionaire

You do not have to be a billionaire to consider yourself to be financially successful. If you have a roof over your head, food on your plate, loving family and friends you are already in a fortunate class. Certain personal financial ratios may help you to evaluate your financial health. These quantifiable benchmarks can help you to develop better financial habits in savings, spending, retirement, investing and debt payoffs.

Financial metrics have some limitations. For example, debt-to-income  will be different for people of different ages. At 30 years old when you are at the beginning of your working career, you are accumulating more debt and likely have low savings amount. However, by age 60-65, as you enter retirement years, the balance shifts to high savings and low-to-zero debt levels. For those who have unpredictable income, ratios may be difficult to assess without normalizing for volatility.

We zero in on a few of the most important financial ratios. For our post on 18 personal financial  ratios where we look at array of money topics, go here.

There are qualitative factors, those you can’t calculate, that can help you measure your financial success.

Having money is not the only factor in our attaining success and happiness, is it?

Have An Emergency Fund That Can Absorb A Financial Shock

Having liquidity on hand for emergency purposes provides much needed peace of mind. Liquidity refers to your ability to easily convert assets into cash with little to no loss of principal. When you are liquid, you have the financial ability to pay for unexpected costs such as a loss of job, death in the family, or your roof is leaking.

Only 38% of Americans have an emergency fund, with 59% of American adults live paycheck-to-paycheck according to a recent Charles Schwab survey. It takes time to stash away money for unforeseen events such as a job loss. However, it should be a priority. Without it, you will be forced into borrowing.

Liquidity Ratio

Monetary assets are among the most liquid of assets. These assets includes cash, cash-equivalent securities or money markets, savings bonds, savings and checking accounts. Liquid assets can be used to support your fixed monthly expenses for 3-6 months. The larger the amount the more comfortable you will feel.

Liquidity Ratio = Monetary Assets/ Monthly Expenses

Your monetary assets should support your fixed monthly expenses such as groceries, rent or mortgage, utilities and car loan for 6 months. A  ratio of 6 means that your monetary assets can pay for your basic needs of food, rent, utilities and car loan for the next 6 months, if necessary.

 Emergency Fund Ratio

The liquidity ratio is linked very closely to the emergency fund. This is essentially a cash fund for emergencies in unforeseen events such as job loss, death in family, unexpected surgery or immediate house repair.

Emergency fund ratio works by using a targeted number of months that you believe is ample enough to support you through these unknowns. If you are looking for 6 months or higher (and this is highly recommended) to set aside in one fund that can be invested in a high yield savings account or in money markets, then:

Emergency Funds Ratio= 6*Monthly Expenses

This ratio will give you a targeted amount of monetary assets needed to be comfortable for the possible emergency. It takes time to accumulate money for these purposes. How long will it take depends on you and your ability to save.

Related Post: Why You Need An Emergency Fund

Net Worth Is A Key Benchmark

Your net worth, also known as net wealth, is a snapshot of your current financial position. How rich are you? It is calculated using total assets, that is, what you own less total liabilities, or what you owe. Hopefully, what you own is in excess of what you owe. I consider knowing what your net worth is to be an essential personal finance benchmark.

Net Worth Ratio

This is your personal balance sheet measuring your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will be getting wealthier. Calculating a net worth statement and updating it is important to do regularly.

Net Worth Ratio= Total Assets Less Total Liabilities

Your total assets are what you own at its current market value. Some assets, like art and antiques, are more difficult to calculate and may require a professional appraisal. Your total liabilities are what you owe based on your debt obligations, notably the balances on your credit card debt, mortgage, car loan and any other loans you have. The higher the positive number you have, the better off you are financially.

 

Targeted Net Worth Ratio (The Millionaire Next Door)

One of my favorite personal finance books, The Millionaire Next Door, is an oldie but goodie. I have read it at least twice and refer to it often when teaching my college students about money habits.

The more successful millionaires are profiled as prodigious accumulators of wealth (PAWs). They tended to not be extravagant or status seekers as commonly believed of millionaires. Instead, PAWs lived frugally, often buying used cars. As such, they accumulated and retained their wealth.

This ratio uses age as a factor in the calculation as some other ratios do.

Targeted Net Worth Ratio= Age x (Pretax Income/10)

Your targeted net worth provides you with an indication of what you should be worth after liabilities.  As a 30 year old making $95,000 annually, your net worth should be $285,000. That amount is derived as 30 x (95000/10). It is a guidepost to help you reach your goals.  Although somewhat arbitrary, it gives you some context of what could be achievable if your goal is financial flexibility.

These Ratios Are Linked To Our Age

There is a fundamental relationship between our income, debt and savings. These ratios (savings-to-income, debt-to-income and savings-rate-to-income)  are closely linked to our age. In our early career years, we make lower salaries, borrow for a house and a car and make debt payments. Keep your debt burden at a manageable levels and save for 401 K retirement and Roth IRA.

Savings-To-Income Ratio

When looking at savings, add your assets including cash and cash-equivalents, current market value of retirement savings, notably 401K and IRA balances, brokerage investment accounts, real estate investments, and current value of other business interests.

Your art, antiques, your car or primary home should not be included in the total for savings. Monetization of these assets are less predictable in terms of time. It is also harder to peg a reasonable value as they are usually less liquid than securities.

Savings-To-Income Ratio= Market Value of Savings/ Gross Income

At age 25 or 30, your ratio will be minimal, growing to a multiple of 3 or better when you are 45 years, and continue to grow to 10x-15x your pre-retirement income so you have a comfortable cushion for retirement.

Debt-To-Income Ratio

A better way to look at whether your debt burden is too high is compare it to your gross income, that is, the amount you make.

Debt-To-Income Ratio = (Annual Debt Repayments/Gross Income) x 100

Typically, when you are age 30, when your salaries are at the low end of your career, you may be borrowing for a home and/or a car while still paying student loans. Your ratio should be no more than 36% of gross income. This ratio should decline as you command higher salaries and save more.

An alternative way to calculate Debt-To-Income ratio is looking at your total debt balances compared to your income.

For example, you owe $175,000 on your mortgage and $25,000 on your car loan. Your salary is $110,000, or (175,000 +25,000)/ $110,000 = 1.81. This is a fairly normal ratio for a 30 year old. As your salary rises and you pay off part or your loan, you should be at a ratio of 1 in your 40s. Target little to zero debt as you enter your 60s so you are debt free in retirement.

Savings Rate-To-Income Ratio

Savings should be one of the most important parts of your household’s financial goals. Adopt a “Pay Yourself First” attitude. Your monthly budget should call for savings to be at least 10% of gross income.

Savings Ratio = Savings/Gross Income

Savings refer to money in the bank, liquid funds, deposits, money markets and other liquid funds, such as your emergency fund. Gross income is your total source of income on your budget, and includes what you earn, side businesses, bonuses, dividends and interest income.

Your savings rate should be at least 10% of gross income. This is difficult to do when you first start to work. As your salary or what you make rises, it should get easier to put money away for savings. A healthy savings ratio of 20% would be a good target and allow you to put some of this money to pay down debt.

 Personal Cost of Debt

Carrying too much debt relative to income is problematic. This ratio looks at your cost of debt influenced by your credit mix and FICO score.  If you have high monthly credit card balances, then you probably have high cost of debt. Card companies notoriously charge high interest rates.

Also, your credit score matters. If you have a lower FICO score, that is, below 650 for example, lenders will see you as a risky borrower and charge  higher interest rates. Reducing debt will help you to raise your credit score.

Pay Down High Cost Debt

In debt reduction plans, there are two types: Snowball Method (tackles the smallest debt first) and Avalanche Method (gets rid of the highest cost first). I prefer the Avalanche Method so that you can get rid of the highest cost of debt first. Try eliminating your credit card balances altogether by paying your bills in full.

Related Post: How To Pay Down Your Debt For Better Financial Health

Personal Cost of Debt = (Loan 1/Total Debt)x(Interest Rate for Loan 1) + (Loan 2/Total Debt)x(Interest Rate for Loan 2)

Debt           Debt Amount             Interest Rate %            % of Total Debt              Interest Rate x Weighting

Loan 1           $25,000                          7.0%                            42%                                      2.9%

Loan 2           $35,000                          4.5%                            58%                                      2.6%

Total              $60,000                                                             100%                                      5.5%

Your goal would be to reduce your higher cost debt, that is, loan 1. You would first target reducing the $25,000 loan outstanding. In considering net worth, you want your assets to be a larger amount than your liabilities. Your investments should be ideally earning returns above your cost of interest.

For example, stocks generate higher pretax returns of 9% over the long term, or 6%-7% aftertax returns. You therefore should look to carry debt at lower costs than stock returns.

This is very similar to how businesses look at borrowing capital for projects. They will pick plans that are expected to generate returns above their cost of capital. Your household is your business. You want to have higher returns in your investments than your borrowing.

Retirement Savings Ratio

There is a Chinese proverb: “Don’t wait until you’re thirsty to dig a well.” 

Saving for your retirement should begin as early as possible so your nest egg can benefit from compound growth. As soon as you start your first job, you should take advantage of your employer’s sponsored retirement plans, usually a 401K, and begin contributing to your account. Save enough to earn your employer’s matched contribution. Open a Roth IRA plan.

Retirement Savings Ratio = 25 x Primary Income

If you make $100,000, your retirement savings should amount to $2.5 million. This ratio is also called the 25X Rule.

This ratio is complementary to the 4% Withdrawal Rule developed by William Bengen in his study, “Determining Withdrawal Rates Using Historical Data.” This means that you should be able to live during retirement by withdrawing 4% of $2.5 million in assets, or $100,000.  It is not a coincidence that 25 x 4% equals 100%. The math at least works perfectly.

Bengen was a financial planner from MIT. His study said that if you withdraw 4% of your assets annually (his analysis pegged the number closer to 4.15%) your retirement savings could last 35 years. Use this as a guideline rather than something etched in stone. You need to figure out what kind of lifestyle you will have in retirement.

The 80% Rule

Some experts use the 80% rule as a rule of thumb for estimating what your income at retirement would be. If your final income before your retirement is $100,000 x 80% = $80,000.

This means that you should be able to live on $80,000 comfortably in retirement. The assumption is you may be able to eliminate some expenses associated with work such transportation and can take public transit.

If you use this $80,000 amount in conjunction with the 4% withdrawal rule, then $80,000/ 4%= $2 million. This lower amount (than the $2.5 million above) reflects the reduced lifestyle needs of a retired person.

Related Post: Saving For Retirement In Your 20s

Qualitative Measures of Being Financially Successful

Sometimes number crunching is just not enough especially for measuring your financial success. We embrace our lives differently. Making a million dollars a year may be a bad year for someone used to making eight figures in the past. Others may feel retiring by age 40 is their mark of success. Being a barber at the age of 108 years was a supreme achievement for Anthony Mancinelli.

What are the qualitative ways of being financially successful?

Being Financial Independent

Having a target of being financial independent means that you have enough savings and income to pay for your living expenses without being employed in a job you don’t want to have or be dependent on others.

You may support yourself through alternative sources of income like dividends, passive income and part or full time work you enjoy. It is a great mindset for those with many interests and don’t want to be tied down to a job you don’t like or non-flexible hours.

Debt-Free And Financially Flexible

You have paid off all your debt. The only debt you carry are monthly credit card payments and are able pay them in full. You have a financially flexible life, meaning you can meet your current and financial obligations and have savings. You are not living paycheck to paycheck. You have liquid savings in the event of an emergency.

Don’t Fight About Money With Your Spouse

You and your spouse are on the same page regarding your financial goals and communicate regularly to stay on track. You have a game plan for spending, savings and debt and are aligned for the most part. This is an ideal scenario and difficult to achieve regularly. It is up to both spouses to meet regularly to review their budget for the short term and assess long term goals.

Couples often fight about money issues. It will happen for most of us. Being honest and transparent to each other is really what counts. If you veer offtrack from your goals, review your plan together and make changes if needed. Don’t think shielding the other from potentially bad or embarrassing developments is the right thing to do.

Be open and proactive about financial problems that should be dealt with promptly. Avoid financial fidelity.

Passionate About Your Career Job

It is easier to increase your chances for financial success if you enjoy your job and career. Some people have had success in starting up several successful companies, or even starting up one great one after several failures. Apoorva Mehta, the founder of Instacart, the online personal shopper, reportedly  had 20 failed startups before he successful built Instacart.

I have had success in very different career paths. When I was worked as an equity analyst, I enjoyed the quick pace and satisfaction of meeting with senior company management and communicating my research with institutional investors. I was passionate about my job. It was an exciting time for the telecom industry as digital Internet technologies created new products and services.

Now, as a professor, I love teaching and the “Aha” moment when students make connections in the classroom. When I feel I’ve made a difference, it is priceless.

Don’t Compare Your Financial Situation To Others

We often compare ourselves to others. It may give a point of reference to our peers which may not be a very complete picture. Obsessing over these comparisons is unproductive and may be stressful.

Social comparison bias is a human reaction. We allow ourselves to be influenced by comparing our financial achievements–income, net worth, our status, job title—to others. We negate different paths, personality traits and possibility that some inflation has been taking place.

A better comparison is to look at you are currently against the person you were in the past. What have you accomplished relative to what you anticipated in your plans? How do your results fit with your long term goals? That is a truer picture and will allow you to move forward with your next moves.

Enjoy Learning And Picking Up New Skills

To be successful, keep learning from your experiences and pick up new skills. Continue to challenge yourself with strengthening a weakness or adding a competence. Continue to evolve in your career, expand your skills, to manage people or learn a language. Not only will it keep you from being stymied, you will be more valuable at this job or elsewhere.

Final Words

Financial ratios are useful as a starting point to understanding your financial health. They do not take the place of a good financial plan. Although they have limitations, like age specificity, these metrics can move you to the next goal post. Consider qualitative measures of what being financial success is. what we all want is to be able to say that we had a life well spent.

How do you measure your financial success? How does it coincide with your financial goals? Look at your financial plan relative to your goals regularly. What works for you? We would like to hear from you!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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