18 Personal Finance Ratios You Should Know

18 Personal Finance Ratios You Should Know

Financial statements, specifically net worth and the monthly budget, use your financial data to describe an individual’s or household’s financial condition. We use that data to calculate personal finance ratios as tools designed to evaluate your financial strength and position.

 Benchmarks can help you develop better financial habits in these areas: savings, retirement, spending, investing, debt accumulation, and reduction. These ratios can be easily calculated and give you a better sense of your true financial health and progress relative to your goals.

Net Worth And Budget Are Key Tools

Your net worth statement and monthly budget statement are the essential financial statements to create and update. As such, they hold the key to your current financial life. Net worth is a snapshot of your financial condition. To calculate net worth, use total assets or what you own less total liabilities, or what you owe. Hopefully, what you own is more than what you owe.

Your monthly budget is your income statement—total income sources less total expenses (fixed and variable expenses). If your income exceeds your costs, you have money to save. Add this money to your emergency fund, pay down debt, and invest for the future. When your expenses exceed your income, you will need to earn more income, borrow to pay costs, reduce spending, or combine these.

Related Posts:

10 Reasons Why You Should know Your Net Worth

How To Control Spending With A Simple Budget

Liquid Net Worth As A More Realistic View

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

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

Financial Advisor Will Help You With Your Plan

Bring your financial statements when you go to a financial advisor. They will review your information and prepare personal finance ratios. Once you can calculate these metrics, you can better assess where you stand financially now and over your life cycle.

However, you don’t need a professional. On the contrary, providing these statements and reviewing your financial ratios will go far to developing your financial plan. Your advisor can better help you meet your financial goals.

Related Post: How To Choose A Financial Advisor

 18 Personal Finance Ratios:


1. Liquidity Ratio

Liquidity refers to your ability to quickly 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 a job, death in the family, or your roof is leaking.

Monetary assets are the most liquid assets. These assets include cash, cash-equivalent securities or money markets, savings bonds, savings, and checking accounts. Use your liquid assets to support your fixed monthly expenses for 6 months.

Liquidity Ratio= Monetary Assets/ Monthly Expenses

Your monetary assets should support your fixed monthly expenses such as groceries, rent or mortgage, utilities, and a car loan for six months. A six ratio 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.

2. Emergency Fund Ratio

The liquidity ratio is linked very near to the emergency funds. This cushion for emergencies should be used for unforeseen events. Such events may mean job loss, family death, unexpected surgery, or immediate house repair. The emergency fund ratio works by using a targeted number of months that you believe is ample enough to support you through emergencies. If you are looking for six months or higher (and this is highly recommended at a minimum) to set aside in one fund that can be invested in a high yield savings account or 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 a possible emergency.

Related Post: Why You Need An Emergency Fund

3. Net Worth Ratio

Your balance statement measures your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will be getting wealthier.

Net Worth Ratio= Total Assets Less Total Liabilities

As discussed earlier, your total assets are what you own at its current market value. 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.

4. 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 when teaching my college students about overspending—the book advocates saving and investing money. The high savers do a better job of maintaining and building your wealth. They use 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 calculate is 30 x (95000/10). This guidepost can help you reach your goals, particularly financial security.

5. The Current Ratio

Several ratios may seem familiar to you. The current ratio is a common one when analyzing the strength of a company’s balance sheet and its ability to meet its short term obligations. A current personal ratio is essentially the same.

It measures the household’s ability to repay a short-term debt in an emergency. The calculation matches short-term monetary (i.e., liquid assets) assets to short-term liabilities. The current ratio is the best benchmark to determine liquidity in your household. 

Current Ratio = Short term Cash Assets/ Short Term Liabilities

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

6. Debt-to-Asset Ratio

The Debt-to-asset ratio is a standard ratio for companies. Industrial firms tend to be more accustomed to higher debt levels because they are capital intensive. Individuals should not have high debt levels. This ratio focuses on the borrowing ability of the individual or household.

Total Debt-to-Asset Ratio= Total Liabilities/Total Assets

If you have a high debt-to-asset ratio, you should reduce your debt. It is essential to lower your overall costs for maximum financial flexibility long term. Certain loans are common to most of us. Total liabilities may include balances on the student loan, mortgage, car loan, and credit card debt.

Your liabilities should not go over 50% of your total assets. A 10% ratio or as little debt as possible is a great goal. Avoid high debt, or consider a debt reduction plan.

7. 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 in your 20s-30s, 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 and decline as you command higher salaries.

8. Debt-To-Disposable Income

It is worthwhile to look at monthly non-mortgage debt relative to monthly disposable income. Monthly disposable income is net of costs and taxes; and what is available for paying down debt, saving, and spending by the household.

Debt-To-Disposable Income = monthly non-mortgage debt payments/ monthly disposable income

The percentage should be 14% or lower. 15% or more is problematic and may reflect a household carrying too much debt.

9. 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 pay a high-interest rate on that debt. Card companies notoriously charge high-interest rates.

Also, your credit score matters. If you have a lower FICO score below 650, lenders will see you as a risky borrower and charge higher interest rates.

Pay Down High-Cost Debt

There are two types of debt reduction plans: 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 interest cost of debt first. Try eliminating your credit card balances 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 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. Therefore, you should look to carry debt at lower costs than stock returns.

 Businesses look at borrowing capital for projects. They seek projects that can generate returns above their cost of capital. Your household is your business. Similarly, you want to earn higher returns in your investments than your borrowing.

10. Solvency Ratio

Could you pay all of your debt using existing assets if you had to due to unforeseen events? This ratio helps you to determine if you are able to take care of your obligations.

Solvency Ratio = Net Worth/ Total Assets

Net worth equals total assets, less total liabilities. The solvency ratio indicates the individual’s ability to repay all the existing debt with the assets. We add debt to acquire assets that we hope will be worth more than the debt. The higher the ratio, the better your financial condition.

11. Investment Assets-To-Total Assets Ratio

The more you save and invest, the better your road to being wealthy. This metric shows you how well you are doing in accomplishing your financial goals.

Investment Assets-To-Total Assets Ratio= Investment Assets/Total Assets

Throughout your life, you want to accumulate investment assets. These assets include stocks, bonds, money markets, mutual funds, and retirement accounts. Using the power of compound growth, they should expand in your 20’s and beyond. Target a ten ratio when you are in your 20s. As you age,  your investment assets should expand, pushing your percentage higher.

12. Savings Ratio

Savings should be one of the most critical 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. That should be just a start.

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 income source 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. Savings may be challenging to do when you first start to work. As your salary or what you make rises, it should get more comfortable to put money away for savings. A healthy savings ratio of 20% would be a bonus (pardon the pun).

13. 50-20-30 Budget Ratio

Harvard Professor, now Senator Elizabeth Warren is known as a bankruptcy expert. Warren popularized this ratio in her book written with her daughter in 2005, “All Your Worth: The Ultimate Lifetime Money Plan.” 

Essentially, you are allocating your aftertax income into three budget buckets:

  • 50% of your spending is for your needs, notably housing, utilities, groceries, car payments, and other needed fixed expenses.
  • 20% of your budget is saved and can pay down debt, emergency fund, and investing or combination.
  • 30% are for your wants: discretionary or flexible spending for entertainment, vacations, and shopping. After your priorities, the remaining amount is for your desires.

Start Budgeting Early

Budgeting is tricky when you are younger and just starting in your life. You may be carrying student debt and renting an apartment while your salary is at the beginner’s level. On the other hand, you have fewer costs to monitor, so make it a good lifelong habit. Use it as a motivational tool to save more and spend less. Be diligent in improving your money management skills. 

Related Post: 10 Ways To Better Manage Your Spending

14. Mortgage Ratio

This ratio is a standard metric you will encounter when you get a loan to pay for your home. Borrowing for your home is usually the most considerable amount of your total debt. Your home may be an appreciable asset. As such, it is often referred to as “good debt” versus other kinds of debt, especially credit cards, which are more expensive and harmful debt.

When you buy a home, buyers usually put down 20% and borrow 80% of the home price you negotiated. A fixed 15-year or 30-year mortgage will determine your monthly payments. A shorter mortgage is desirable if you are willing and able to pay higher monthly payments. You will be paying lower interest costs over the loan’s life overall than the 30-year mortgage.

Mortgage Ratio = 2.5 x Primary Income= Mortgage Payment

If you make $120,000 annually (reasonable if you are dual earners), you should not borrow more than $300,000 for a house priced at $375,000. Calculating total home loan is based on $300,000/.80 (or borrowing 80% of the price). Some buyers like to put down more money, say 30%, to drop the amount you need to borrow.

Related post: 7 Steps To Buying A Home

15. Total Debt Service Ratio (aka Front End Ratio)

This ratio is what lenders crunch when looking at how capable you are in servicing your housing debt.

Total Debt Service Ratio = Monthly housing costs/ Gross monthly income

The housing costs are primarily your mortgage costs and property costs. Lenders look at a 28% ratio as desirable, with anything over 36% being excessive. This ratio is sometimes called the 28/36 rule.

16. Life Insurance Ratio

The life insurance ratio is simple, but this benchmark should be a starting point. Life insurance is essential for families, particularly with children. Single people should consider a policy as well, but their needs may be different. Insurance sales folks will use this ratio to start a discussion on your circumstances.

Life Insurance Ratio = 10 x Primary income

If you make $100,000 a year, the ratio indicates that you get a $1,000,000 policy. Consider what your family needs to protect with the life insurance policy. The amount of your policy needs to cover your household’s fixed expenses and your children’s needs, including college costs.

A single person buying a $1,000,000 policy may be excessive. However, if your household has three young children with only one spouse working, that amount may not fully cover your family adequately.

Related Post: A Beginner’s Guide To Insurance

17. Investing Ratio

This ratio guides you to the stock asset allocation in your investment portfolio. Generally, the younger you are, the more you can tolerate risk as opposed to someone approaching retirement. Age plays a big factor in this ratio.

Investing Ratio = 120 – Age

If you are 25 years old, then 120 less 25, your portfolio could allocate 95% stocks/ 5% bonds. Stocks carry higher risk producing higher returns than bonds. As you age, your risk tolerance goes down with lesser years to accumulate growth in your portfolio. A 50-year-old should be moving their allocation to 70% stocks/30% bonds. For many closing in on retirement, a 50%/50% or less is appropriate.

The ratio is a gauge for asset allocation in your portfolio. Take your circumstances and risk appetite into consideration.

Related Post: 10 Tips To Diversify Your Investment Portfolio

18. 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. Others have said 4% was too conservative and a better withdrawal rate is closer to 3%.

The point of this ratio is to use it as a guideline rather than something etched in stone. You need to figure out what kind of lifestyle you will have in retirement. 

Related Post: Saving For Retirement In Your 20s

Final Thoughts

These financial ratios are useful as a starting point to understanding your financial health. They do not take the place of a sound financial plan. Gathering your financial data to develop a net worth statement and a monthly budget plan is essential. It may help you identify the risks you have when carrying too much high-cost debt. If so, change your spending and reduce credit card debt. Get in financial shape!

Use the ratios to see where you stand relative to your financial goals and make changes to how you save, spend, borrow, and invest.

Thank you for reading!

Let us know what ratios you find most useful. Do you know of a ratio we missed and should include? Please let us. We would like to hear from you.

What Is A Current Ratio And Why Does It Matters

What Is A Current Ratio And Why Does It Matters

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

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

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

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

Personal Net Worth As A Key Benchmark

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

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

Liquid Net Worth As A More Realistic View

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

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

What Is The Current Ratio?

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

Who Evaluates Your Current Ratio

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

Our Focus

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

The Current Ratio Definition

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

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

Not All Assets Are Equal

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

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

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

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

Current Assets In The Household Balance Sheet

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

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

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

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

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

Use Caution When Determining Your Current Assets

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

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

Don’t Count On Retirement Or College Savings

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

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

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

Current Liabilities In The Household Balance Sheet

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

Outstanding credit card balances of $6,000

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

Auto loans or leases due $5,400

Student loans $4,500

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

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

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

Any other short term loans coming due.

Total Current Liabilities $28,900

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

What A Current Ratio Reveals

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

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

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

Limitations Of The Current Ratio

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

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

Strategies To Increase Your Current Ratio And Overall Financial Position

Spend Less

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

Track Your Spending

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

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

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

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

Boost Income

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

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

Allocate Some Savings To Investments

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

Manage Your Debt Properly

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

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

Final Thoughts

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

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














































10 Tips To Diversify Your Investment Portfolio

10 Tips To Diversify Your Investment Portfolio

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”  Robert G. Allen

When you have some savings, it is good to invest and allocate your money to work.

Keeping too much of your money in your checking account is too tempting to spend and counterproductive.

The best time to begin investing is now—the earlier in your life, the better your wealth accumulation.

As you grow your savings, you want to consider your investment goals, risk tolerance, time horizon, and where to invest.

Investment Goals

How to invest and allocate may differ on a range of factors. You may adopt different strategies based on age, income, family responsibilities, lifestyle, financial resources, risk tolerance, and desires. 

 You are diversifying your portfolio by considering various asset classes: stocks, bonds, money markets, and real estate. We have some guidance for new and experienced investors: Investing Rules For Success-It’s Not Rocket Science!

At different points in your life, your priorities may be to realize one or more of the following objectives:

  • Buy your own home, finance your children’s education, take vacations, buy a car, or start a business.
  • Gain wealth and financial freedom.
  • Increase your current income or add some financial flexibility.
  • Meet your retirement needs.
  • Preserve your capital.
  • Set risk tolerance

There are degrees of risks for all types of investments. The exception is when you keep all your money in savings accounts in the bank where they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per person and per bank account. However, you will earn little to no money.

Risk and reward, sometimes referred to as your return, are positively correlated. The risk/return relationship means that higher returns come with greater risk, while low-return investments come with low risk.

Investment Horizon

If your time frame is short given your age or needs, you may want to opt for low-risk securities versus someone who can invest for a 20-30 year horizon. They can better absorb risk and volatility.

 10 Tips For Diversifying Your Investment Portfolio:

#1 Asset Allocation

You should distribute your money among different assets based on your age and lifestyle. You can afford more risk in your portfolio at a younger age and be aggressive with more growth, such as stocks, than someone closer to retirement age. A good rule of thumb for allocation is to subtract your age from 100, and that would be the percentage of stocks in your portfolio.

For example, a 30-year-old could keep 70% in stocks (100-30) in the portfolio with 30% in bonds. On the other hand, a 60-year-old should reduce risk exposure and have 40% in stocks and 60% in bonds.

#2 Diversification Is A Must

Don’t put all of your eggs in one basket. Instead, you should be distributing your money among various classes of securities using an appropriate allocation. You should diversify within each security class. Investing in 10 energy stocks is not diverse. Branch out into multiple industries with different characteristics (e.g., high growth and strong dividend history).

# 3 Growth Stocks

Stocks provide more growth, appreciating faster than other financial instruments over the longer term. However, the stock market can be volatile, as witnessed by the 57% decline during the Great Recession. It is a good idea to buy mutual funds or ETFs when you are first investing to achieve a diverse stock portfolio.

#4 Money Market Securities for Cash

Investors can easily convert money market securities into cash without loss of value. They are low risk/ low return instruments with liquidity, stability and provide access to money. The Treasury bills rated AAA are the closest to risk-free securities. They can be bought individually or as part of a MM mutual fund, including other short-term securities.

While these securities are known for safety, they do not provide much income. The Fed has battled the COVID-impacted recession in 2020.  They reduced the fed funds rate to virtually zero and used aggressive measures. As a result, its needed actions have extended the low yield environment, challenging investors to find income from low-risk securities.

#5 Bonds With Different Characteristics

Investing in bonds is desirable for more predictable income streams. It is desirable to invest in various bonds: treasury bonds, municipal bonds, and corporate bonds. These all differ in terms of credit risk, liquidity, and tax benefits.

#6 Buy-Hold Strategy and Don’t Be Greedy

It is a prudent idea when building an investment portfolio to use a buy-hold strategy rather than trading securities. That said, don’t be afraid to pare down a holding that has appreciated too fast or begins to occupy a more significant proportion than you prefer. An old Wall Street saying is: “Bulls make money, bears make money, pigs get slaughtered.” I mean, don’t be greedy.

# 7 Understand factors that impact the financial markets

You should know the role of interest rates, their connection to inflation, and how the Federal Reserve’s monetary policy can significantly impact the financial markets. To calm the markets, the Fed stepped in with substantial liquidity to combat the economic downturn caused by the pandemic in 2020. The Fed reduced already low-interest rates, making it hard to find income for savers and risk-averse investors.

#8 Have Some Exposure to Global Markets

Investors seek potentially higher returns and exposure to faster-growing global markets, especially when the US markets are experiencing weakness. The best way to do that is to find an ETF or mutual fund representing the exposure you want.

# 9 Start Early To Benefit From Compound Interest

The earlier you begin to save and invest for retirement and investment accounts, the longer the time to take advantage of the power of compound interest.  Start in your 20s. Find a compound interest calculator, plug in some numbers, using what you can set aside monthly for investing.

Use a reasonable return (don’t use 12%, which I have seen and find it challenging to achieve. Instead, try 7%) and provide the number of years you have until your retirement.

# 10 Rebalance Your Portfolio Periodically

It is essential to periodically review your investment portfolio and consider rebalancing the various assets. Review it annually and make changes based on significant life milestones. Meeting with your financial advisor or accountant is an excellent way to review where your investments stand relative to you and your lifestyle.

Different Asset Classes

Common Stocks

With the highest historical  S& P 500 annual returns of 10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. Investing in stocks is among the best ways to build wealth.

Common stocks represent equity ownership in a publicly-traded company or business enterprise. Your holdings reflect the number of shares you have. As common stockholders, you have voting rights on major company issues determined by your fractional share amount.

These equity shares are different than money market and bond securities, commonly referred to as debt securities. Owners of these instruments have creditor rights and do not vote like equity owners.

The Wealthy Get Wealthier, But You Can Get Rich Too

A recent study by the Federal Reserve in 2016 found  51.9% of families owned stocks either directly or as part of a mutual fund for investment and retirement accounts. However, the distribution of stock ownership by wealth percentile shows that the top 10% hold 84%, the next 10% have 9.3%, and the bottom 80% save 6.7%, according to a 2017 paper published by NYU Professor Edward N. Wolff.

Asset Allocation And Diversification

Recognize the challenges of investing. I have been an investor, an equity analyst, and I teach finance courses in college. As part of their requirements, students develop diverse stock portfolios using the stock market game. To a great extent, I share my experiences and mistakes during the bull and bear markets. Nothing prepares you for the next great crash as we had in March 2020. The unexpected pandemic of 2020 caused substantial market volatility.

Many factors impact the stock market. Investors should have a basic understanding of the economy, differences between industries, and company fundamentals. You need to understand the basics when investing on your own instead of having a financial advisor or buying mutual funds.

Learn about the differences between stocks, bonds, money market securities, and other asset classes. Be aware of what you own, whether it is individual stocks, or through mutual funds in your portfolio, setting up a  529 Savings Plan, or as part of your retirement accounts. Stocks tend to generate high returns but naturally carry higher risks and volatility than money markets and most bonds.

How To Determine Your Allocation

You need to manage the risk with a balanced portfolio with assets distributed among stocks, cash-equivalent securities, bonds, and real estate.

Generally, a stock allotment guideline in your total portfolio considers your age deducted from 100. So if you are 30 years old, you should invest 70% of your portfolio in stocks with the rest in a mix of money markets and bonds. The 70% percentage is conservative and can go higher to 80% allocated to stocks.

However, a typical 60 years old’s portfolio should divide their ownership more conservatively: 40% in stocks with 60% in bonds and money markets.

Diversification is essential and your best means for reducing risk.

Holding a broad stock portfolio, along with a variety of bonds and money market securities, smooths out the bumps you encounter. Investing at an early age helps to weather the ups and downs in the financial markets and benefit from the compounding of returns long term.

Once the shares are publicly issued, they typically trade on the New York Stock Exchange or the NASDAQ. The stakes are accessible for all investors to buy and sell. If they are privately issued, they are closely-held, usually by a small group of individuals who may be founders or families owning a substantial part of the business.

Stocks tend to be the most common investment vehicle for households, either through tax-advantaged retirement accounts or taxable investment accounts.

Active Versus  Passive Investors

Individuals and households can be active investors by buying the shares outright through brokerage accounts or Robo-advisors, thus becoming direct owners. Alternatively, as passive investors, they can buy mutual funds and exchange-traded funds (ETFs) representing indirect ownership of publicly traded shares.

If you are just beginning to invest and have limited resources and research time, consider buying a mutual fund or ETF.  Exposure to only one or two individual stocks is too risky.  I have different types of funds you can search for just below. Funds or ETFs will provide you with a more diversified basket of securities from the get-go. Later on, if you want to become more active, you can do your stock picking.

Those with more assets often have access to private money managers and hedge funds. Their fees are often higher than low index mutual funds and ETFs without necessarily providing higher returns.

Dividend income, dividend growth, and stock price appreciation determine stock returns. Related Post: How To Start Investing: A Guide For Investors

Choose from the different types of funds (or ETFs) that might fit your needs:

#1 Company market capitalization.

From large-cap company stocks with a capitalization of $10 billion to midcap stocks from $2 billion up to $10 billion range; and small caps of less $ 2 billion.

#2 Industry Sector.

You may be seeking one or more industries with different characteristics to counterbalance your portfolio. Adding tech, consumer discretionary, industrial, and finance companies would diversify risk.

# 3 Value stocks

Value stocks are stocks trading below their intrinsic value compared to their fundamentals. Benjamin Graham is the founder of this type of investing. Warren Buffett and Charlie Munger favor these strategies for their Berkshire Hathaway portfolio. Examples of value stocks are General Motors, GE, and Philip Morris.

# 4 Growth-oriented

Above-average growth comes with higher risk. These stocks appreciate at higher rates above the average for the market but don’t always pay dividends. Growth companies tend to plow their cash flow back into their business rather than pay dividends. A few examples of growth stocks are Amazon, Tesla, cloud companies like Salesforce, biotech stocks.

#5 Blended funds

A combination of value and growth stocks can offset some of the risks in # 4. 

#6  Dividend Growth Stocks

This group contains companies that have above-average dividend yields like ATT, British Petroleum, REITs. They are presumed to be safer, defensive, and slower-growing companies. Look for high-quality companies that have a history of paying above-average dividends. These names provide less risk but provide exposure to stocks.

# 7 Dividend Aristocrats

An elite subsector of above-average dividend-paying stocks not only provides above yields but are known for 25+ years of dividend increases. Chevron and PPG Industries are in this select group.

#8 Balanced

An investment portfolio should have a mix of different asset classes with fixed income and equity to help you achieve asset allocation.

#9 Index To A Specific Market Benchmark

It is difficult for the best portfolio managers with the expertise to “beat the market.” These funds track market indexes’ performances like that of the S& P 500 or the Russell 2000 for smaller cap stocks. These are prevalent ways to participate in the stock market.

# 10 Target Date Funds

These mutual funds adjust the asset mix based on your age and retirement plans. Vanguard has many funds labeled by decade eg. “2040.” They are appropriate for 529 Savings Plans and 401K retirement plans and a taxable investment portfolio.

# 11 Domestic or Global Markets

Suppose you may want to add international exposure to a mostly domestic-only portfolio for higher growth, especially if the USS is experiencing weak or recessionary growth. Several funds provide equity or mixed (including bonds) basket of companies in many countries, regionally oriented like Asia, or specific markets like China or India.

#12 Specialty funds

Gaining in popularity are specialty funds that contain stocks that represent companies with strong social responsibility or sustainability. ESG funds are portfolios of equities or bonds which address environmental, social, and governance factors into the investment process.

Money Market Securities

Money market securities are debt securities and are also known as cash-equivalents because investors can quickly convert them into cash with little or no loss. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These generally mature in one year or less and trade in the secondary market.

The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.

T Bills or Money Markets Account

Individuals and households would largely buy the more popular T-bills with minimum denominations of $1,000. Individuals can buy a pool of money markets as an FDIC-insured money market denominated account (MMDA) or money market mutual funds. The investor would be holding a bundle of different money market securities, including Euro CDs issued in US dollars by European banks at higher yields is often in the funds.

On their own, the other money markets have higher denominations ($100,000) and are out of reach for the average household. Institutional investors often own or trade these securities.

For example, a six month T-bill currently yields just  0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free security but has been more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range and low yields.

Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly for your emergency fund. Today’s yields are significantly lower than historically based on the Fed’s actions to combat the pandemic’s effects on our economy. 

In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, significantly when interest rates rise.

Older investors should be reducing their exposure to risky stocks and placing more of their portfolio in these securities and bonds

A Variety of Bonds

Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon) and a specific maturity date when the issuer pays the principal.

To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate. The payment is paid semiannually or $20 every six months.

Bonds provide these predictable fixed income streams. Bonds vary in credit risk from the Treasury Bonds rated AAA to munis and corporate bonds with varying debt levels. There are also corporate bonds with high yields, so-called “junk bonds” because of their risky nature.

When you invest in a bond, you are effectively lending money to the issuer instead of owning part of the equity of a company when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors over stock ownership.

Relationship between bond prices, interest rates, and inflation

Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issued bonds hav higher yields.

Warning: A Mini Macroeconomic Lesson For You

These securities also have inflation risk. There is a close connection between interest rates and inflation. Inflation refers to the rate at which prices for goods and services increase, reducing our purchasing power.

As inflation increases, so do interest rates. Interest rates, of course, are the amount charged by a lender to a borrower. The federal funds (“fed funds”) rate set by the Federal Reserve influences interest rates.

The fed funds are the interest rate at which depository institutions borrow and lend each other from their reserve balances overnight. That rate influences different interest rates, such as the prime rate, mortgages, and auto loan rates.

When inflation rises above the targeted 2% rate, the Fed, through its monetary policy, will raise the fed funds rate to stem inflation from going higher.

Related post: 11 Reasons Why Investors Need To Understand The Fed

As a bond investor, you don’t want your bonds to erode in value because of other bonds’ availability sporting higher yields. Issuers of Treasuries, municipal and corporate bonds know this so that they will offer inflation-indexed or protected securities. The yields on these bonds will adjust according to a formula linked to an inflation indicator like the Consumer Price Index (CPI).

Without that protection, a bondholder with a 4% interest rate is doing fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.

Minimum denominations range from $1,000 for Treasuries, $5,000 for municipal bonds, and $1,000 or $5,000 for corporate bonds.

There are several different types of bonds with notable risk differences.

Treasury Bonds Are Safe and High Quality

In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities.  Like money markets,  Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.

Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,

Historically, T-bonds returned 5.5% per year though they too are lower these days. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is subject to interest rate and inflation risk. TIPs or Treasury Inflation-Protected securities are in demand as they adjust rates with the inflation-indexed CPI.

Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation.

A True Story

I recall a story early in my Wall Street career when a friend of mine, a trader, had received an eight-figure bonus at the end of the year.

Curious, I asked what he was going to invest in with his bonus? With little hesitation, he practically yelled out, “Treasuries, of course!”

I was a stock analyst, and being surprised at his choice, I asked him why and he said, “Treasuries are safe, I have young children, I have all that I need, and I spend modestly, save abundantly, I donate generously, and I am risk-averse.”  That made more than a modest impression on me.

Municipal Bonds Have A Unique Tax Benefit

State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households.

Tax Exemption A Big Plus

One of the outstanding benefits of owning a municipal bond is favorable tax treatment. Muni bondholders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the riskier corporate bonds.

These securities are attractive, especially if your marginal tax rate is above 25%.

While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with various muni securities.

Corporate Bonds: High Grade Or High Yield

These debt instruments issued by corporations vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.32% versus 3.02% a year ago.

Disappearing AAA Corporate Bonds

There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with mergers & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the great recession.

High Yield AKA Junk Bonds

For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Diversity is your best path to exposure to these risky instruments.

The riskier, higher-yield bonds may be called “junk” bonds. Historically, junk bond yields are 3%-7% higher yields than high-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Debt-heavy companies or those restructuring often issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds in the 3%-4% range but carry higher risk.

Drexel Burnham And Michael Milken

The earliest part of my career began at Drexel Burnham, known for developing high yield bonds by Michael Milken and his role in that market. That high yield market ultimately forced the company into bankruptcy. Mixed thoughts aside, many companies I covered as analyst survived and prospered due to those high yield bonds.

Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock.  Bondholders are creditors who have priority claims in the event of a default, which stockholders do not have.

Rebalance Your Portfolio Periodically

It is essential to review your portfolio periodically and make sure it is balanced for your life. When you are young, you should take some risk given your longer investment horizon. As you grow older, you want to reduce risk by shifting more into predictable income streams.

Thank you for reading!

Have you reviewed your portfolio? Is it diversified enough? It is a good idea to work with a financial advisor or professional when considering changes. What strategies have worked for you? Please share your comments as we love to hear from you!


How Our Emotions May Lead To Irrational Money Decisions

How Our Emotions May Lead To Irrational Money Decisions

“People do not buy goods and services. They buy relations, stories, and magic.”

Seth Godin

As consumers, we are often driven by our emotions. Neuroscientists have learned that nearly 95% of all our decisions are made emotionally and intuitively. The forces of marketers and our biases make it nearly inevitable that we make irrational purchase decisions. Marketers embrace irrational customers because that is part of their primary goal. Their marching orders are to attract and retain profitable customer relationships. Our biases keep them busy as they collect big data about us, our purchases, and how we spend.

It is no wonder that it is easy to overspend and ramp up our credit card balances. That makes the credit card companies happy as consumers “buy now, pay later” allows them to pay much later at higher interest rates over a longer period of time. Do you see what I am getting at? We will discuss some of the marketing tactics and biases we need to overcome with better financial discipline. By understanding more, we may become more rational decision-makers.

Marketing Tactics Can Be Harmful To Our Perceptions

Let me just say that marketers are not bad people and consumers aren’t defenseless. We are bombarded daily by an average of 1,500 ads or brand messages, most of which we don’t really pay attention to. Our tendencies are to screen most of the information we are exposed to. These perceptual processes, called selection attention, selection distortion, and selection retention, help us to either screen out the messages or align them with our beliefs and attitudes.

The Invisible Gorilla Experiment

A famous psychology experiment in a 1999 study by Daniel Simons and Chris Chabris that tested selective attention about a gorilla, better visualized here makes the point about selective attention. For those who don’t mind the spoiler, the experiment showed 6 people- three people in white shirts and three people in black shirts passing basketballs around. As participants watched, they kept count of the number of passes made by people in white shirts. At some point, a gorilla strolls into the middle of the action, faces the camera, and thumps its chest. It then leaves, spending nine seconds on the screen.

Who saw the gorilla? Half of the people who watched the video counted the right number of passes but missed the gorilla thought to be invisible. Our visual systems have evolved in recent years for the benefit of marketers. They have worked hard to play with our intuitions. The role of big data plays a crucial role for marketers. A recent infographic from Domo courtesy of Visual Capitalist displays mesmerizing 2019 stats on how much data is generated every minute and from which platforms.

A Sampling of Statistics Per Minute:

  • Americans use 4,416,720 GB of Internet data.
  • There are 188 million emails sent and 18,100, 000 texts sent.
  • Consumers spend $1 million online.
  • Nearly $240,000 worth of transactions occurs on Venmo.
  • 390,030 apps loaded.
  • YouTube users watch 4.5 million videos.
  • Giphy serves 4.8 million gifs.Big Data enables marketers to access:
  • Information about users’ purchasing patterns.
  • A user’s past purchases.
  • Behavioral information from growing history and patterns on a website.
  • Streaming data from millions of users.

Marketers use huge customer relationship systems to more efficiently find a single user’s behavioral and shopping information to make recommendations. As one marketing consultant said, Bias-driven marketing is a no-brainer. As such, marketers can leverage biases to create better user experiences and boost conversion rates.

How They Can Manipulate Shoppers

They use manipulative and subliminal messages convincing us to buy products we may not need. Often prices even on sale days like “Black Friday” are still higher than before but they use eye-catching “50% off” signs. “Buy More, Pay Less” stimulates our brains into thinking we are seeing a bargain.

Expert Endorsements

Marketers use expert opinions to convince consumers of the safety of their products. I recall my Dad, a heavy Camel smoker, telling me that doctors endorsed smoking when he began this bad habit and many people fell for the ad. It seemed funny at the time and I dismissed that as a possibility. However, my Dad was right though I never got to tell him as he died of emphysema, no doubt from his cigarette habit.  An old Camel ad among other ads discussed in this study, “The Doctor’s Choice Is America’s Choice” ran 1930-1953 when smoking became the norm. The use of a doctor’s endorsement was convincing to sell the product.

Tom Selleck And Nellie Young

The strategy of using experts or actors who are credible is used today. Tom Selleck, a trustworthy figure to many, has endorsed reverse mortgages to much success for American Advisors Group (AAG). In the ad, Selleck is a voice of reason about reverse mortgages are good for those who don’t have enough savings like Nellie Young. She is among the first to get a reverse mortgage loan in 1961 when she lost her husband. He makes us care about Nellie and others in a similar situation.

Reverse mortgages are loans that enable homeowners, usually at retirement age, to tap into the equity in their homes. There is little discussion in the ad regarding the downside of the upfront costs, variable interest costs, and lack of tax deductibility on interest paid. A significant downside of reverse mortgages is the lowering of the value of your home as an asset. Selleck’s emotional promotion of reverse mortgage must be accompanied by an understanding of the drawbacks for those considering this loan.

Emotional Ads

Many ads contain emotional messages to build brands. Through nice storytelling, music, and entertainment, we can get sucked into the sales pitch unknowingly. Even using words like “Last Chance” may create that fear of missing out or FOMO. Many times I am in a rush scrolling for a specific email but I see that message or “Time is running out” and I stop to stare at it before I remind myself that I am in a hurry.

Have you ever bought clothes you didn’t need but saw it on someone else in the ad and buy it? I have and I am sorry to admit it. This is a self-deception buy when you can visualize it with the hope it will look as good on you. It doesn’t and you later realize it wasn’t you so you stop wearing this new garment. Hopefully, as it is barely worn you can give it away to stop who will appreciate it.


Overspending Due To Irrational Decisions

Marketing strategies, if successful, may lead to consumers being profitable customers and happy being so. For many consumers that will lead to overspending because of irrational decision-making. They nudge us to buy even if we don’t need it. Nudge marketing is used to influence consumers’ decisions towards certain options. It refers to deliberately manipulating our choices and stimulating purchases also known as higher sales for their business.

We, as the buyers, need to take the blame for overspending, recognizing our vulnerability to falling for marketing trickery. Manage your spending better in these ways. It is not only the marketers that are nudging us, our own biases are at work as well. Wherever we shop, the convenience of having a credit card allows us to spend more. This has been referred to as the “credit card premium” in an MIT study by Drazen Prelec and Duncan Simester.

Biases Add to Our Bad Choices

Biases often result in us spending more than we should, paying off slower or not at all. We need to better understand them to fight off the tendencies to act irrationally when it comes to money. We focused on just a few here, but we wrote about many potential biases we have when we invest or overspend.

Present Bias Allows To Favor Instant Gratification

The present bias values the present when we are planning for the future. Present bias causes many of us to spend money on the latest new shiny object rather than save for retirement or paying off our monthly credit card balance fully. As a result, we favor the present because we favor instant gratification. However, this bias comes at the expense of our financial discipline. Overspending leads to ramping up big bills on our credit cards we can’t pay off properly.

Stephan Meier’s study in 2010 found present-bias minded individuals are more likely to borrow and accumulate higher balances on the credit cards. That means your debt is growing at compound rates detrimentally rather than the positive compounding growth you would get in your retirement bucket. As cardholders, we don’t fully internalize the costs that may stay us for years. Instead, we should consider future savings for retirement, investments, and paying down debt. We need to be rational when making purchase decisions that harm our finances.

Who Are The Beneficiaries Of Overspending? Credit Card Issuers

Credit card companies are direct beneficiaries of our overspending habits. According to Mercator Advisory Corp, it costs about $250 to acquire each customer but retention is the long-term goal. To acquire customers, they may offer a host of features and special perks, including introductory offers as low as 0% APR, cashback, points, mileage, discounts on certain retailers, and dollars on dining, hotel, or other travel needs. Many of the perks are offered upfront and short-term or just part of the trial period.  Both the offers and the costs are difficult to understand.

Teaser rates and rewards disproportionately hurt consumers with biases for instant gratification. We use our credit cards more freely than if we were paying with a finite amount of cash. A study by Theresa Kuchler and Michaela Pagel proved present-biased preferences contribute to households’ inability to reduce debt levels associated with credit card use.  The higher the impatience of participants, the more likely they preferred to spend their paychecks rather than lower the debt paydown of the credit card balances.

Hyperbolic Discounting Focuses On What Is Immediately Available

Hyperbolic discounting is a bias that occurs when people will opt for immediately available rather than later on. For example,  People will take $50 right now rather than $100 a month from now. We just don’t want to wait any longer. This happens when we see desirable upfront benefits offered by credit card issuers. Never mind that your teaser rate or points reward is a one time or one month period. You may have missed the fine print that lets you know that your APR is set 1%-2% higher for the long term. This is a bad consequence if you have a tendency to carry big card balances.

The Fine Print Is Hard For Us To Read

Have you seen a credit card contract lately? They are wordy and complex, deliberately so. CreditCards.com analyzed the readability finding the average credit card agreement was 4,900 words in 2016 and lacked clarity. Are first-time cardholders, either young or average person on the street, likely to power through these documents? I don’t think so.

Increasingly, credit card companies are reaching out to subprime users, those with poor credit histories, offering credit for the first time. The US Consumer Finance Protection Bureau published a model credit card agreement that was 1,188 in length for issuers to emulate for consumers to read. It is not simply the length of words but a lack of clarity of signing up for a card. The high level of complexity of these agreements for most people to really understand their responsibilities.

Used properly, cards are convenient tools for toxic financial products for many people. This is concerning as issuers are getting a growing share of this market of people who may be ramping up unaffordable debt. Didn’t that happen when subprime borrowers bought houses with mortgages they couldn’t pay? This is a growing concern and should be for everyone, especially regulators.

 Did The Credit CARD Act of 2009 Help Consumers?

The Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 provided consumers, not businesses, with more protections, better disclosures when it comes to hidden fees, interest rate changes, and details on rewards programs. Some improvements have been noted in the latest Consumer Finance Protection Bureau report in 2019 but more needs to be done.

Card issuers prosper in many ways. When we cannot pay our card balances in full–and 58% of Americans do not– it is profitable for the companies. By paying the minimum amount we incur finance charges at high-interest rates in the high teen which are carried over month-to-month at huge costs. Please read our views on the pros and cons of credit cards here.

Credit card issuers earn money in a lot of different ways. They make money on fees besides the monthly finance charges on consumers’ hefty balances after the credit card’s grace period. Unless there a change in behavior, the compounding effects are huge for issuers. They also take a processing fee that is somewhere around 1%-3% of the transaction from merchants.

Here are typical fees consumers pay:

  • Annual fees that average about $80, in a range of $20 to more than $200.
  • Penalty or late fees if you don’t pay the minimum monthly amount of about $30 initially but the amount rises if it recurs though are capped based on inflation changes per the Credit Card Act.
  • Over-limit fees for when you go over your credit limit. You still have this feature but you need to opt-in since the Credit CARD Act.
  • Balance transfer fees on the amount you are moving from one credit card to another because you found a better deal.
  • Card replacement fee if you lost your card.

As noted, there have been some reductions since the Credit Card Act of 2009. These amounts may differ between companies and individual consumers based on their credit scores, discipline, and behavior. These fees are usually discussed in the fine print. However, many of these fees may be hidden more than glaringly obvious. You need to really understand what the credit card offer means regarding your responsibility. Take the time to shop for a card and take control of your spending and paying off your bills fully.

The Credit Card Industry Is Evolving

The credit card industry is evolving. The growing competition of new payment providers is good news for consumers. Recognizing that issuers have come under scrutiny since the Great Recession has resulted in the CFPB issuing reports on credit card issuers disclosing how they are faring with the Credit Cardholders’ Bill of Rights. Advancing digital technologies can provide more tools for users to pay bills promptly, get balance notifications when they are close to their credit availability, and spending trackers for consumers.

With increased scrutiny, better credit card agreements, increased competition, and advanced tools, consumers can control their finances. That said, it may not be easy. However, it is essential to control what you can at the point where you may be at your weakest. Be a more discernable customer. That may be shopping more carefully, planning for the future rather than acting out of a need for instant gratification. Whatever your weakness, offset it with strength. Be aware of these marketing tactics and biases that may encourage irrational decision-making.

Financial Discipline Is Your Responsibility

There are a lot of forces that are collaborating to get you to spend money. While some people excel in financial management better than others, most of us have blind spots. The following list may be something you already, and other rules may resonate with you. Of course, you may have suggestions that work for you and you are willing to share. Having better discipline over your money will give a better feeling over the long term.

Use These Rules For Better Money Habits:

  1. Shop wisely for a credit card understanding the hidden fees that may not be worth the perks.
  2. Read the fine print– 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. Spend below your means always.
  5. Pay with alternatives to credit cards if you are carrying large balances.
  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 important 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 rates are punitive for a reason.
  11. If your child is an authorized user of your credit card, teach them about 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 to correct impulsive spending.
  14.  Once COVID goes away, hopefully soon, use cash for some of your discretionary purchases.
  15. Find a credit card that gives you alerts when payments are due, balance notifications when you are near 30% of the credit available, and  automate paying your credit balances by your paycheck


Final Thoughts

Marketers appeal to our emotions so that we will be better customers. Their tactics are a fact of life likely to continue if not rise in the future. How you react to these efforts and your own biases is important. Be aware of your emotions and stop and think when making money decisions. You are not defenseless but may need to work on how to avoid temptations to overspend and have too much debt. Delay your shopping when and how you can.  Manage your spending so you do not overspend and ramp up high-cost credit card debt.

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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

Being called a cheapskate when I was a young kid 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 and I was picked on for getting an ice cream without sprinkles or ratty clothes. My parents were more frugal for 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 definitions: charging or obtainable at a low price and of 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 when considering if a person is being 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 has been cited as 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 teenager during the war, he suffered from the traumatic effects of the camp, losing his family, except for my mom, and did not get married until 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 wanting to save money or extreme frugality was a tragic symptom of his experience.

In contrast to being cheap, frugality is a strategy toward not only saving money but 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 has lived in the same home in Omaha since 1958. He has been known to eat in McDonald’s and at his company’s cafeteria. He is a value-seeker when investing or in his lifestyle. Yet, for all of his frugalness, Warren Buffett has donated $37 billion since 2006, a very generous person indeed.  He uses the same frugal nature when investing. 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 Without Being Called A Cheapskate


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 carefully what is best 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. More factors are considered.

Frugality is a lifestyle that people adopt for the simple pleasures of life. It is not new. Modest or minimalist living has been advocated by the likes of Plato and Henry David Thoreau in Walden. It is in contrast to 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, 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. This 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, well 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 important 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 millionaires who were more frugal. They avoided a showy lifestyle, bought used cars, often living in blue-collar areas. Goal-oriented, they made smart 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 certain 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, frugal people will consider quality, usefulness, reliability, durability, style, convenience, past 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 going to dive into all those factors for convenience products. Those purchases are frequently products like toothpaste or laundry detergent. The price will play a bigger role. 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

When 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. Apparently, cheaply made, it didn’t hold up our books for too long.

5. Frugalness Is Good For The Environment

Practicing frugality has become a cult and more acceptable in recent years. This is partially due to frugality is good for the environment which we all want to save. 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. It cannot be replenished. Saving money is important 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 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 you 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.

If you are pressed for time, 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 thought of as cheap. Being frugal, on the other hand, 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 eliminate pleasures just for the sake of being frugal. Instead, prioritize what is most important for you.

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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 own cards until the Equal Credit Opportunity Act of 1974  was passed. 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%  from the first week of that March to the last week of the month as compared to the previous month. Inquiries for all kinds of loans–auto and mortgages–dropped substantially as our priorities were shaken to their core.  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 in an already rich year of strange happenings.

Credit Card Statistics:


Advantages of Credit Cards


1. Convenience

Compared to cash, credit cards are a convenient 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, it is hard to carry a lot of cash–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 a good 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 responsibility in 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

Reviewing your credit card bills regularly 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 spending is a realistic way to correct yourself. The credit bills serve as a receipt or a record of the purchase in the event of making a return.

One particular month, I recall seeing a very high bill with a number of 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 still 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 a host of perks. Typically, use of the card may allow you to earn a percentage of cashback, rewards, airline miles or points, discounts at eligible merchants, restaurants, theaters, hotels, travel insurance, welcome bonuses, early access to tough-to-get tickets, and free museum passes. Before signing up a certain 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 cash 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 it. I once thought I lost my card so I called the card company quickly only 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 for businesses. With this law, issuers are required to notify consumers of significant interest rate hikes at least 45 days beforehand. Also, fees and charges, previously hidden, must be better disclosed clearly. There are some other practices that were 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. This leads to carrying high-cost debt on your balances. This 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 to tickets to sporting events. One event was a desirable basketball playoff game and the other was a regularly scheduled baseball game. Those participants encouraged to buy tickets using credit cards spent up to 100% more than those who 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 gives me an immediate pain as opposed to 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 each and every month, you are not charged 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. That is all that is required by the issuers who prefer their cardholders to carry balances that feed these 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 which is 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 which may be imposed 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 a period of time.

3. Lower Your Credit Score

Just as you may be able to 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 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 on your creditworthiness to lenders, landlords, and other professionals and could impact you negatively.

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 that you should know about. In recent years, consumers have been able to compare credit cards more easily. Among my favorite sites are WalletHub, NerdWallet, and CreditCards.com which have a ton of good information on credit card features.

Be aware that if you have a dispute with your card issuer, you are usually subject to mandatory arbitration. This has been relaxed in recent years but is still buried 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 large 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 important 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 about 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 to correct impulsive spending.
  14.  Once COVID goes away, hopefully soon, use cash for some of your discretionary spending.


Final Thoughts

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

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