Knowledge is power, so think about how much better off you
could be if you learn about your money.
"Financial education is key to unlocking the
foundations of economic opportunity and powering a strong and resilient
economy," says the U.S. Financial Literacy and Education Commission in a
2020 report noting people facing financial difficulties caused by the
COVID-19 pandemic. Helping you access and understand financial resources will help
you achieve greater financial recovery and resilience, it says.
However, our financial literacy rate is falling, not rising,
the commission says. The average correct score on a six-question quiz about basic
money decisions was merely three.
Most of us think we're financial geniuses, but we're not, says Emily Garbinsky,
assistant professor of marketing at Notre Dame's Mendoza College of Business.
"People generally hold positive illusions of being financially responsible
because this enables them to feel good about themselves," she says,
explaining her recent
study about trying to change attitudes to help people save more money.
Decisions you make affect you in some way financially now
and in the future. These seven terms are crucial not only for you to survive your
current money situation but also to help you know how to make
your money last at least as long as you do.
We'll start with where you are now.
Net worth
It's
tough to feel positive about money if your net worth is negative. Your net worth is all of your assets minus all of your
liabilities, or the value of everything you own after
subtracting what you owe.
Computing your net worth gives you a snapshot of where you
stand financially.
Tracking how your net worth changes over time will show you
whether you're heading in the right direction financially -- and how your money
habits can raise or lower it. You'll want to see your net worth generally rise as
you get older.
To compute your net worth:
- Add up
the value of your major assets: for example, your home, car, and all the
money in your savings, checking and retirement accounts, and maybe the value of some big-ticket items such as jewelry,
furniture and a 75-inch 4k TV.
- Add up
the value of your debts: for example, your mortgage principal, car loans,
student loans and credit card balances.
- Subtract No. 2 from No. 1.
While more than 1 in 10 U.S. households had a negative net
worth as of 2017, according to a 2020 Census
Bureau report, the median household net worth was $104,000 in 2017 (meaning
half of households had a higher net worth and half had a lower net worth).
Compound interest
Money may not grow on trees, but it can grow by what's often
called the magic of compound interest. Alas, so can debt.
For savings, compounding speeds up your
earnings because, as your account balance grows, each new interest payment is
based on a larger amount.
Say you open a $5,000 savings account paying 2% interest
annually and don't touch it. After one year, you'd earn about $100 in interest
and your balance would be around $5,100. But after five years, do you think
you'd have more or less than $5,500?
The answer is more! That's because each year you're earning
interest on the interest already paid to you as well as on your original
balance. That's compounding! Leave that $5,000 for 20 years and the snowballing
effect of compounding grows the account to more than $7,400.
Calculate compound interest with this calculator from the U.S. Securities and Exchange
Commission.
Compounding works against you when you borrow money.
That's why if you make a minimum credit card payment of 2% a month on a
$5,000 credit card balance with a 20% interest rate, it would take you nearly
44 years to pay off the debt and cost you more than $20,000 in interest alone,
according to Debt.com's credit
card payoff calculator.
Annual percentage rate (APR)
An APR, which stands for "annual percentage rate,"
is the annual cost you pay to use someone else's money to buy something.
It is often confused with "interest rate." That's
because credit
card interest rates that you see every month on your statements generally are stated as annual percentage rates.
However, the APR on other types of debt, such as loans, reflects interest as
well as fees and other charges.
A mortgage
APR, for instance, includes the interest rate as well as costs like
mortgage broker fees and discount points. Your car loan might have an origination fee included.
So, an APR is often higher than an interest rate. The federal
Truth in Lending Act requires
lenders to disclose the APR, among other figures, in writing when offering a
loan.)
The money you pay for borrowing money is money you won't
have around to enjoy later. The faster you pay off your credit card balances the more you'll save on interest payments. When you leave a credit card balance at the end of the month, you may start owing interest on any new purchase as soon as you say, "Charge it!", rather than owing interest only on your month-end balance.
Credit score
It pays to have a high credit score. Your credit score is a report card on how well you do repaying money you borrow -- your creditworthiness -- for home and car loans and using your credit cards.
A score differs from a credit report, which is a detailed record of your credit history. However, credit
scores are based on information from your credit history.
Lenders look at your credit scores to decide if they should lend you money or extend credit, and at what interest rate. Generally, the higher your score, the more you can borrow
(if you must) for, say, a home or car loan, and the lower the APR (see above)
will be. This easily can save you -- or cost you -- tens of thousands of
dollars over the life of a loan.
For example, a 30-year, $500,000 mortgage with a fixed rate
of 3% would cost you about $259,000 in interest over 30 years, a FreddieMac mortgage calculator shows. If the rate were 4%,
you would pay about $359,000 in interest -- $100,000 more.
There are many types of credit scores, but the most widely
used are FICO scores, which are created by Fair Isaac Corp., aka FICO.
FICO
says it scores you based on:
- Your
on-time payment history (comprises 35% of your score)
- The
amounts you owe, especially as a percentage of how much credit you have
available (30%)
- The
length of your credit history (15%)
- How
much new credit you've sought recently (10%)
- Your
mix of credit cards, mortgage loans, installment loans and other debt
(10%)
FICO scores mainly range from 300 to a perfect 850. So, a higher means you'll have more of your own money left after paying interest on what you borrow.
Inflation
You know $20 doesn't buy what it used to. As you get older, it will buy even less. That's inflation, eroding your purchasing power over time.
If you're working and seeing your wages go up, a little inflation won't seem like a big deal and may even be good for the economy overall. But if you stop working, or you're setting aside money that will last through a hopefully sweet retirement, inflation can sour your plans.
What $20 would buy in 1981 cost nearly $60 in December 2020, a Bureau of Labor Statistics calculator shows. In another 20 years, thanks to the same compounding mentioned above, with inflation even held at just 2% a year, what you can now buy for $60 will cost you close to $90 in 2041, another calculator shows.
To make sure your money lasts despite inflation, investigate low-risk investments such as insured high-yield savings accounts, CD's or Treasury securities or higher-risk aggressive investments such as index funds (see below) or stocks. Or you could also plan a lower-cost lifestyle.
Expense Ratio
It costs money to make money for you
in a mutual fund.
A mutual fund is when you pool your
money with other investors so fund managers can buy and sell mainly stocks or
bonds for you. The cost of operating the fund is reflected in its expense
ratio. Expenses can include management fees, advertising costs and even
assembling and printing the fund's prospectus, the pamphlet that explains the
fund's investment objectives, risks and, yes, those pesky fees.
The fees look like a tiny percentage
of a fund's value. And you may not realize your paying them, as you don't write
a check to cover them. They're taken from the fund. When it comes to fees, little things mean a lot, especially over time.
The Securities and Exchange
Commission's Investor.gov website provides a great example: If you invest $10,000 in a fund
with a 10% annual return and an expense ratio of 1.5%, after 20 years you would
have roughly $49,725; another fund with a 10% annual return but an expense
ratio of only 0.5% after 20 years would get you $60,858.
Compare
the costs of owning mutual funds, especially when choosing 401(k) or IRA investments,
to make sure fees don't take a big bite out of gains you're counting on to live
on.
Index
funds
An index fund merely mirrors the
movement of a large basket of stocks reflecting the overall performance of the
stock market. For example, the best-known S&P 500 index funds invest in the
the 500 largest U.S. companies. Want a broader basket? A fund following the Russell 3000 Index will include stocks representing 98% of U.S. companies.
Because index funds don't need stock
pickers, they need little management and take far fewer fees than funds whose
managers try to beat the market.
The expense ratio of the Vanguard
Russell 1000 Index fund, for example, was recently listed as 0.07%. Managed
funds often range up to 2%.
Very few managed funds beat index
funds like the S&P 500 over time, say analysts and even billionaire
tycoon Warren Buffet. The S&P 500 averages about a
10% a year gain. So even if a managed fund beats the market by a percentage
point or two, its fees may eat up the
higher returns, meaning less money for you.
