Working with a trusted financial professional is important when it comes to strategizing and preparing to meet your financial goals. But as most of us handle money on a daily basis, it’s important to have an in-depth understanding of the fundamentals of financial literacy. Below we’ve identified five financial basics everyone should know. Understanding these important concepts can serve as a basis for your financial standings.
Basics #1: Debt & Credit Scores
Understanding the ways in which credit or debt can work with or against you should serve as the foundation of your financial knowledge. First and foremost, it's not wise to avoid credit or debt altogether out of fear or intimidation. Instead, it’s important to have a firm grasp on your financial standings and a plan for tackling debt responsibly.
When used correctly, debt can be useful. But when misused, it can spiral out of control fast. Missed payments can accrue interest or penalties and may impact your credit score in a negative way. Debt that is managed responsibly can help you reach important goals like buying a car, purchasing a home, going to college, starting a business and more.
Your credit score is one of the factors lenders use to judge your trustworthiness and qualification for mortgages, auto loans and other lending opportunities. Landlords and employers may also check your credit before renting to you or offering you a job. Your credit score is dependent on a number of factors including previous credit history, current debts, history of payments and more.
Basics #2: Interest
There are two sides to interest that can make it a tricky concept to grasp - interest accrued on debt and interest accrued on savings.
When you take on debt (like credit card debt, an auto loan or mortgage), you’ll be responsible for paying back both the principal amount and the interest accrued on the loan. The interest is how a lender makes money on the loan and provides the borrower with an incentive to pay the loan back in full and on time.
When you have a savings account that accrues interest, the interest earned gets added to the principal. Then, interest is earned on the new, larger principal, and the cycle repeats. This is called compounding interest, and it can be an integral part in growing your retirement savings - as the longer the interest has to compound, the greater the savings will grow.
Basics #3: The Value of Time
As a general rule of thumb, it’s never too early to start saving - for retirement, homebuying, a child’s education or whatever could be coming down the line. The earlier you start saving, the more you’ll be able to tuck away over time - especially with the power of compounding interest. This leverages the value of time to your advantage.
Basics #4: Inflation
Inflation has the potential to eat away the purchasing power of your money. That means, with inflation, the dollar you earn today may not be worth a dollar in the future. Below are two important concepts to remember regarding inflation.
Cash in a Mattress
Keeping all your cash under a mattress is not only unsafe, it literally costs you money. Assuming the annual rate of inflation is a hypothetical two percent, every dollar you keep under your mattress and not earning interest would shrink in value to $.98 next year.
Rate of Return
Because inflation erodes the purchasing power of your money, any returns you earn on your accounts may not be the “real” rate of return. If your account earned a hypothetical six percent rate of return over the last year, but inflation was 1.5 percent, your real rate of return was 4.5 percent.
Basics #5: Create a budget and forecast in small steps
Independently your net worth is $100,000 or $400 million, account for your income and expenses. It is overly easy to overspend on instant gratification items rather than experiences. Traditionally one person who works an average of 40 years accumulates sufficient assets to have a dignified retirement, then spends these assets during the next 30 years.
Basics #6: Save and invest with a long-term purpose
You might want to consider the dollar cost average DCA approach to invest your automated contribution to your savings plan. At a minimum, you should save 10% of your income, on top of your 401K savings if your employer offers you this benefit. Nobody wants to get rich slowly.
Basics #7: Identity Theft and Safety
Especially as the world shifts to doing everything virtually, identity theft remains one of the biggest threats to financial and personal security. A cracked password or misplaced Social Security number can have big consequences on your current and future finances.
The common wisdom is to use a unique password for each site or service you use. A password manager can make this easier by generating and storing strong passwords automatically.
While this is a brief overview of some important financial basics, it’s important to work with your trusted financial professional to explore these topics further. Remember to reach out if you have questions about any financial basics, and take this month to reevaluate your current financial knowledge as you identify potential areas for improvement.