Financial education is one of the biggest blind spots in America. We know when two trains will pass if they leave different stations, at different times, traveling at different speeds. But when it comes to understanding the consequences of long-term compounding -- what Einstein called "the most powerful force in the universe" -- we haven't a clue.
This article won't attempt to cover the whole syllabus of an adequate personal finance course. Instead, it offers up five heuristics -- rules of thumb -- that will generally keep people out of financial trouble, and offer more personal freedom in the future.
Master these five and you'll be way ahead of the rest of the crowd.
1. Avoid high-interest debt like the plague
There's nothing quite so destructive as debt that's compounding. High-interest debt will financially keep you a slave to your debtors -- most likely, your credit card company. But it can also ruin you emotionally, causing many lost nights of sleep worrying over making ends meet.
Generally speaking, I consider high-interest debt to be anything with a rate of 7.5% or higher. That means -- in today's environment -- things like mortgages, student loans, even car loans wouldn't fall into this category... if you have a good credit score.
Credit card debt, on the other hand, most certainly would qualify as "high interest." Right now, the average rate sits at 17.2%.
To give you an idea of how damaging that can be, let's look at the long-term effects. Say that you have $10,000 in debt on your credit card. We'll assume you pay off $200 per month -- a likely minimum during the first month.
In the end, it will take you over seven years (89 months) to pay off this debt. That's the blue line. And you will finish having paid an extra $7,700 in interest because your debts were compounding that entire time -- the red line.
And here's the real kicker: We assumed that you won't be charging anything else to your credit cards over that time frame! The takeaway message is simple: Unless it's to meet your most basic needs for food, clothing, or shelter, you should never be using high-interest debt.
If you don't take care of this first point, none of the following will ever be possible.
2. Prepare for the worst: Emergency fund and insurance
You lose your job unexpectedly; your spouse has a serious medical diagnosis; your house floods and you don't have adequate insurance protection. We commonly think "these things happen to other people but not me."
Here's the thing: Given a long-enough time frame, the odds are decidedly not in your favor. Let's say that there's only a 3% chance of something financially devastating happening to your family in a particular year. That means in any given year, you have a 97% chance of relatively smooth sailing. Those are great odds, right?
Over time, your probability of experiencing one bout of such devastation is actually a lot higher than you think.
Four years in and you already have a 1 in 10 chance of such devastation. After 10 years, it jumps to 1 in 4. And after just 23 years, you are more likely to have had such a devastating event than not. Here's the shocking part: If you aren't protecting yourself, that one event could wipe you out completely.
This is purely a hypothetical exercise -- I have no way of knowing such percentages for you. But it highlights an important truth: Even low-probability events need to be considered if they can wipe you out. Over time, those probabilities add up, and make such devastation more likely.
There are two ways to defend against this:
- Insurance: This includes making sure you have appropriate medical, disability, renters/homeowners, and auto insurance. You can read more about different types of insurance here.
- Emergency fund: This is cash that sits in your bank collecting a tiny bit of interest every month. Typically, this should cover three to six months of expenses for your household with no other forms of income. Read more about the importance of emergency funds here.
3. Find your level of "enough"
Now we get more philosophical: How much do you really need to be satisfied with your life?
- Will the new Ferrari satisfy your deepest inner needs, or are you content with something that can safely get you from point A to point B?
- Is sending your child to the most expensive college a goal? Or are you content with taking a savvy -- but less glamorous -- route?
- How big of a house is really necessary? In the 1950s, the average house was 983 square feet. By 2008, it was over 2,500 feet. And these houses have fewer people in them now.
The answers to these questions are of the utmost importance. They cover our three biggest expenses: car, college, and home. And there's little doubt that over the past 50-plus years, the median American has had access to more and "better" cars, homes, and colleges.
But our levels of happiness have been flat for decades, and suicide rates and antidepressant use have risen markedly.
There isn't space here to debate why this is -- though it's something I've often written about. Instead, when it comes to the intersection of finding your "enough" and your finances, I'll turn it over to Mr. Money Mustache, who retired at 30 and has led the FIRE (Financially Independent/Retire Early) movement since.
The FIRE Movement is.. .about decoupling your happiness from your level of consumption. This happens to make you rich.
I thoroughly encourage you to take every material possession -- or service you pay for -- and test eliminating it from your life. Don't worry, you don't have to do this forever -- make it temporary. Perhaps that means cancelling your gym membership or, more drastically, trying to buy nothing (beyond basic goods) for a month. The results might be enormously eye-opening.
How does this make you rich? It increases the amount of money you have left each month, while lowering your overall needs. You can save and invest the difference in a simple index fund. The results will compound -- in your favor -- over time.
4. Treat your house as a social and emotional investment, not a financial one
For most retirement-age Americans, their household is the most valuable asset they own. We often make an automatic jump based on this fact: Investing in a house is a great financial move.
Nothing could be further from the truth. Nobel Prize winner and Yale economist Robert Shiller has shown that between 1890 and 2012, real estate prices returned almost nothing, after adjusting for inflation. Stocks, on the other hand, have returned almost 3,500% -- after inflation -- over the same time frame. The key reason: Homes are manufactured goods -- they become outdated, worn down, and start to break. The upkeep costs are enormous and often overlooked.
But that doesn't mean you should abandon buying a home altogether. It just means that you need to understand why you're doing it -- namely to give you and your family a stable presence in a community. The social and emotional benefits of putting your own skin in the game of your neighborhood has enormous advantages.
5. Make sure your finances serve a larger purpose
This is very similar to the third rule, but with a twist. While it's important to know what your level of "enough" is -- in terms of material goods -- it's equally important to know what truly feeds your soul, completely divorced from those material goods.
Martin Seligman runs Penn's Positive Psychology Center. He's been at the forefront of investigating what gives humans a sense of well-being for decades. In his 2011 book Flourish, he outlines the five distinctive aspects that contribute to our well-being:
- Positive emotions
- Meaning and purpose
- Engagement in what you're doing, or "flow"
- Deep and healthy relationships
- A sense of achievement
Your money should help you maximize these five areas. Sometimes, that means giving you free time to spend on relationships -- at other times, it means choosing a profession in which you can lose yourself (flow).
The bottom line is this: Your money should serve you, not the other way around. If you follow these five rules, you'll be doing yourself a huge favor -- now and in the decades to come.
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