Published in: Banks | March 18, 2020
Financial Lessons to Learn While You Can't Leave the House
By: Christy Bieber
While you're social distancing, here are some key financial lessons you can learn.
As the novel coronavirus threatens lives, Americans throughout the country are practicing social distancing to slow or stop the spread of the virus. This has left many people with time on their hands.
If you're looking for something to do to pass these difficult days while improving your long-term financial situation, now may be an ideal time to learn key concepts related to money management and growing your net worth.
Not sure where to start? Here are six concepts to learn about.
1. Building a budget
There are different kinds of budgets, including:
- Traditional budgeting: This method requires you to calculate your income, add up your expenses, and then allocate a certain amount of money to specific expenses and to saving.
- Proportional budgeting: With this method, you limit different kinds of spending to different percentages of your income. The most common approach is the 50-20-30 rule, in which you allocate 50% of your money to your needs, 20% to savings, and 30% to wants.
- Zero-based budgeting: With this approach, you give every dollar a job, so you budget for every penny you earn, allocating money to savings, investments, retirement accounts, and so on. You'll want your planned spending and saving to exactly match your income, so if you have $2,400 a month, you'd budget for every single dollar of that $2,400. For example, your budget might be $800 for rent; $400 for food, $480 to savings; $200 for a car payment; $100 gas utilities $100 for gas; $100 for insurance; $50 for clothing; and $170 for entertainment.
- Value-based budgeting: With this approach, you'll make a list of the things you place the most value on, then allocate part of your income each month to the things you value most.
No matter what kind of budget you plan to make, you should:
- Track spending so you know where you're starting
- Work with others in your household, such as your partner or children
- Choose the budgeting method that's most appropriate
- Make your budget on paper, on a spreadsheet, or using an app such as Mint
- Track your progress to see how well you're sticking to your budget
You can learn more in our guide to how you can make a budget you're able to stick to.
2. The debt snowball method
If you're in debt, the debt snowball is a popular payoff method. The premise is that scoring quick wins helps you stay motivated to continue paying off debt. Here's how:
- Determine which of your debts has the lowest balance.
- Make extra payments on the debt with the lowest balance first.
- Make minimum payments on the rest of your debts.
- After you pay off your lowest-balance debt, roll the extra amount you were paying to the debt with the next-lowest balance.
Let's look at an example. Say you're paying $100 a month to your credit card with the lowest balance, and $75 a month to the card with the next lowest balance. After you pay off the first card, you'd add that $100 to payments on the second debt, paying at least $175 every month on that debt. You'd continue until all your debts are gone.
There's another budgeting approach called the debt avalanche, which works similarly. Instead of starting with the lowest balance, you start with the debt with the highest interest rate and pay it off first -- even if the balance is bigger. It will take longer to score a win, but this approach is the most effective in terms of paying less in interest.
You can also check out our guide to nine ways to pay off debt to find out more.
Interest is the cost of borrowing, or the amount you're paid when you invest your money with a financial institution. It's expressed as a percentage of the loan amount or deposit amount. For example, you might be charged 6% interest on a loan, which means you pay 6% of the principal balance each year to borrow.
Lenders set interest rates based on your borrower profile if you're borrowing, always within a minimum and maximum. For example, a personal loan lender might advertise rates between 7% and 15%, with borrowers who have the best credit scores and sufficient income to repay the loan eligible for the lowest rate. When you borrow, lower interest rates are always better than higher rates, because a lower rate reduces the amount you have to pay back.
If you've borrowed at a high rate, you can sometimes refinance to pay off your debt. For example, it's common to take out a personal loan, which tends to have a lower rate, and use the loan proceeds to pay off high-interest credit card debt.
You can learn more in our guide to how credit card interest works.
4. Understanding your credit score
You have lots of different credit scores, but most are on a scale of 300 to 850, with scores above 670 considered good, very good, or excellent, and scores below 670 considered fair or poor. The key factors that determine your score include the following:
- Payment history: This is the most important factor. If you've been 30 or more days late on a payment, or have any judgements or delinquencies, this will result in a lower score
- Credit utilization: This refers to the amount of credit you've used versus the credit available to you. This should be kept lower than 30% to avoid hurting your score, and borrowers with the best scores typically keep it below 10%. If you have a $1,000 credit limit, this would mean you're using no more than $100 in credit.
- Length of credit history: This refers to the average age of your accounts. The longer your accounts have been open, the higher your credit score.
- Mix of credit types: It's generally better to have different kinds of credit, including credit cards and loans called installment loans that you pay off on a set schedule over time, such as personal loans or mortgage loans.
- Number of new credit inquiries: When you apply for credit, you sometimes get a hard inquiry on your credit report. Too many can be damaging to your score.
5. Calculating your net worth
Your net worth is how much your holdings are worth in total. It's calculated by:
- Adding up the value of every asset you own, including your home, vehicles, investment accounts, and personal possessions
- Subtracting for all liabilities including mortgages, credit card debt, and other debt.
A high net worth means you have assets that greatly exceed the value of your liabilities. A negative net worth happens when you have more debt than assets. Your net worth changes throughout your life as you repay debt and acquire property and investments. When your net worth is high enough, you're considered wealthy.
6. Mortgage loans
Mortgages are used to buy homes, since few people can pay cash for them. They are secured debt, which means there is an asset guaranteeing the loan that the lender can seize if you don't make your payments. The house is the asset that secures your mortgage.
- With a fixed-rate loan, your payment remains the same for the whole time you're paying off the house. With an adjustable rate mortgage, or ARM, it changes periodically.
- ARMs have names like "5/1" or "7/1 ARM," with the first number referring to how long the rate is initially fixed for, and the second referring to how often the rate could change. So a 5/1 ARM has a fixed rate for five years, and the rate can adjust once annually after that. A 7/1 has a fixed rate for seven years, and a rate that can change once annually.
Mortgages are typically paid off over a long time -- a 30-year mortgage is most common, although some people take out 15-year mortgages that come with higher monthly payments but cost less in total. If you itemize on your taxes, the interest you pay on your mortgage may be tax-deductible.
Qualifying for a mortgage often requires a lot of financial paperwork, including documentation of your income, and proof you don't have too much debt. You'll need at least a good credit score to get a loan from most lenders, although there are some loans with a government guarantee -- such as an FHA or VA loan -- that you can get with a score as low as 500 in some circumstances.
Lenders typically also want you to put a 20% down payment on the home to get a mortgage. If you're buying a $300,000 house, that would be a $60,000 down payment. This protects the lender if you can't pay your bills, because if the lender had to foreclose and sell the house, it should get back enough to repay the loan. While you can qualify for a loan with much less -- as low as 3.5% down in some cases -- this often means you have to pay for private mortgage insurance (PMI) to protect the lender from loss.
Take the time to improve your financial knowledge
The impact of the novel coronavirus on your finances is likely to be profound for many people. While you may face challenges budgeting in the midst of a pandemic, you can use the time you're home to learn about these key financial concepts so you'll be better prepared for money management when life returns to normal.
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