This is the third of five posts (in our Financial Must series) where we’re aiming to provide you with a tremendous foundation to achieve your financial goals. We will be posting 2 musts every Friday until the list is complete. If you are enjoying the posts, please take a minute to subscribe to MikedUp Blog. Just click on the ‘subscribe’ button in the bottom right corner, enter your email, and you will get every post as soon as it’s published.
We have the previous four Musts listed below to remind you what we’ve covered. If you’d like to read about those in detail, check out Must Post 1 or Must Post 2. Thanks for reading!
1) Find a way to earn an income and do it at an early age.
2) Set goals for yourself financially, and make sure at least one is attainable in the short term.
3) Open a checking account.
4) Get a credit card with a low limit.
5) Do not put anything on that credit card if you don’t have the money for it in the bank.
Just because I advocate for having and using a credit card, this does not remove any of the responsibility. Actually, credit card debt is one of the biggest reasons people resort to bankruptcy. Here are some how-to’s to make sure that’s not you.
The most important thing is the title of this section. If you don’t have the cash already in your checking account, mattress, or freezer, don’t make the purchase. Gambling with someone else’s money is not a practice you should employ regularly. Just because you expect a certain amount of cash to come in next month does not make it so. People get laid off, sales dip, and believe it or not you can’t trust everyone. If you only purchase items on your credit card with cash you already have, you build credit, receive points, and avoid debt. Everyone wins… well, you win.
Let’s rewind a bit though. When first starting out, it’s unlikely that you’ll be approved for the big fancy card with the big fancy point system. A great way to start is with a low limit card either at a department store you frequent or through a bank with which you have your checking account. People may also advise you to go for the lowest interest rate possible. While i do agree with this, because you’re not buying with someone else’s money and are doing what’s below, this may not be as important a factor. This should be a factor in your choice but maybe not the most critical.
Don’t put everything on this card. At your stage of the game, quantity is not necessarily your friend. As long as you’re putting about $20 on the card each month, you’re establishing credit history. Also, using up a majority of your credit each month can hurt your credit score. This is called bad credit utilization and It shows you borrow perhaps more than you should. 20% or lower is the sweet spot, so keep it simple and start small. That means $40 per month on a $200 credit limit – “anything more would be uncivilized…” (google it).
When you get your bill – pay it in full. You already have the money for it in the bank so make it happen. If you pay the bill before your due date you’re showing good credit history and avoiding those ridiculous interest rates that put good people under water. 30.00% APR only applies to remaining balance that is not paid in full at the end of the month. Because we don’t get to that point, the interest rate doesn’t matter.
As you continue this process for a period of months your credit score will continue to rise, at which time you may be able to apply for a better card with a better rewards program and interest rate. Don’t get ahead of yourself though. Keep it small for a while. This reduces your exposure and allows you to build good habits you’ll take into your higher income earning years.
6) Start an investment savings plan.
Your thought bubble may be: “Why should I care about saving for retirement, that’s like eons away (if people still use the word ‘eon’)?” Let me tell you. If you are able to save and invest just $100 per month into a conservative fund – meaning a modest 6-8%, we’ll use 7% for arguments sake – the time at which you start doing that is immeasurable. Well that’s not true, let’s measure it. If you assume ‘retirement’ at age 65 and start doing this when you’re 35 years old, you can expect to have roughly $114,000 in your account. If you begin investing $100 per month at age 18… about $397,000!! A difference of $283,000 and you only paid about $20,000 of that. That’s crazy talk! False, it’s actually widely reported talk.
Saving money is important. I understand that $100 each month may seem like a lot of money now, but don’t get bogged down by a figure. $20 is better than $0. Start small and work toward your goal, we’ll get more into this below.
Time and compound interest are amazing allies when it comes to saving money. Fortunately, you have both. A crude explanation of compound interest is this. After your first year of saving money, lets say you have $1000. Assuming our 7% rate of return you should have $1070 in your account starting year 2. At this point, your total principle (the total amount of money in your account) is up $70 so that next year you are not earning a percentage of $1000, you are earning it on the new total, $1070. If you make no new additions to this account during year 2 (which you would never consider because you know how important saving is, right?), you’ll have $1,144.9. This process will repeat itself year-after-year and as your principle grows larger and larger, the amount of interest you earn increases at an exponential rate. Time is vital. Every year leads to a more powerful principle and a higher amount of interest earned. Use your time and knowledge of compound interest to your advantage. If you don’t believe me, take it from my buddy, Al.
‘Al’ – or – Albert Einstein once said two things (well, he said a lot of things, but here are 2 of them): “The most powerful force in the universe is compound interest,” and “compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” Earn it, don’t pay it.
Alright Mike, I get it, I need to save money. Now what? 401 (k), IRA, 403 (b), 495, 529, and a regular old savings account will all be relevant to you at some point in the future, but for now let’s just start with one, IRA. There are two types, Traditional and Roth. Both have advantages and disadvantages, honestly it comes down to preference and what works best for you at the moment. For your age group, the relevant difference centers around when you pay tax on the money in your account.
For a Traditional IRA (T-IRA I’ll call it) you must earn an income to contribute. The money you earn goes tax free into your T-IRA. What does this mean? OK, let’s say you earn $1,000 during the month and decide you are contributing $100 to your T-IRA account. In essence, that $100 goes directly into the account and it’s like you’ve only earned $900 that month. Therefore, you pay a percentage of income tax based on the $900 rather than the $1,000 you had initially earned. Your total tax paid will generally be lower. The drawback is that your distributions are then taxed when you take the money out. Let’s say you’ve saved and done well for yourself. After the appropriate age you want to take money out of your T-IRA to pay for bills, trips, or whatever else you like. No problem, that withdrawn money will now be taxed as if it were income from a job. A benefit to this system happens up front. Because your $100 dollars is not taxed, it is a true $100 instead of ~$85ish. Your principle grows higher so that your interest rate can work harder for you earlier because of the compound interest magic we discussed above. A solid benefit, no doubt.
Know this for the future – you are only eligible to contribute a certain amount annually and this adjusts most years, just know it’s quite a bit above your $100 per month goal.
Roth IRA (R-IRA) accounts, on the other hand, are taxed up front so that when you get your money out down the road, it’s generally tax free. Benefit: when you’re older you won’t have to pay the tax. Drawback: your $100 is actually the ~$85ish and doesn’t have the ability to grow quite as fast…
Whichever you choose is good by me. Saving money is better than not, so taxes now or later will still equal taxes. We’ll cover more of these investment accounts in a separate post but let’s keep this personal finance train moving… Next Friday (March 25).
Thank you for reading! If you’d like to read about our other financial musts, check out Must Post 1, Must Post 2, Must Post 4, or Must Post 5. If you’ve enjoyed this post please subscribe to the blog so that every new post comes straight to your inbox. You can also check out the YouTube channel (MikedUp Blog) or follow Mike on Twitter (@RealMikedUp). Have a question or comment? Let us know by commenting on the post or emailing Mike at [email protected] We’re glad you’re here. Thanks again and talk soon!