Basic finance is one of the most important things you can learn in your life. For good or bad, everything evolves around money. In today’s world, you either have it or you owe it. Being in the latter category puts you at a disadvantage while the former gives you more control over your life.
Finance isn’t taught in most schools. Some of the biggest decisions you make in your life will revolve around money- buying a house, a car, getting a business loan, paying for college. Then there are credit cards. Credit cards are a convenience with a tremendous cost.
Don’t worry, finance is actually simple. You don’t need to understand complex math or fancy equations. You just need to understand the actual cost of spending more money than you have and then make changes to stop doing it.
You spend more money than you make. It’s that simple. You struggle to pay all your bills every month. Most purchases are made with your credit card. You purchase $5 here and $20 there and are shocked when you see your credit card bill. Surely you didn’t buy that much.
You know you should be saving more and investing, but there just isn’t enough money at the end of each month. You don’t purchase frivolous things.
You think, “I just need more money”. Once you get a raise or find a better job, all your problems will be solved. You’ll be able to start saving and pay down your credit cards. You’ll even be able to start looking at buying a house.
The costs of overspending are higher than you think, and not just because of interest. But interest is the most common one, so let’s start there.
Let’s say your just starting out. You got your first credit card and are eager to use it. You’ve got a $1000 limit and can buy things without having money in the bank. You’ve heard that if you pay off your bill each month you don’t have to pay interest (20%), so you are keeping your purchases small. But small purchases add up quick. Let’s look at an example of a few purchases over a month.
- Morning coffee ($4) (5 days a week) x 4 weeks =$80/month
- Afternoon coffee ($4) (3 days a week) x 4 weeks =$48/month
- Lunch ($10) (5 days a week) x 4 weeks =$200/month
- Dinner with colleagues $20 (twice a week) x 4 weeks =$160/month
- Total =$488/month
A few small, regular purchases such as morning coffee and you are already at half of your $1000 limit. You haven’t even made any shopping purchases. This is a really important point. Small purchases add up. They are dangerous because we don’t think about them. Without any additional purchases, your credit card will be full in only two months.
It’s also important to note that these costs can mostly be avoided. For example, making coffee at home and bringing your own lunch would cost far less than purchasing a coffee and eating out for lunch.
Your credit card is full. But you can’t afford to pay it off. In fact, money is as tight as ever. But the minimum payment is only $35/month. You can afford that.
Assuming you don’t make any additional purchases on the card until it is paid off, your $1000 of purchases will actually cost $1,369.20. Even scarier, it will take 3 years and 4 months to pay off.
This means that everything you purchase actually costs nearly 37% more than the purchase price. Your $4 cup of coffee actually cost you $5.48. $20 dinner with a colleague? That actually cost closer to $30 ($27.4).
Not only do the small things add up, when purchased on credit, they cost far more than we realize. 20% isn’t even high for a credit card rate. Many cards are in the 30% range. At 30% your interest costs become nearly double. Your $1000 balance will take 4 years and 3 months to pay off and cost $1,775.70.
You can figure out what your credit cards and loans actually cost by using a credit card calculator like this one.
The “Other” Cost
High debt reduces your choices and opportunities. You don’t have a lot of options because you have to pay your bills.
Hate your job? Too bad, you have bills to pay. Want to take a break from work and travel around the world? Sorry, bills to pay. Want to spend more time with your family or go back to school? Nope, bills to pay. In fact, with all of these bills piling up, you might want to think about looking for a second job.
High debt limits your options and causes stress. Finances are one of the top causes of stress. High stress can lead to medical issues, which can cost more money.
Reducing debt and your monthly expenses gives you more choice in how you want to live your life.
Spend less money
No, really. It actually is that simple. Most people focus on the fact that they don’t make enough money rather than the amount they spend. They think, “If I get a raise, a promotion, a better job, then everything will be better.”
Making more money won’t help if you don’t change your mindset.
A couple my friends, we’ll call them Tom and Lisa, were in serious debt. Tom and Lisa both had jobs, but had maxed out credit cards, student loans, personal loans, and car payments. Every couple of years they moved into a larger and more expensive rental house. They were at their limit. Then the baby came.
They were no longer able to cover their monthly expenses and had to borrow money. Lisa was only able to spend a few months with the baby because they needed her income. They managed to scrape by.
A few months later Tom had a new job that paid more and Lisa was back at work. Their income had increased significantly. Their financial situation hadn’t. They purchased a third car, began taking trips, eating out more, and increased their spending.
More money didn’t solve Tom and Lisa’s financial problem because their problem wasn’t the lack of income, it was overspending. When their income increased, so did their spending.
Small purchases make a big difference
That $4 cup of coffee may not seem like much, but it makes a huge difference overtime. At $4 a cup plus tax, your trip to the coffee shop each morning cost you over $1000/year. Purchase some sort of food to go with your coffee and you are paying over $2000/year. $2000/year that could easily be saved by making coffee at home and taking your own breakfast.
Now consider how all those small expenses add up over the course of a year. I don’t drink coffee, so in college I was shocked that my classmates purchased Starbucks coffee on a daily basis, often multiple times a day. I began to calculate the monthly cost in my head and was shocked. I called it the Starbucks Effect. Staying poor by making small unimportant decisions that add up to have a great effect. David Bach refers to this as the Latte Factor in his new book The Latte Factor. $4 a day may seem unimportant, but $1000/year is enough money to make a difference.
Improve your future, then your present
David Bach and Robert Kiyosaki refer to this as “paying yourself first”. Pay for the things that improve your future (savings, investments, education, buying a home) and pay for everything else with what is left over. You decide your monthly budget with what is left over.
As an example, if you make $4,000/month, put $1000 to the savings, investments, and planning for a house. Use the remaining $3000 to pay your rent, your car, your phone, your food, and your coffee. When you invest in your future first, you never have to feel guilty about other purchases because you have already covered yourself for the future. If you find that your money isn’t going far enough, cut back your costs to stay within your $3000 budget.
Make it automatic
We are easily tempted. “This TV is such a great price that I can’t pass it up. I’ll put extra into savings next month.” The best way to pay yourself first is to take it out of your hands altogether. Have the amounts automatically pulled out of your account. Take away the temptation to use that money. Do the same for your 401k and similar investments through your company.
Remove your ability to succumb to temptation and make it automatic.
Understand Compound Interest
Compound interest means that you make money on the amount you put in plus the amount of interest you have gained. Remember that time is your friend when it comes to compound interest. The earlier you start investing, the better. As we saw above, this also works against you with credit card and loan interest.
Look at the below examples of compound interest. They all start with a $1000 investment at an annual interest of just 6%. Notice that after 5 years you have only made $338 and after 10 years you have made $1,790. After 30 years you have made nearly 6 times the amount you started with. Only 10 years after that you have made over 10 times your starting amount, $10,285.72.
- After 1 Year=$1,060.00
- After 5 Years=$1,338.23
- After 10 Years=$1,790.85
- After 30 Years=$5,743.49
- After 40 Years=$10,285.72
The earlier you start investing, the more your money can work for you. Unfortunately, credit cards work the same way. The longer it takes you to pay off your debt, the more it costs you.
If you made it this far, you are serious about improving your finances. But if you stop here, nothing will change. I’ve created a short list of actions you can take to start improving today.
- Purchase The Automatic Millionaire or The Latte Factor. These books show you exactly what steps to take to get your finances under control. I prefer The Automatic Millionaire, but The Latte Factor is a quicker read. Consider this purchase an investment. Here are my notes on The Latte Factor.
- Make a list of all of your expenses. What can you give up? What seems small but adds up over time? What can you change? Could you bring lunch to work instead of eating at a restaurant? You won’t miss most things as much as you think, especially when your finances start improving.
- Automate your investments. Remember that when it comes to compound interest, time is your friend. Don’t wait.
- Once you are able, increase your payments on your credit cards and loans. Even better, automate extra payments. The books mentioned above describe the best way to do this.
- Set goals and savings plans for the bigger things you want in life. This will help you avoid wasting money on the small things.