3 Baseline Rules of Financial Health
When we go to school, we learn how to read and write. We learn arithmetic and basic geometry. We learn about world history, and some of us even learn a little bit about art. However, public school seldom teaches us about those things we use the most. We might find ourselves utterly in the dark when it comes to something as basic and frequently necessary as financial management.
Financial health is a crisis in modern society. Far too few people know how to manage their own finances, which leads us into unprecedented debt and cataclysmic stress levels.
This stress affects our job mobility, our marriages, and our standard of living. Furthermore, it has a long-term effect, crippling the potential of our children as well as ourselves.
And while we’d like to think that as adults, we have a handle on the most basic rules of finances, the truth is that most of us are thrown into terrible financial situations by a variety of circumstances: medical debt, difficult life crises such as divorce or addiction, or even by terrible habits that we learned as young adults and never broke.
So, what can you do to be more financially healthy? Here are the first three things that everyone should know in order to build a solid financial future for themselves and their loved ones:
1: Understand How Debt and Credit Works
Credit allows us to make big purchases and pay them off over time. Credit in credit cards are kind of like mini-loans.
Loans are an important tool to enable anyone who wants to to buy a car or house, get an education, or start a business. Overall, this is a great thing… unless we’re unable to pay back that loan.
In order to offset the risks of not being paid back, institutions that offer credit or loans charge interest.
This means that when you pay back the amount that you borrowed, you also pay an additional amount. That interest will usually change according to how big of a risk you are (which can be determined using your own personal financial history.)
When credit and loans work correctly, they’re wonderful things. However, all too often, it goes wrong and creates a muddled mess of financial mismanagement and victimization.
The primary mistake that people make is to assume that when they’re given a line of credit, or a loan, that that money is theirs.
If you get an ad in the mail saying that all you have to do is fill out an application, and $5,000 will be yours… do you believe it?
Always remember that there are strings attached to these offers. Sure, there are mutually beneficial arrangements out there. But do your research to find out for sure.
The person who sent that mailer did it to make themselves richer; not to do you a favor. With that money also comes an obligation to pay them back, with interest.
Think of it this way: If you buy a car up-front, for the actual cost of the thing, it might be a total of $25,000. However, if you take out a loan for it, offered at 6% interest for 5 years (which is a fairly average rate) you’ll be able to pay off the car and own it scott-free in 5 years, for a manageable monthly payment, sure.
However, in the end, you’ll have paid out about $4000 just in interest fees. This means that your car didn’t really cost $25,000. It cost $29,000.
Again, this can still be a worthwhile choice for you to make, if having the car now is more important than saving $4000. However, this same principle applies for all credit and loan scenarios.
So before you utilize money that isn’t yours, ask yourself whether you’d really like to spend $29k for a $25k car. The first rule of money management is to live within your means. Avoid spending money you don’t have.
2: Have a Safety Cushion
The second rule of money management is to take safety precautions. You might have the most exacting and careful budgeting techniques.
These might make it so that you’re never forced to go into debt for your planned expenses. But what if those expenses go up, and your paycheck doesn’t? What if the landlord raises the rent? What if your car breaks down?
What if you need a medical procedure done, or your child needs to go to a special school? Most of all, what if you suddenly lose your job?
This is where a safety cushion comes in. Life throws us all kinds of curveballs… and most of them cost money!
These expenses will be outside of what you usually expect for your monthly costs. You need a reservoir of money that you can tap into when this happens, or you’ll be forced to turn to creditors who see you as a high risk, and therefore charge you astronomical rates of interest.
A safety cushion protects you from this. The generally-recommended amount of a safety cushion you should have is three months’ income. Depending on your risks and dependents, that number might need to be adjusted.
3: Plan for Retirement
Even if you’re fully set with a healthy safety cushion, your financial health isn’t well-rounded until you have a plan for your retirement.
When you’re old, working is much harder. You want to go easier on your body, and spend your time doing those things that bring you joy. Social security is meant to provide a baseline income for each person, based on their needs.
However, there are often problems with social security and government health insurance programs that leave the elderly without the funds to pay for the care that they need, or the lifestyle they want.
Additionally, it’s hard to rely on the ever-changing political climate to plan for your old age. And so, the responsibility for long-term saving is on you.
The goal of retirement savings is not to provide enough of a nest egg that you can pull from that reservoir until you die. After all, how can you know how many years you’ll have to live after you retire? People are living longer and longer these days.
“Rather, the point of retirement savings is to have such a good chunk of money in savings that you can live off of the interest, rather than the principal amount.”
This means that you can live off of it indefinitely. It also requires a pretty good amount of money for the principal. Fortunately, that chunk of money will start accruing interest before you ever have to start using that interest.
That means that the interest payments get turned right back into savings. This is the miracle of compound interest, and it works exactly the same way as credit and debt… just flipped upside down. Interest is working FOR you, instead of AGAINST you.
You’re through the looking glass! That means that you can put in $20,000 into a savings account, and it can double within a decade. The wealthiest people in the world (and the happiest in retirement) are those who have learned to use this system to their benefit.
However, it requires the first two rules of financial basics that I mentioned above to be in place. It also requires a certain level of discipline and planning.
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Category: Financial Education
