While working with a trusted financial professional is important for managing big financial goals, most of us handle money daily. It’s unrealistic to speak to your financial advisor for every money decision, so it’s important to have a working understanding of financial literacy fundamentals. Here are five financial basics everyone should know to help you in your day-to-day decision-making.
Basics #1: Debt & Credit Scores
An important part of your foundation is understanding how credit and debt can work for or against you. Many people avoid debt altogether out of fear or intimidation, but this can be unwise. Instead, it’s important to have a working understanding of debt and a plan for dealing with it responsibly.
When used correctly, debt can be a critical key to unlocking financial security. It can help you reach important goals such as buying a car, purchasing a home, going to college, starting a business, and more. But when misused, it can rapidly spiral out of control. Missed payments can accrue interest or penalties and cause a significant hit to your credit score.
Your credit score is one factor lenders use to judge your trustworthiness and qualification for mortgages, auto loans, and other lending opportunities. Landlords and employers may also check your credit before renting to you or offering you a job. Your credit score is based on several factors, including previous credit history, current debts, debt level compared to available credit, history of payments, and more.
Basics #2: Interest
Interest is a double-edged sword: it works against us when it accrues on debt and works for us when it accrues on savings. Mathematically, these are two applications of the same concept, but it just depends on which side of the transaction you are on: are you lending money, or are you borrowing it?
Interest on Debt
When you take on debt, you’re responsible for paying back the principal amount and the interest accrued on the loan. The interest is how the lender makes money on the loan. Lenders use your credit score to determine how much risk they’re taking on by lending to you. The higher the perceived risk that you will default, the higher your interest rate.
Interest on Savings
When you have a savings account that accrues interest, you are lending the bank money so that they may pay you interest. Any interest earned gets added to your savings. Then, interest is earned on the new, larger principal, and the cycle repeats. This is compounding interest,1 and it can be an integral part of growing your retirement savings. The longer the interest has to compound, the faster the pace at which your savings will grow.
Basics #3: The Value of Time
It’s never too early to start saving, whether for retirement, home buying, a child’s education, or unexpected expenses. The earlier you start saving, the more you’ll be able to set aside over time. In addition, the sooner you start, the more your earnings will compound, where you’re earning interest on the interest you’ve previously earned. More time means more compounding—this concept can be applied to your investments, your home, and even your salary. If you start early, you can leverage the value of time to your advantage.
On the other hand, it’s never too late to start saving, either. Plenty of people start saving later than others due to family situations, low earnings, or early indulgence. It’s almost always better to start saving late in the game than never to save at all.
Basics #4: Inflation
Inflation erodes the purchasing power of your money: the dollar you have today may not be worth as much in the future. Here are two important ideas to remember regarding inflation.
Cash in a Mattress
Keeping all your cash under a mattress is not only unsafe but also costs you in purchasing power. Suppose the annual inflation rate is 2%: every dollar you keep under your mattress and not earning interest would shrink in purchasing power to about $0.98 next year.
Rate of Return
Due to inflation, any returns you earn on your accounts don’t translate directly to an increase in your purchasing power (or your real rate of return). If your investments earn a nominal 6% over a year, but inflation runs at 1.5%, your real rate of return is a bit less than 4.5%.2
In a time of low interest rates, it is easy to feel like this means that you shouldn’t have any money in cash. That is not true: cash in the bank serves the important function of staying safe. But while keeping all of your money in cash trades away the risk that you may lose money in the short-term, in return, it makes all but certain that you will lose purchasing power in the long-term.
Basics #5: Identity Theft & Safety
As the world continues to shift to more and more transactions taking place online, identity theft remains one of the biggest threats to financial and personal security. A cracked password or over-shared Social Security number can have severe consequences to your current and future finances.
One basic defense is to use a unique password for each site or service you use. A password manager can make this much easier by automatically generating and storing strong passwords, so you don’t have to struggle to commit every complicated combination of characters to memory. You would gain access to your password manager using a master password: make sure it’s particularly secure and memorable. While you may want to keep a written copy until you are sure you have it memorized, destroy that copy as soon as possible, so you don’t inadvertently give a thief access to all of your passwords.
This is a brief overview of some essential financial literacy. It’s vital to work with your trusted financial professional to explore these topics further. Remember to reach out if you have questions about any financial concepts, basic or otherwise. Tax filing season is a great time to reevaluate your current financial knowledge and identify any areas for improvement.
1. Britta likes to say that compounding interest is the closest thing we have to magic.
2. The most precise calculation is a bit more complicated than just subtracting 1.5% inflation from a 6.0% nominal rate of return. In this example, the real rate of return is about 4.43%.