Introduction To Personal Finance
I’ve gotten more into podcasts recently, and heard a Freakonomics episode claim only 30% of Americans are financially literate. Not too surprising since we know the American education system is lackluster. A study of 1,000 people found that 13% had a 5-year plan for their finances and 33% didn’t have a budget. In 2017, 17,000 people took a national financial literacy test and 48% passed. For those who would like to know more: here’s the basics.
Of course, some people have different advice: “just make more money.” Frankly, that’s decent advice. The internet has a lot of opportunities to create meaningful value and get paid for it. But I’ll cover that in a separate post. This post is for those who’d like an overview for banking, budgets, or goals. Everyone needs a foundation before they can build.
Disclaimer: This is not legal or financial advice and is for informational purposes only. It’s a compilation of opinions and research; a general course which may not apply for everyone. For professional individualized help, please see a financial advisor and/or lawyer. The below information may vary in the future, such as APR amounts; do your own research as needed.
- Understand your financial situation and have a budget
- Set aside money for emergencies
- Company 401(k) match
- Pay off high-interest debt (like credit cards and personal loans)
- Contribute to a Roth IRA or Traditional IRA as needed
- Reduce debts and save 10-20% of income
- Grow while avoiding actively managed funds
This isn't a path for everyone, but it can be a start.
First, know how much is going in and out. How much income? How much in expenses? Any specific financial goals to keep in mind? Are there expenses to eliminate, lower, or replace with alternatives? When income is low, reducing expenses can have a faster impact than increasing income.
Creating a budget, even if it’s done just once, can set things in order. Some people use spreadsheets, while others use websites and apps. Options include:
- Mint by Intuit https://www.mint.com/ (free)
- ourLibra https://ub.ourlibra.com/ (free)
- Personal Capital https://www.personalcapital.com/ (free)
- YouNeedABudget https://www.youneedabudget.com/ ($84 a year)
Housing costs (such as rent and insurance) shouldn't exceed 25-30% of income. If housing is above 30%, it is what it is; sometimes that's how life goes. But look into increasing income through monetization of hobbies, freelance work, or something else. Or move to another area for remote work. For each other spending category (such as food and transportation) it's recommended to not exceed 10-15% of income.
A former Wall Street executive advocates a "50-30-20 plan." 50% of income toward necessities (like rent or utilities), 30% of income toward optional things (like travel or dining out), and 20% of income into savings/investments.
Remember, there isn't a need to micromanage funds. It's often a bad idea to devote too much mental energy to minutiae. Just check transactions and balances from time to time, and correct areas when necessary. For example, if half your money is spent on eating out, maybe you need to scale back.
2. Emergency Funds
Everyone should set money aside for emergencies, as insurance. No one agrees on a “correct” amount for emergency funds, because it varies by individual. There’s only wide agreement that cash needs to be available “just in case.”
$1000 is usually the starting point. Once all high-interest debt is paid off, the emergency fund can increase to 3-6 months of living expenses. Bills would still get paid if there’s a job loss, and a job hunt shouldn’t (ideally) last longer than 3-6 months. Some people aim to save 12 months of salary to cover catastrophic losses. This is fine, but other things are more important first (like paying debts). Three months’ expenditures should do it for most people. That’s still often unrealistic. CNBC reported in 2018 how “60 percent of millennials don’t have enough money to cover a $1,000 emergency.” In 2020 they reported "41% of Americans would be able to cover a $1,000 emergency with savings." Some economists recommend saving $2500 for emergencies.
This is another reason why a budget is useful. A person can't save 3-6 months worth of expenses if they don't know how much money they need.
Keeping emergency funds in a high-yield savings account is best. It’s rarely needed immediately (otherwise it’d go into a checking account) but it needs to be accessible on brief notice (thus no investments). CDs/bonds are okay for most people, but high-yield savings accounts are generally better (increased flexibility and sometimes better rates).
2a. Financial Institutions: Checking and Savings
A reasonable budget and small emergency fund will set many people on the right path. There’s one other basic thing: the method of spending/storing money.
“Studies have shown that the average American household can spend as much as $155,000 over their lifetimes in financial, bank and investment fees. In 2018 alone, U.S. consumers paid $11.5 billion in bank overdraft fees…. The average savings account pays 0.10% interest, while the average 12-month CD pays 0.66% interest, according to the Federal Deposit Insurance Corp. However, some online banks offer savings accounts with APYs up to 2.80%.” (Marketwatch, 2019)
The first priority is to eliminate fees. There are plenty of banks which have zero/low fees, and paying extra is unnecessary. A free checking account is always the first step, and some offer cash sign-up bonuses for opening an account. There will likely be small requirements to avoid monthly recurring fees. Everyone has to shop around and see which company best suits their needs. ATM fees are harder to avoid, although some banks refund fees for customers.
After that, a high-yield savings account for the emergency fund, as mentioned above. Most, like Ally Bank, have no minimum balance and no fees. (Aside from fees for making “excessive” monthly withdrawals.) It’s easy to avoid charges these days, since banking is a competitive field. Many banks are aggressive about getting new long-term customers. It’s easy for people to switch banks if a better offer arises.
2b. Financial Institutions: Card vs Cash
Next on the list for accounts: rewards credit card(s). Except for those with existing credit card debt, because that needs to be paid in full. Credit cards are only worthwhile if we don't pay interest. It's high, and even one debt payment can hit hard. They need to be like debit cards: never spend what can’t come out of checking. Credit cards without annual fees are also plentiful, and if used correctly, are always 100% upside. Those with credit card debt should only consider a new card if there’s a good balance transfer option combined with a 0% APR offer.
Building positive credit history is near-essential in the United States, making credit cards important by proxy. They can even affect employment opportunities. So if having a card is necessary, might as well get paid for it by having a card which gives out rewards. Debit cards almost never give usage incentives, and cash can be inconvenient. Neither contributes to credit history either. Plenty of credit cards offer 2-3% cash back on everyday spending, with some giving 5-6% cash back. (Limited offers can give 10% or more.) It’s basically free money. (Not quite, but that's a topic for another post.)
For more information, check out what I wrote on no-fee credit cards. I'll add updates to this site in the future.
3. 401(k) Match
A 401(k) is an employer-sponsored retirement plan available at certain companies. Some people will have a 403(b) instead, which is almost the same thing. Contributions are automatically taken from pre-tax income at a percentage set by the employee. As of 2020 there’s a $19,500 annual contribution limit ($25,500 if 50+ years old). Employees may be automatically enrolled, manually enrolled, or eligible only once they’ve worked at the company for a certain number of years. Funds are then invested into chosen areas.
401(k) plans differ from company to company, and I won’t cover everything. It’s too individualized. The important part is that some companies offer a “match” where they’ll add money to the retirement account as well. This doesn’t count toward the employee’s annual contribution limit and doesn’t come out of employee pay. “About 40% of companies contribute 50 cents for every dollar employees contribute up to 6% of their pay. Another 38% match employee contributions dollar for dollar, but the maximum is normally lower – commonly 3%.“ (Investopedia)
Any match at all, no matter how low, is free money for the employee. This is why finance experts recommend prioritizing 401(k) contributions when possible. It's important to note, however, that maxing out the annual $19,500+ can be a bad idea. It depends on personal wealth goals. For people who don't need the tax benefits, a regular stock portfolio might be better.
To avoid penalties, 401(k) withdrawals can't happen until at least 55-60 years old. Meanwhile, there are no penalties on regular stock portfolios, just capital gains taxes. (Which can be as low as zero. Some states and income thresholds don't have these taxes.)
4. Reduce Debt
There are two recommended methods:
- Avalanche - Pay off debts starting with the highest interest rate. This is optimal because less money is owed in the long run.
- Snowball - Pay off the smallest debts first to get them out of the way. This can free up some cash flow and give a psychological boost, although more might be owed in the long run.
The “best” method varies for each person’s unique situation. For exact calculations, sites like unbury.us are good.
Some types of debt and average interest rate:
- Payday loans (400%)
- Credit card debt (14-20%)
- Personal loans (5-36%)
- Auto loans (3-14%)
- Student loans (5-8%)
- Mortgage (4%)
American student loan debt and credit card debit are currently in the trillions so a lot of people are concerned about those categories.
Vehicle loans can be more manageable than other types of loans, in terms of interest rate and payments. Depends on credit score and other factors. Plus some people don’t have cars or they lease instead. Leases are typically less efficient than buying a car, but it can work for some situations. Similarly, buying a house is often more cost-effective than being a renter. Please see a financial advisor for personalized advice.
It’s important to note that debt isn’t always bad. If the interest rate is low. That money can be leveraged to get returns outweighing the APR. This is an advanced strategy, though, and not for everyone. Most people probably prefer to be debt-free. Or they'd increase their income enough to reduce the usefulness of debt (leverage).
5. IRAs and Retirement
An IRA (Individual Retirement Account) is a retirement account similar to a 401(k). There are key differences, but essentially, IRAs are not employer-sponsored (depending on the type of IRA), they have more investment options, and there isn't a "match." Using both 401(k) and IRA accounts creates diversity which can lead to better returns. Aim for a low-cost provider like Vanguard. Keep an eye on fees and expense ratios.
- Traditional IRA earnings grow tax deferred, but are taxable as income upon withdrawal; contributions may be tax deductible. Federal and state taxes apply.
- Roth IRA earnings grow tax exempt. When withdrawn, income tax isn’t charged on the earnings (if meeting requirements for a “qualified distribution")
Traditional IRAs are better for people who want an immediate tax break, and/or expect to move to a state which has lower taxes. Some states don't tax retirement account withdrawals. To withdraw the money without penalties, one has to be at least 59 1/2 years old (although rules vary).
Other considerations include HSAs (Health Savings Accounts) which have a $3,400 annual contribution limit.
Like 401(k)s, it's not always best to max out an IRA. It varies according to each person's financial situation and goals.
5a. Math for Retirement
Another item to consider: when contributing to a retirement account, inflation eats into the account value. Money now is more useful than money later. Retirement accounts also take a lot of time to build up, and aren't usable for long.
As an example:
Let's say you "make it" by the time you're 30. A decent job with all extra money going into retirement. You can max out your 401(k)/IRA/HSA accounts every year, and want to retire at 65. Without a 401(k) match, that's barely over a million dollars (not including ROI, taxes, or IRS rule changes)
- $568,000 for 20 years of contributions (age 30-50)
- $531,000 for 15 years of contributions (age 50-65)
The average life expectancy in the USA is 78, so by withdrawing retirement funds after 65, you have just 13 years to use your life savings (35 years of contributions). One online calculator estimates IRA + 401(k) value at $3 million (assuming 7% ROI). Which, divided by 13 years, is about a $250,000 annual salary. A comfortable amount, but you have little time to enjoy being in a high tax bracket. And this is assuming you MAX OUT retirement account contributions, every year, starting at 30.
Other options, such as starting a business, could lead to higher returns and cash flow. A business generating annual profits of $100,000 (under $2,000 per week) may outdo retirement account contributions in the above example (without even investing those profits). Although starting a business isn't for 80-90% of people. Most are fine with the 401(k) route.
This is just food for thought. Do your own research (DYOR).
6. Save and Invest
There are too many options and strategies to give one starting point. Each situation is unique. Like taxes. For anyone who wants to take a peek into investing, try one of these:
All are free or low-cost. Lots of information and ideas are floating around the internet. Some, like M1 Finance, can be DIY or a hands-off automated strategy. People can go in-depth or stay on the surface; either is fine.
The most basic low-level financial path is “create a budget, avoid big debts, maximize free money, think about retirement.” In-depth investment information doesn’t have a place here—it’s better suited to its own post. It can be good to check out investing early and see how it works. Putting $100 into M1 or Robinhood and playing around is a fair hands-on learning experience. Or set up a lazy portfolio. Just remember that active trading has worse returns.
Either way, stocks are not that worthwhile until someone has lots of money in the bank. Small investments = small returns. There are more efficient ways of using/obtaining money until you've accumulated six to seven figures. And some people are concerned about the sharp increase in money supply. This will likely impact prices for a lot of things.
For those who do have lots of money in stocks, they don't need to sell anything to get cash when needed. Some institutions allow clients to borrow a percentage of their portfolio, sometimes at a lower APR than personal loans. This is often a better deal than selling funds and incurring capital gains taxes. Also see: margin. For example, M1 Finance allows people with a balance of at least $10k to borrow up to 35% of their portfolio for any reason, at 2-3.5% APR.
One last note: It's not possible for someone to "save up" their way to legitimate wealth. It needs to be built. Don't obsess over minor details, but never stop learning. And good luck.
7. Additional Considerations: Decentralization
Bitcoin, Ethereum, and other decentralized technologies will change the way we live. Legacy banking institutions face potential obsolescence if they don't stay ahead of the curve. With decentralized finance and internet, open source apps, peer-to-peer transactions, and more innovations, everything could be in our own hands. IPFS for example.
Like the stock market, there's too much to cover in this introductory article. However, search engines have plenty more information. No one knows what the future looks like, but decentralization will be a part of it. Therefore, it's important to consider the how and why. "Knowledge is power," after all.