Introduction To Personal Finance
I’ve gotten more into podcasts recently, and heard a Freakonomics episode which said only 30% of Americans are financially literate. This was a mild surprise, but I 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: The below is not legal or financial advice and is for informational purposes only. It’s a compilation of opinions from various sources; a general course which may not apply for everyone. For professional individualized help, please see a financial advisor and/or lawyer.
- 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 which can be eliminated, lowered, or replaced with cheaper alternatives? When income is low, reducing expenses can have a higher (and 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. For other spending categories (such as food and transportation) it's recommended to not exceed 10-15% of income.
2. Emergency Funds
Everyone should set money aside for emergencies, as insurance. No one agrees on a “correct” amount for emergency funds. There’s only wide agreement that cash needs to be available “just in case.”
$1000 is usually the starting point. Once all debt over 10% APR 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 off high-interest debts). Three months’ expenditures should do it for most people. That’s still often unrealistic though. CNBC reported in 2018 how “60 percent of millennials don’t have enough money to cover a $1,000 emergency.” Some economists recommend saving $2500 for emergencies.
In any case, keeping this money 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 short notice (thus no investments). CDs/bonds can be okay, but high-yield savings accounts are far better (increased flexibility and sometimes better rates). More on that in the next section.
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 that doesn't see much discussion: 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)
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 have no minimum balance and no fees. (Aside from fees for making “excessive” monthly withdrawals.) It’s not difficult to avoid charges these days, since banking is a competitive field. Many banks are aggressive about getting new long-term customers. It’s easy 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 used 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 impact 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.
For more information, check out what I wrote on no-fee credit cards. I'll write a new post about it soon.
3. 401(k) Match
A 401(k) is an employer-sponsored retirement plan available at certain companies. 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. Some people will have a 403(b) instead, which is almost the same thing.
401(k) plans vary widely 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.
People can't withdraw from their 401(k) until at least 55-60 years old, if they want to avoid penalties.
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 also 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.
5. IRAs and Retirement
An IRA (Individual Retirement Account) is a retirement account vaguely 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.
5a. Math for Retirement
Note that, like a 401(k), maxing out yearly IRA or HSA contributions isn't always the best plan. Inflation and taxes may eat into the account's value. 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 US 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 salary. A comfortable amount, but you don't have much time to enjoy being in the 35% tax bracket.
Other options, such as starting a business, could lead to higher returns and cash flow. A business generating annual profits of just $100,000 (under $2,000 per week) will outdo retirement account contributions in the above example (without even investing those profits). There's more to consider, of course, but what I've written is just food for thought.
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 first look into investments, try one of these:
All are free or low-cost. Lots of information and ideas are floating around the internet.
The most basic low-level financial path is “create a budget, pay off debt, 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 with the options is a fair hands-on learning experience. Or set up a lazy portfolio.
However, stocks are not that worthwhile until someone has a good amount of money in the bank. Small investments = small returns. There are more efficient ways of using money until you've accumulated a fair amount. And some people are concerned about the sharp increase in money supply. This will likely impact prices for a lot of things.
One final note: It's not possible for someone to "save up" their way to legitimate wealth. It needs to be built. Don't obsess over small details, but never stop learning. And good luck.