Americans seem to have gotten religion when it comes to managing their money — or at least they talk a good game. Three in four adults say they’re trying to increase their financial knowledge as a result of the economic crisis, according to a survey by Mintel Comperemedia.
But making consumers financially savvy is a challenging task. In a sobering study, Financial Literacy Among the Young, published by the National Bureau of Economic Research, authors Annamaria Lusardi, Olivia S. Mitchell and Vilsa Curto found that fewer than one-third of young adults in their twenties had a basic knowledge of interest rates, inflation and how to control investment risk. Asked whether the statement “Buying a single-company stock usually provides a safer return than a stock mutual fund” was true or false, only 47% answered correctly (“false”), and a whopping 38% didn’t know.
A whole library of books has been written on investing, not to mention other financial themes, such as buying a home or planning a secure retirement. But if I were to design a curriculum in financial literacy that would be both simple and practical and would put you on a firm footing, I’d include the following eight lessons.
LESSON #1: Know where your money goes
Create your own spending and savings plan at a budgeting Web site, such as Mint.com or Wesabe.com. Or simply track your expenses the old-fashioned way, by scouring your debit- and credit-card statements for a month to see where you’re leaking cash (you can use our budgeting worksheet and fill in the blanks).
Perform financial triage. Pay your bills in order of priority: health insurance, mortgage, high-interest credit-card debt. Then, pay off the lowest balances first; it will give you a feeling of accomplishment and free up cash for other uses.
Start an emergency fund. Aim to have enough in the bank to cover at least six months’ worth of expenses. If that’s too daunting, start with a more modest goal. Even being able to cover a month or two of expenses will help you feel more secure.
LESSON #2: Save, save, save
Have money taken right off the top from your paycheck so you’re not tempted to spend it. Regardless of how much you earn, the surest way to save is to have someone else do it for you.
Divvy up your savings among different pots, depending on your goals: a computer, a vacation, a new car or a house (see Why You Need Multiple Savings Accounts).
Use our compounding calculator to see how your savings will grow. Remember that inflation can take a big chunk out of your savings in the future. Even at a modest rate of 3% per year, rising prices can cut your buying power in half in 25 years.
LESSON #3: A credit card is not cash
Paying with plastic is the same as taking out a loan, for which you will often pay a steep rate of interest. Use our calculator to see how long it would take you to dig out of debt.
Get a free copy of your credit report every year at www.annualcreditreport.com (despite those clever commercials, other Web sites advertised on TV generally don’t provide free services). Your credit history, as compiled by the three major credit bureaus, is a record of all your credit transactions. Your credit score distills that history into a single number, generally your FICO score (calculated by the company Fair Isaac). Order it, along with your free credit report, from the credit bureau Equifax for $7.95.
Pay your bill in full each month, pay it on time, and keep your balances low — say, less than 30% of your credit limit on each card. Those three simple steps will keep your credit record squeaky-clean. In a bind? Negotiate with your creditors, or get help at www.helpwithmycredit.org.
LESSON #4: Start early to plan for retirement
A Roth IRA is the best all-around retirement plan. It’s portable, flexible and gives you tax-free income in retirement (see Why You Need a Roth IRA).
Sign up for your employer’s 401(k) or other retirement plan as soon as you start working.
Try to contribute at least enough to get any company match — which, after all, is free money. Start smaller if you can’t afford that much. No company match? Stick with a Roth IRA.
LESSON #5: Know what you’re getting into when buying a home
Don’t overstretch to buy a house. Blinded by prices that never seemed to stop rising, buyers lost sight of the basics in recent years. For example, it takes time to build equity — the money that belongs to you after you sell the house and pay back the lender — because during the first several years of your mortgage, you’re mostly paying back interest and very little principal (the loan amount).
Principal and interest aren’t everything. Your monthly mortgage payment probably also includes a slice of your property taxes, plus hazard insurance in case your home is damaged or destroyed. Factor that in when you’re figuring out how much house you can afford (use our calculator for help). And keep in mind the ongoing costs of homeownership and maintenance. For a comprehensive rundown on buying (and selling) a home, go to www.trulia.com.
Your total monthly payment, including taxes and insurance, shouldn’t exceed 28% to 31% of your gross income, and total debt shouldn’t exceed 30% to 40% of your income. Another number to remember: Home prices generally rise slowly — on average, about 2% to 3% a year, tracking the rate of inflation.
LESSON #6: Be smart about paying for college
A state-sponsored 529 plan is the best way to save (see College: Keep on Saving). Stick with your state’s plan if you get a tax break for your contribution. Otherwise, use one of our favorite plans.
Don’t count out financial aid. Schools have stretched the definition of need to include families with higher incomes. Also, many schools give merit-based aid.
The best deals for borrowers are government-sponsored Perkins and Stafford loans for students, and PLUS loans for parents and graduate students (see www.studentaid.ed.gov). You need to fill out the Free Application for Federal Student Aid (FAFSA), even if you don’t expect to qualify for financial aid based on need and you want to borrow using just government-sponsored loans.
LESSON #7: Buy enough insurance coverage at a good price
Life insurance. You need life insurance if you have young children, or if your spouse or someone else depends on your income to pay the bills. Figure on buying enough to cover eight to ten times your annual income (use our calculator for a more precise estimate). After plummeting for a decade, premiums for term insurance — pure coverage with no savings component — have been rising recently. But you can probably still buy all the protection you need for only a few hundred dollars a year (get quotes at AccuQuote.com).
Car insurance. Shop frequently, because premiums can vary enormously by insurer (find quotes at www.insweb.com or www.insurance.com). And get all the discounts you deserve. Some are automatic, such as a price break if you have several cars or multiple policies with the same insurer. But some you may have to ask about, such as discounts for low mileage or carpooling.
Homeowners insurance. Don’t overinsure. Boosting your deductible from $250 to $1,000 and paying small claims out of pocket can lower your premiums by as much as 25%. You need enough insurance to replace the building and details inside, but not the land. To calculate rebuilding costs, go to www.accucoverage.com. (For more information on all types of insurance, see our Insurance page).
LESSON #8: Invest wisely
Don’t be afraid of stocks. The recent market plunge notwithstanding, stocks have delivered the highest investment return over the long term — averaging about 10% per year for big-company stocks since 1926. The best way to invest without losing sleep is to use dollar-cost averaging, which means investing a set amount each month or quarter. Automatic transfers prevent you from letting your emotions or the latest news prompt you to buy high and sell low (see Be a Better Investor).
Know how much risk you can live with. One conservative rule of thumb is that the percentage of stocks you own should equal 100 minus your age, or 60% if you’re 40 years old. Spread your risk by investing in different kinds of assets, such as large and small U.S. companies and foreign firms.
Put your money in an index fund. This is the easiest — and cheapest — way to diversify your investments. An index fund pools the resources of many individuals to invest in a broad-based portfolio of stocks (or bonds). Index funds also charge very low fees — and the surest way to boost your investment returns is to cut your costs.