National Financial Literacy Month is recognized in the United States in April to highlight the importance of financial literacy and teach Americans healthy financial habits. Throughout the last few weeks at Rooted Planning Group, we have tried to learn as much as we can about the CARES Act and pass that knowledge along to all of our clients and readers. But today, we want to pivot and teach you how to increase the other areas of your financial literacy and make you an official Financial Smarty Pants. Below are some terms and components that we feel are important to have strong financial literacy knowledge.
Emergency Savings - what does that even mean and do I really need one?
While it is common knowledge we need to have money set aside, having an emergency savings is the most important savings you should have. I do believe the current situation we are in with COVID-19, highlights just how important it is to have emergency savings. We recommend that you have 3 to 6 months of expenses set aside in case you and/or your spouse/partner lose your source of income. This means you need to be able to pay your bills and provide food and other necessities for 3 to 6 months without receiving any income.
Interest Rate - this can work for you or against you (hopefully for you most of the time)
Interest rates can work for you when you save your money. For example, depositing it into a savings account, money market account, or Certificate of Deposit (CD). Often the interest rate is quoted annually but can be calculated for periods shorter than that. The bank will deposit a certain amount into your account monthly, quarterly, or annually.
Example, if your savings account pays a 5% interest and the balance is $1,000, the interest you will earn annually is $50.
This is called simple interest and here is the calculation - $1,000 (amount) x 0.05 (APR) x 1 (Number of Years)
Simple interest is a very basic understanding of how interest rates work, however, things are not always that simple, especially when you borrow money.
Interest rates work against you when you borrow money. Often lenders will state the interest rate as an APR or Annual Percentage Rate. This is very important because this is a way for you to calculate what something is actually costing. The APR will be the amount the lender will charge you for using their money.
Example, if you purchase a $20,000 automobile, pay $2,000 down, and borrow $18,000 for 5 years, the interest you pay on your loan will be $2,381. This makes the total cost for purchasing the vehicle $22,381 vs. the $20,000.
Auto loans are often calculated using simple interest. Bankrate has a great calculator I use often when calculating auto costs. I am personally getting ready to buy my daughter a car before she heads off to college in a year and have been doing a lot of research. In addition to the Bankrate calculator, two other resources I recommend is Episode 38 of Amy’s Wine and Dime Podcast on this subject and Financial Mentor’s calculator that shows the true cost of owning a car. This is detailed and shows the annual cost of owning a car and the cost per mile. It also allows you to compare two potential purchases.
Your Home Mortgage is another example of borrowing money and while every lender calculates differently, the important takeaway is that you need to think long and hard about your home purchase and the true cost of your home. NerdWallet has a mortgage calculator that compares a 15 year mortgage vs. a 30 year mortgage. 15 year rates are often lower than 30 year rates. But also remember that you will also have homeowners insurance and property taxes.
Example - $100,000 Home, $20,000 Down Payment, Financing $80,000. What will it actually cost you if you finance for 15 years and 30 years?
Total Cost for a 15 Year Mortgage with a 3.4% Interest Rate - $122,238
Total Cost for a 30 Year Mortgage with a 4.1% Interest Rate - $159,162
Final Note for your Financial Smarty Pants self on Interest Rates
Always, always, always, think about what interest rates are doing for you or what the rate is costing you when you purchase something.
So far, we have learned the importance of emergency savings, interest rates working for us and against… So what else is important to become a smarty pants??
Risk Management - what??
Risk management is a very fancy smarty pants way to say you need insurance. I won’t go into too big of a spill about insurance because this is a subject that needs its own article but this is one of the areas we see clients making mistakes on, not litigating risk. You need to have health insurance, property (home, auto, and umbrella) insurance, and other fun stuff like short term and long term disability. Often, these can be provided by your employer but if not, this is something you may need to purchase from an outside source.
Retirement and Investing
Saving for retirement and investing money can be a very intimidating subject. For one, I believe this is one of the reasons we have financial literacy month. Also, there are so many different types of financial people out in the world throwing all kinds of fancy jargon, like asset allocation, mutual funds, ETFs, IRA, Roth IRa, etc. How is a person supposed to know all of these terms and if these products are right for them? This is something we find important to educate our clients on and as Certified Financial Planner’s at Rooted Planning Group, that is what we do with our clients.
Here are a few terms and components of retirement and invest that we think are important.
Retirement Savings - Money that you save while you are working that is set aside to use during the years you are no longer able or want to work. The earlier you start to save, the easier it is to accumulate a significant amount of savings set aside for your retirement. This can be accomplished through your employer in a 401k or other type of employer savings account. This can also be accomplished if you are self employed through Traditional IRA’s, Roth IRA’s or other investments savings account. Additionally, to increase your smarty pants knowledge, IRA stands for Individual Retirement Account.
This subject brings the second important term we want you to learn:
Compound Interest
I know we talked about interest above but if you can get this term down, it will change your life. This is an interest that you want working in your favor. Rumor has it that Einstein called the Power of Compound Interest, the 8th Wonder of the World. “He who understands it, earns it. He who doesn’t, pays it.”
Here is a quick video on what compound interest is and on how it can work for you while saving.
Compound Interest - 8th Wonder of the World
Compound interest is important because this is how you get momentum when saving for retirement with investments. So what are investments?
Investments
Investments are another one of those things that can be very intimidating and confusing and financial people also are anonymous for throwing jargon around sometimes. The biggest takeaway from this is, if you do not understand something, do not invest in the product. Find an advisor that is willing to educate you on what you are actually investing in or educate yourself first and then invest. I will, however, increase your financial smarty pants knowledge with a few terms below that are common when it comes to investing.
Stocks - a stock is a piece of a company that you can purchase. Companies will sell shares of their stock to raise cash. Investors can buy and sell these shares. Sometimes, a stock can have a high return and gain you money when you sell the stock. But, this can also lose money if you purchase a company that does not do well (or closes their doors). Buying and selling stocks can be risky. The best thing you can do to help with the risk is to educate yourself and/or find an advisor that is also an educator at heart.
Bonds - a bond is a loan you make to a company or government. When you purchase a bond, you are allowing the bond issuer to borrow your money and pay you back with interest. Bonds are generally considered safer than stocks, but they also generally offer lower returns. Bonds are issued by a lot of different companies, as well as the government.
My favorite example is building a stadium. The owners of stadiums cannot afford to just build a stadium, so one way to finance it would be to issue bonds. You could purchase a bond from the stadium owners and allow them to use your money; once the stadium is built, they will repay you the amount you loaned them through the purchase of the bond plus interest on the bond.
Mutual Funds - if investing in individual stocks does not sound like fun to you, then mutual funds are a great way to invest. There are a ton of complex definitions of mutual funds however, I like to explain it like this: visualize stocks (companies) like Easter eggs, now a mutual fund is the Easter egg basket. If a mutual fund is an Easter egg basket, then inside of it you can have all kinds and colors of Easter eggs (companies). Now there are thousands of mutual funds out there to purchase, so again educate yourself on the fund and the expenses of owning the fund.
And, to add to your smarty pants knowledge, you do not just go and purchase a stock or mutual fund, you have to have opened some type of an account and the stock or fund is purchased inside that account.
There are other types of investments like Index Funds and ETF’s (Exchange Traded Funds) but they are 1st and second cousins to the mutual fund. This is where your head may start to hurt so we will end here.
There are other important terms to keep in mind like credit, credit score, asset allocation (fancy way of saying make sure all of the eggs in your basket are not the same color), re-balancing, itemized vs standard deduction, and I could go on and on.
We at Rooted Planning Group love to educate so reach out anytime to any one of us if you have a question. I hope you feel like a Financial Smarty Pants and that your pants get bigger everyday!