After high school, I was lucky enough to find a well-paying job. The problem I had was knowing what to do with my new-found money.
The fact that I didn’t know wasn’t a surprise. Most people graduating are sadly under-educated when it comes to money. In fact, the National Financial Educators Council asked a handful of young adults between the ages of 18-24 what course would benefit them the most in high school. Not surprisingly, 51.4% responded with money management. So it makes sense that it took me many years to get a grip on my finances.
If education is an essential human right, financial education should be a large part of that. But it’s not. So, in the hopes that I can help others facing the same cold reality, here are the top four things I wish I knew about finance before I was 20:
1. The Compound Interest
Compound interest will be the main driver of growth for your retirement nest egg. It’s not that complicated, but if you don’t take a look at the numbers you may not understand why it’s so important.
Imagine you put $1000 into a savings account that has an annual interest rate of 5%. That means you would gain 5% on your account balance, every year!
Year One: $1,000 + 5% ($50) = $1,050.00
Year Two: $1,050 + 5% ($52.50) = $1,102.50
Year Three: $1,102.50 + 5% ($55.13) = $1,157.63
Year Four: $1,157.63 + 5% ($57.88) = $1,215.50
After five years, without putting any more money into your account, you would end up with $1,276.28. It might not seem like a lot, but after 25 years you would have $3,386.35. Now imagine what it would be like with regular contributions! The earlier you get started with an account that earns you interest, the better your result. As your account grows, so does the benefit of compounding.
2. Compound Interest – The Bad
Everything you just learned about compound interest is amazing. The only problem is, you aren’t the only one armed with this knowledge. You know that amazing credit card you got that you used to fund your vacation? Let’s pretend it has an interest rate of 20%. You used $2,000 of credit, and you don’t pay your bill. Here’s what happens after a few years:
Year One: $2,000 + 20% ($400) = $2,400
Year Two: $2,400 + 20% ($480) = $2,880
Year Three: $2,880 + 20% ($576) = $3,456
After five years, you now owe the bank $4,976.64. That got out of hand fast, didn’t it? As you can see, compound interest works wonders in favor of whoever has the cash.
Alarmingly, 43% of millennials use high-interest borrowing methods such as payday loans. As a result, they have compound interest working against them. Make sure you keep that in mind when you’re spending money that you don’t actually have (aka credit).
3. How To Create A Budget
Two-thirds of Americans would struggle to gather $1,000 in an emergency situation. Are you one of those people? Making a budget can be difficult at first. There are several different ways you can approach it. After trying (and failing) at a few different methods, I finally found one that worked for me.
It was obvious I needed a method that was simple. Something I could do on a daily or weekly basis, without getting bogged down by too much work. I settled on a gamified method that goes like this:
- Calculate your after-tax income per month
- Add up all your fixed expenses (think rent, phone, gym, loan payments etc.)
- Subtract fixed expenses from after-tax income; this is your allowance
- Divide your monthly allowance into 31 days to get your daily allowance
- Every time you spend, you subtract from your allowance!
If you spend less than your daily allowance, you Win The Day! Try to win at least 75% of the days in a month. Again, there are many other methods out there but this is the one that stuck for me. I love trying to see if I can win the day and the month.
4. Couch Potato Investment Strategy
Once you have a budget down, and you’re spending less than you’re making with no high-interest debt, it’s time to start taking advantage of compound interest in an investment account. The problem with high-interest debt is that you cannot guarantee that your investment returns will be higher than your debt. So – unless you can predict the future – squash the high-interest debt before embarking on an investment account.
A lot of people want to invest and make fast money. The problem is, the stock market is quite unpredictable. What you want to do is play the long game. I like to use the couch potato strategy. It’s easy to manage, it’s fairly safe, and it will make you money.
This strategy recommends that you invest your money in Exchange Traded Funds. These are like stocks but they often track a basket of assets like an index fund instead of single companies. You get great diversification and usually have lower fees than mutual funds. Reading the Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School helped me develop my first investment strategy. I recommend it as further reading.
If our schools aren’t going to teach us what we need to know about money management, we will have to do it ourselves. Becoming financially literate enables us to plan for our future.
Not only will financial planning help you retire, but it can also reduce your stress. 67% of Americans say that paying their bills or expenses is their greatest source of anxiety. I’m just going to assume that you’d prefer to keep your stress levels below moderate levels.
In short, your personal finance journey will be a lot like a marathon versus a sprint. Warren Buffet summed it up well when he said:
“Someone is sitting in the shade today because someone planted a tree a long time ago.”
Plant your tree as soon as possible, but give it plenty of time to grow.
Now that you know the four things I wish I knew before I was 20, what are the tools or strategies you wish you would have known?