Saturday, Jan. 19, 2019 | 2 a.m.
Two-thirds of Americans can't pass a basic financial literacy test, according to a study of 80,000 people by FINRA Investor Education Foundation. That means the majority do not have the knowledge needed to make smart financial decisions, potentially costing them thousands of dollars over a lifetime in missed investment opportunities, debt, poor saving habits and more. At even greater risk are minorities, less-educated individuals and women. While the gender gap is closing for females of younger generations thanks to financial education in schools, a 10 percent knowledge gap still exists between millennial men and women. So what steps can you take to become financially literate, you ask? The following is a brief overview of the basics.
+ $150 utilities
+ $350 loans
+ $250 groceries
= $1,550 (monthly essential expenses)
÷ $4,000 (monthly income)
= 39% debt-to-income ratio)
Note: The Federal Reserve considers a DTI of 40 percent or more a sign of financial distress.
Assess your finances
Before you even begin to save and invest, you need to understand your financial health, taking into account everything from credit card debt, student loans, monthly bills, income and savings.
Spend a day pouring over finances and cataloging everything—annual income pre- and post-taxes, debts, credit cards, mortgage payments, savings, IRA or 401K contributions, and subscription membership services, such as Netflix and gyms.
Group expenses into two categories—essentials and nonessentials. Essential expenses include housing, utilities, groceries—things you cannot live without. Nonessentials include wants and elective spending, such as entertainment.
Once this is done, determine your debt-to-income ratio by adding all of your monthly essential expenses and dividing that total by your total monthly income.
The basics of budgeting
Now that you know where your money is going, it's time for fine tuning.
The 50/30/20 budget guideline divides your take-home pay into percentages to help establish a baseline for financial health:
• 50 percent of your take-home pay should be spent on necessities
• 30 percent should be spent on wants
• 20 percent should be saved or put toward financial goals.
Groceries are unique because they straddle the line between wants and needs. You need to eat, but do you need name-brand cereal? Food is one of the easiest areas to cut your budget.
Continue to monitor every dollar in and out to keep yourself on track. Need help with this? Lean on apps to carry the load. Mint, YNAB and Wally are widely used for creating and maintaining a budget. They'll help you categorize expenses, connect to your bank and track your remaining budget throughout the month to deter overspending.
Despite what you may hear, not all debt is bad. Good debt, such as reasonable car or student loans, as well as mortgages, show banking institutions you're capable of paying back what you owe, and this can help you build your credit score. Bad debts include high-interest credit card balances carried over month to month. Often times, you pay more in interest than the original purchase cost. So how do you tackle these debts and improve your financial footprint?
Whichever method you choose, make sure you’re paying at least the minimums on all of your debts each month to avoid late fees and penalties.
Pay off high-interest debts first. Take a look at the debt balances carried on each of your accounts and focus on the one that carries the highest interest rate (while still paying the minimums on your other debts). If it’s credit card debt you’re combating, call the issuer to ask for lower rates. Eliminating high-rate accounts first frees up money you’re spending on interest.
If seeing progress is more important to you, try the snowball method. The snowball method may not save you the most in interest in the long run, but it generates quick momentum. Focus the majority of your payment on your smallest debt. Once that’s eliminated, move on to the next smallest and so on. For some, seeing quick results is essential to their quest for a debt-free life.
Student loans, car loans and mortgages are often debts with low interest rates and can be paid off slowly over the duration of the loan. Of course, if you don’t have debt with higher interest, it doesn’t hurt to pay more than the minimum each month.
Check your credit score
Your credit score is one of the most important numbers tied to your identity. It can affect most large commitments, purchases and interest, such as auto loans, apartment applications and mortgages. Freecreditreport.com, Credit Karma and most major banks have a feature that allows you to see your credit score.
There's nothing wrong with using credit cards. In fact, many earn you fantastic rewards and bonuses on your spending. Just be sure to pay off the balance each month.
Building savings and investments
More than a third of Americans don’t have $400 to pay an unexpected expense, according to the Report on the Economic Well-Being of U.S. Households in 2017. Additionally, less than two-fifths of Americans think their retirement savings are on track, and 25 percent have no retirement savings at all. Even if it’s just a few dollars at a time, finding ways to contribute to retirement funds early can yield thousands of additional dollars over time.
When it comes to pre-tax contributions, IRAs, Roth IRAs and 401(k)s are great ways to save for the long haul.
If your employer offers a 401(k) match, be sure to earn the whole match. For example, if you earn $45,000 annually and your employer matches 50 percent of your 401(k) contributions up to 5 percent, that’s an extra $1,125 annually.
Roth IRAs and regular IRAs grow your contributions over time depending on the earning power of your investments. For more information and annual contribution limits, visit the IRS website.
• Build an emergency fund: The standard advice is to save 3-6 months of living expenses in your emergency fund. While that should be the ultimate goal, aim to have $1,000 in an easy-access savings account for emergencies, such as car or home repairs. After you have the first $1,000, work up to the 3-6 months goal. Look for savings accounts with the highest annual percentage yield. Over time, the accumulation of interest can add hundreds of dollars to your savings.
• Build a fun fund: Don't forget to reward yourself for your hard financial work. Instead of being dependent on credit cards or your checking account for activities that bring you joy, create a separate fund for things such as travel or shopping.
• Practice zero-dollar spending days: Set days where you spend no money, and instead divert that savings into your fun fund. For example, if you normally go to lunch with coworkers, pack a lunch instead. Look up what you spent on those extra daily purchases and transfer them to your fun fund. In time, your big dreams of backpacking through Europe will become more accessible.