The 5 Most Important Rules of Personal Finance
Personal finance can seem a bit intimidating to most people, but you really don’t need to be a finance expert to manage your money.
In fact, many of the basics are easier than you think. Here’s 5 rules that, if followed diligently, will go a long way towards improving your financial security.
1. Run a budget surplus.
Perhaps you’ve heard the famous quote from Wilkins Micawber in David Copperfield:
“Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness.
Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Simply put: If you want to avoid financial disaster, you’ve got to earn more than you spend.
Obvious, right?
But it’s a simple rule that escapes most of us. Usually, when we begin to earn more money, our spending increases accordingly. It’s tough to resists the lure of all the new things you can buy. And when you’re consistently spending more than you make (particularly when this spending is going on your credit cards), can you guess what the long term result is? That’s right: Misery.
2. Understand compound interest.
Einstein once reportedly declared compound interest the most powerful force in the universe (at least that’s the urban legend). Whatever he actually said, there’s no doubt compound interest can be your greatest friend or worst enemy, depending on which side of the equation you fall on.
Compound interest is a fairly simple concept: Whenever interest is calculated (be it on your savings account, your credit card debt, your mortgage, etc…) it’s based not just on your original balance but on any interest that has been added. Basically, your interest earns interest, which in turn earns its own interest, and so on, leading eventually to an exponential growth rate.
Interest is typically compounded annually, biannually, quarterly, monthly, daily or sometimes even continuously. The more frequently interest compounds, the faster it grows. Compound interest is why a small amount saved and invested can grow into a large sum over time. It’s also why your debt can grow to unmanageable proportions if you’re only making your minimum payment each month (more on that later).
3. Start saving early.
If you’re young and can afford to save regularly, compound interest means you can turn a small initial investment into a huge retirement fund. For example, a 20 year old who puts $1000 into a 5% interest savings account compounded daily (many online banks offer similar rates) and is disciplined enough to add $100 per month will see this account balloon to $213,184.53 by the time they turn 65.
If that same 20 year old had instead been stuffing that $100 under their mattress every month, at 65 they’d have saved just a paltry $55,000. That additional $158,184.53 came about purely through the miracle of compound interest.
To find out how many years it will take you to double your money on any investment with compound interest, use the Rule of 72. Simply divide 72 by the interest rate you’re getting. For example, with a 5% interest rate, it’ll take you 14.4 years to double your money (72/5 = 14.4). With a 15% interest rate, you’ll double your money in just 4.8 years. Even if you’re not in your 20s, compound interest will still work strongly in your favor. But the earlier you get started the better.
4. Always make more than your minimum monthly payment.
The other side of the compound interest equation is when you owe money. It can take you 25 years to pay off $5000 debt on a 12% interest credit if you just paid the minimum balance each month. At that point, you will have also racked up nearly an additional $5000 in finance charges (which is exactly what credit companies want to you do).
That’s because a big chunk of your minimum monthly payment goes towards paying the accrued interest which, as we know, keeps growing and growing. Same with your mortgage. Minimum monthly payments are designed to take as long as possible to pay off your debt, allowing the lender to rack up the highest possible finance charges they can.
The rule here: Start saving early and frequently to have compound interest working strongly for you, and always make more than your minimum monthly payment on bills where compound interest is working against you.
5. Control your spending.
Seems obvious, yet few do it. Here’s one way look at it: If you were to get a $5000 a year raise, you’re going to lose about 30% of that raise to state and federal taxes. However, if you find ways to trim your annual spending by $5000, you get to keep 100% of that money tax-free. From that perspective, cutting unnecessary spending is actually better than earning more money, because you get to keep more of your money.
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