"To laugh often and much; To win the respect of intelligent people and the affection of children; To leave the world a bit better, whether by a healthy child, a garden patch or a redeemed social condition; This, is to have succeeded." - Ralph Waldo Emerson

Friday, December 10, 2010

Financial Management for the Newly Independent Part 1: The Basics

Being frugal or thrifty often gets a bad rap, and is seen as a boring or stifled way to live your life. It doesn't have to be that way. My partner and I live a fairly frugal lifestyle, without sacrificing a rich social life, comfortable home life, great food, or travel. I thought I'd share a few of our favourite tips for living a happy, frugal life. This is a long post, but this information has completely changed my financial situation for the better, and I believe it's worth explaining in detail.


Our Situation
First of all, a little about our own financial situation. We are by no means wealthy. One of us makes a couple of dollars above minimum wage, but has benefits, while the other makes a few dollars more, but has no benefits and is in a higher tax bracket, meaning our take home pay at the end of each month is not substantially different. Combined, we have about $35,000 in student debt, and as of March 2011, we will have no consumer debt (very excited for that milestone!). I acknowledge that we have certain financial advantages - we have dual income, we live in a rural area, which significantly reduces our housing costs (our lovely home would cost at least double what we pay if it was in an urban area), our driving records are flawless and as a result we have very low insurance rates, but I still think the majority of the following tips are applicable to everyone, regardless of how similar or different your financial situation is to ours.

Understanding Money
First and foremost, a basic understanding of banking and finances is essential to good money management. Do you know your credit score? More importantly, do you know what financial decisions affect your credit score, and which don't? Did you know that opening a new credit card lowers your credit score? Did you know that closing an old credit card lowers your credit score? Did you know that holding a balance of more than 30% of your credit limit on your credit card really, really lowers your credit score?

Of course, you can't simply never open or close a credit card to protect your credit score, but timing is everything. Opening or closing a credit card will cause an immediate hit to your credit score, but it will almost immediately start improving from there. This means it's a poor financial decision to cancel or open a credit card immediately before applying for a big loan, as your credit score will be lower than usual when applying for the loan, meaning your interest rate will be higher. A difference of only a couple of points in your credit score can cost you literally hundreds of thousands of dollars over your lifetime on a big loan (like a mortgage) so a basic understanding of credit and credit scores is one of the most important financial steps you can take.

Another key financial concept to understand is compound interest. Compound interest is when interest is added to the principal (meaning the original money you put into a savings account), and then that interest that's been added to the principal ALSO earns interest, and then the interest on the interest earns interest, and so on. This has a ripple effect, meaning the earlier you start investing money in savings, the faster that money increases in value. Here's an example. If you started putting $100 a week into savings when you were 25, and you were getting a 6% return on investment (which is a high interest return in this economy, but that's not really the point here), you would have $868,146 upon retiring at 65 (40 years later). However, if you waited only 10 years to start saving, and started saving the same amount at 35, you'd have $437,604 at 65, or roughly half of what you'd have if you'd started only 10 years earlier. The younger you are when you start saving (no matter how little you're saving) the faster that money will multiply.

Saving vs. Debt Repayment
A word about saving. No matter what your financial situation, you should always have an emergency fund. While you should always make at least the minimum monthly payments on all your debts, any extra money should go into savings until you have at least $1000 for emergencies in the bank. After that, whether you should be investing more of your money into debt repayment, or into savings, depends on your specific situation, and your interest rates. In our case, putting a substantial amount of our monthly income into savings, while only making slightly above the minimum monthly payments on our student debt, makes the most sense for us because the amount of compound interest we'll earn on the savings we invest in our 20s significantly outweighs the amount of interest we'll PAY on our student loans, which have a low interest rate. This is NOT the same for everyone and you need to either calculate it for your own situation, or talk to your banker to figure out which is best for you. For some people, especially people with high levels of consumer debt (which tends to have very high interest rates), you're better off focusing on debt before savings, at least once you've got your emergency fund established. Figure out what's best for you and do your research, rather than copying our model exactly.

Getting Organized
Now, on the topic of saving - a lot of young people in fairly low income brackets often believe they can't afford to put any money in savings. For some people this is true, but for many it's not. The first step in establishing whether or not you actually can afford to save is to get your finances organized. My partner and I honestly believed we had no extra money that could go into savings, until we signed up with www.mint.com, now we save almost 1/3 of our income every month. I know I sound like an infomercial at the moment, but hear me out. Mint.com allows you to link all of your bank accounts, credit cards, loans, etc to one site, so you can see all your finances clearly laid out in front of you (it's safe, and was recommended to me by my bank). It tracks all of your transactions, and allows you to categorize all your spending, and then lays it out in tidy graphs so you can see where most of your money is going. The very first thing my partner and I realized, was that almost 1/4 of our income was going... well, we don't know where. Almost 1/4 of our income fell into the category of 'uncategorized' - meaning we couldn't remember where it was going - likely to things like coffee at work, lunches bought in the cafeteria instead of brought from home, little impulse purchases at the grocery store - basically 'stuff' that hadn't added any value to our lives, but was eating up a lot of our income. We also realized we were spending an obscene amount on groceries.
Mint.com helps you set up really effective, straightforward budgets, and by doing this, we realized that once we had budgeted for all of our essential expenses, as well as a bunch of fun expenses like dinners out, shopping, and so on, we still, in theory, had a lot of money left over. This was the money that was getting wasted each month, so we opened a high interest savings account and started putting that amount directly into savings each month, right on pay day, before we could miss it. And frankly? We haven't missed it. At all. We don't even notice it's gone, yet a third of our income is going into savings each month, bringing us rapidly closer to our goals of travel, and eventually buying a house. And all it took, in our case, was organization. I highly recommend everyone at least try it. Worst case scenario, you find out you really don't have any money left over for savings, but best case scenario, you discover you do!

Since this is getting very long, I'm going to break it up into 2 posts. Now that you've got the basics, the post following this one will talk about some everyday money saving tips that we use that have really worked for us.


  1. Great post! Interest point about paying off student debt/saving (something I still need to do the math on once I finish school in the spring...).

    Our current plan was to maintain our current standard of living and hopefully pay off my student debt in under a year and a half. For me having a large amount of debt is a constant source of stress/worry and there isn't a good way to fact that into the calculations! For me there is nothing more depressing than setting 'debt repayment' as a goal on mint and seeing a goal completion date WAY in the future (and the corresponding crazy amount of interest!)

  2. @Rachel Ferguson - That's a very good point! If paying down your debt more slowly in order to accelerate your savings is going to be a huge source of stress, then it may not be worth it to approach it that way, even if there are savings.

    In our case, we'll have our student debt paid down in 7 years, based on our current income and savings/debt repayment plan. It's a relatively long wait, but because the interest rate on our student loans is fairly low, and the interest rate on our savings account is fairly high, we'll earn almost twice as much interest on our savings as we'll spend in interest on our debt, so it's worth it for us to take the slower approach.

    However I doubt I'd take the same approach if I had a lot of consumer debt, since the interest rates on credit cards or consumer loans can be exorbitant. To tackle the small amount of consumer debt we have, Chris and I put all savings on hold (once we had an emergency fund established) to tackle consumer debt more aggressively. This saved us a lot of interest, and allowed us to pay off in a few months what would have taken over a year if we just did minimum payments.

    Anyway, moral of the story is there's no hard and fast rule in terms of debt vs. savings - it varies widely from situation to situation :)


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