There is no shortage of financial advice in the digital world. From the “next hot thing” to your 401(k) to your discretionary income, the Internet is cluttered with recommendations. So rather than telling you what to do, let’s talk about some money mistakes that are costing you thousands. Using your assets to their fullest potential requires a greater understanding of how money and basic financial instruments work.
Checking Accounts – Keeping funds in excess of impending debits plus “spending money” in your checking account is costing you. For every dollar you keep in your checking account that you really don’t NEED to have on deposit, you throw away the interest on that dollar that you should have earned. It really adds up quickly. You are in essence giving the bank a free loan! If the bank called you and asked for a free loan, you’d surely say, “No way; you need to pay me interest!” I keep only enough money in my checking account for: 1.) debits that are being withdrawn within the next three to five days (this takes careful planning) and 2.) enough spending cash to hold me over until I get paid again. That’s it! I don’t loan my money to the bank for free. Every time you receive a credit to your account (say above $250), you should transfer all funds in excess of the “needed” amount.
Alternative option: Savings accounts should be used to store emergency funds and as a place to keep cash for monthly expenses that aren’t quite due yet. In case of an emergency, you can have your funds transferred into a checking account within 24 hours. Online savings accounts should be used as “secondary checking accounts” rather than the typical way most of us think of them. You should not keep the cash for monthly expenses in a checking account. Your checking account balance should only have enough money to cover the expenses being deducted that week plus any cash you may need to withdraw, which begets the maximization of earned interest. You can keep $100 – $200 extra in the checking account as a reserve margin.
Certificates of Deposit (CDs) – As of Monday, the best CD rate I could findi was 1.1 percent APY for a one year term. The average inflation rate YTD is 1.6125 percentii according to the Bureau of Labor Statistics. Let’s do the math. If you invested $10,000 in a CD on January 1, 2013 at a 1.094 percent interest rate (1.1 percent APY), you would have $10,109.40 on December 31, 2013. However, inflation was working in the background, which made goods and services cost more as time passed. Something that cost $10,000 on January 1st would cost $10,161.50 on December 31st. In other words, it would take $10,161.50 on December 31st to buy something that would have cost $10,000 on January 1st. Inflation has beaten your return to a pulp! You actually lost $52.10 of purchasing power in one year by settling for CD interest rates.
Alternative option: Make private loans secured by assets to get above average returns without much risk. See Become a Private Lender: How to Earn 6% Interest in any Market! by Daniel Wynn to learn more.
Savings Accounts – First off, let’s dismiss brick and mortar bank savings accounts. Online savings accounts offer much better yields and are more convenient. I just saw an advertisement for GE Capital Bank’s Online Savings account with an APY of 0.9 percent (i.e. 0.896 percent APR). That’s the highest I’ve seen in quite some time for a savings account. Doing the same math, you would lose $71.90 worth of purchasing power in that same one year period because your return rate is less than the rate of inflation. I use FNBO Direct and earn 0.85 percent APY (even worse!). I prefer savings accounts to checking accounts to store excess funds because I get paid interest, albeit a small amount, without sacrificing access to my money.
Alternative option: Yes. You definitely need an emergency fund. It must be easily and quickly accessible. They are a necessary evil and end up costing purchasing power if inflation is greater than the interest rate. Online savings accounts are FDIC insured and are a smart place to store your emergency funds. Experts suggest having at least six months’ worth of living expenses stored away for that rainy day. I hope you never need it, but it offers great peace of mind. Any amounts over your emergency fund (assuming you have an income that is greater than your expenses) should be invested in less liquid, high return assets. For example, see my earlier post on real estate investing.
Home Equity – Is your house an asset or liability? If your home is costing you more money than it produces, it is a liability. But, you can turn it into an asset! The equity in your home is most likely the most underutilized source of funds that you have access to. Real assets produce income. Unless you are on a strict, fixed budget, there is no reason why you should not be using your home’s equity as an income producing asset. If you have more than 30 percent equity in your property, you are missing out on a key wealth builder. We won’t get into real estate leverage in this post, but just know that it is Donald Trump and other real estate investor’s key to becoming wealthy.
Alternative option: If you can lend your home equity at a rate higher than the rate you pay to use it, the difference is your profit. For example, if the bank charges you four percent interest on your home equity line of credit, but you can lend it out for eight percent (secured by real estate or some other asset), you are earning four percent profit without using any of your cash or retirement accounts. Using a home equity line of credit (“HELOC”) to your advantage has major benefits. 1.) The interest charges on the HELOC are tax deductible. 2.) You are leveraging your biggest asset (i.e. turning it from a liability into an asset), which is a key to wealth building. 3.) You do not sacrifice one dollar of appreciation. 4.) You have access to the funds, but you don’t pay interest until you have a place to invest them. 5.) It is easy and painless to set up!
Credit cards – Credit cards, when used properly, are great! We all know that we shouldn’t carry a balance on a credit card if interest is being charged. Assuming we know that, there are definitely substantial benefits to using credit cards. Credit cards: 1.) improve your credit score when you prove you can handle them responsibly (Note: Closing an open credit card actually hurts your credit score.), 2.) offer rewards (points, miles, cash, etc.), 3.) often have 0% balance transfer rates, 4.) give you a free loan for up to 60 days (see TVM), 5.) are much more convenient than cash, 6.) have fraud protection unlike cash, 7.) have the best exchange rates when traveling to foreign countries, and 8.) have free insurance/warranties on certain purchases (car rentals, trips, electronics, appliances, and more).
Alternative option: First you have to promise that you will pay your statement in full every month. If you are on a zero percent rate, you should be paying the minimum payment until that teaser rate runs out. Then you need to pay it off (or transfer it to another zero percent card) before you get charged interest. Take advantage of using credit cards for your purchases, but make sure to keep an eye on the balances. Some people tend to spend more when using credit than they would if they used cash. If I can pay for something with a credit card, I do.
You can maximize your net worth when you become more engaged in your money. Understanding the benefits, risks, and alternatives of each financial decision you make will help put you on the path to financial freedom. Just know there are options, and do a little homework. It will pay off!