Friday, May 14, 2010


Financial Literacy

What's the best way to convey meaningful lessons in financial literacy to 18 year olds?

I'm consistently struck at the disconnect between "what's supposed to be true" and "the real world."

For example, if you use the 'retirement planners' online, you'll routinely see statements like "assuming an 8 percent return..." Over the past ten years, the average return on the IRA I opened in 1998 has been...wait for it...negative. Not just after inflation, either; literally (or 'nominally') negative. One could argue that twelve years is a small sample, but it's a significant fraction of the average adult's working life, and I would have been better off putting the money in a coffee can. So telling young people that stocks always pay off over the long term just seems very...twentieth century. Assuming an 8 percent annual return, I'd have at least twice as much as I actually have. That must be a lovely world.

I grew up hearing that renting was throwing your money away. That position was sustainable until about 2003.

I've heard and read that you should "pay yourself first" and set aside, say, ten percent of income in savings. But what does that actually mean? Is that ten percent after the retirement deduction? (If so, we're really talking twenty percent.) And when you're just starting out and making next to nothing, just how realistic is that? Do you know what young men are charged for car insurance?

It's certainly true that I've seen students make some bizarre economic decisions. A few years ago, my office had a particularly great work-study student who helped my administrative assistant with various routine tasks. When she graduated, we gave her fifty bucks and a card. She responded "you guys are great! Now I can go tanning!"


At the risk of being the crotchety old guy, isn't sunlight free?

I've heard students refer to financial aid money as if it were all grants, even though it's frequently borrowed. That worries me, since they'll be hit with surprisingly large loan payments while making entry-level money. And failure to grasp the idea of compound interest will make you a patsy for Visa.

Although I like to think I'm a relatively educated person, many of my financial lessons have been accidental. A passing comment to my brother-in-law led to the lesson that putting two married people's cars on a combined insurance policy is dramatically cheaper than carrying two separate policies. I could have gone years without knowing that. And that's without even mentioning the depression caused by pairing the concepts of 'opportunity cost' and 'graduate school.'

Real world economics should acknowledge that many of the Sound Financial Principles we've been taught are either outmoded or irrelevant, but the new rules are hard to pin down.

If you had a chance to teach a financial literacy course to youngish college students, what would you focus on?

I've been reading financial blogs for a while, both those that deal with the macro level of what the heck is going on in our economy and the ones that deal with personal finance. They're kind of depressing. The personal financial planning ones suggest a life of austerity where you have a small house, a very low grocery bill, buy cars with cash and buy clothes at thrift stores. While I recognize that it's a financially sound way to live, that's unrealistic for most people. I would say though, that a lesson I wish I'd learned is that it's better to get a personal loan at say 8-10% interest than it is to live off a credit card. In fact, I wish credit cards had never entered my life. I also wished I'd bought a house sooner, but I'm not sure that's good advice now. Believe it or not, my regular savings account wasn't such a bad investment. At least it didn't lose money.
I think it's true that you can't always teach what market conditions can be. But you can teach basics in way that allows young people to make better decisions. The basics to me really are:

Spend less than you earn. The possible exception to this is during university in which case the mantra should probably be minimize debt.

Understand the costs of everything you do - the borrowing costs of credit, the management expense ration of investments, etc. This also goes for taxes at state and federal levels.

Evaluate risk. That's a tough one but I think basic literacy in what things are (bonds, junk bonds, stock, mortgage, guaranteed investment certificates (whatever those are in the US)) is important.

Most importantly IMO - learn to settle for less than the best. Your first home doesn't have to be glorious. You don't have to have all matching stuff right away.
this is what i wish someone would've told me (and what i always tell other people)
- Don't get married young, and when you do, get a prenup. Sh*t happens, and if you are going to be making the bulk of the money, cover your ass. It can get a lot worse with children (especially if you're a man).
- Put at least a 20% down payment on your house, and only get a 15 year loan. in 10 years, you'll think you've won the lottery.
- Go to community college (especially if you live on the coasts) to get your gen-eds for cheap (unless you have a scholarship).
- Get a scholarship. A high SAT/ACT score is incredibly easy to get. No excuses here.
- Whatever your company matches for 401K, you should put in (minimum 4%).
- Pay cash for everything.
- Move where you work. A 50 mile one-way commute is moronic and expensive.
- Whenever you interview for a job, and you discuss salary, overshoot. with my current job, i was asked what i wanted, and i said $25k over what i was making. they gave me $15k, and with my raises, i'm up to that $25k in less than 2 years. don't undershoot. be confident.
- Get in and get out of college. 4 years for a bachelors, 5 for a masters. intersession, summer school, heavy load. do it all.
- Get an internship in college. This will definitely help you when you're looking for jobs (industry experience).
The best class my sister took at CC was personal finance. I think THAT should be a breadth requirement unless you can test out of it.

The motley fool book on personal finance is an excellent and accessible one that I would recommend to any kid about to leave home.

Learning the difference between what you need and what you want is critical.

I think the best lessons are never take out a loan if you don't have to (car loans are optional, not required!), never spend more than you earn, have a 6 - 9 month cushion saved just in case and that it pays to shop around and use the internet to find competitive prices on things, especially big purchases.
I agree with Laura that one of the biggest financial lessons for young people starting out should be on avoiding debt as much as possible. Credit card debt is appallingly easy to rack up in college or as a young graduate and can cripple your financial future for decades to come. It's one big lesson I'm hoping to teach my own kids, along with careful budgeting, so they can try to avoid some of the mistakes I've made.
The power of compounding interest, especially when it's on a credit card.

Anonymous said well above that learning the difference between want and need is vital.

Learning to budget realistically, and learning to balance a bank account.

Learning to get a sense of opportunity costs and risk are also vital.

Sex education. Seriously, choosing to have (or not, or when) kids should be in part a financial decision in this day and age.
I'm a little shocked at what Laura describes as depressing and unrealistic because it describes my parents' way of living since I was a kid. Now that they've put both their kids through college and themselves through graduate school--without any loans--they're living a lot better, but the lack of money was never depressing and being frugal was never unrealistic. I'm now a grad student, paid only nine months out of the year, and I'm one of the few people in my program who doesn't have to scramble for summer funding because I mismanaged my money over the regular year. I manage to live off my stipend, give ten percent to charities, and still save 15% of income yearly. When I get my PhD, I'll probably have most of what I need to put a down-payment on a house, if that's what I want to do.

Here's what I learned from my parents:

Interest can be your friend. Find a bank (or, more likely, a credit union) that will pay interest on everything from a checking account on up. Every penny helps.

Interest can be your enemy. Pay off your credit card every month. You are allowed to pay off your credit card more often than that (and this is really easy in the age of internet banking), so consider paying it off every time YOU get paid. Oh, and get a card that gives you miles or cash back.

You don't need everything you want. Repeat it: you don't need everything you want. Learn to prioritize spending and keep a budget. That doesn't mean you can't ever have anything nice, but that you are always willing to give something else up in order to get it.

Wherever you can, share the load. Get a roommate. Buy into a co-op. Buy meat in bulk with a few friends straight from a farmer (if you live in an area where you can do that) and split the costs so you get better quality food for less. Be a part of a community garden.
"I think the best lessons are never take out a loan if you don't have to (car loans are optional, not required!)"

I'm not sure I'd take it that far.
(1) A car loan helps you to establish good credit, which helps you get larger loans for things that there's no way you could afford to pay cash for (houses).
(2) If you do the math, you may actually be better off taking a loan for the car and investing the money you would have spent on it. Because the car is collateral, interest rates can be low if you already have good credit.
My top 3 topics for incoming Freshman:

1) The true cost of purchasing on credit cards (when you don't pay off the balance in full every month). Suppose you have a $2000 balance on a card with a 19.9% interest rate. You want to purchase a $500 item. You only pay the minimum payment each month. How much will that $500 purchase actually cost you? The number is shocking, even with the higher minimum payments that went into effect a couple years ago.

2) The ins and outs of student loans. Yeah, the college probably does not want me to teach this as it could lower enrollment if some students knew that they were being turned into debt slaves. But students need to know how these work. They need to know that they aren't dischargeable in bankruptcy. They need to be fully aware of the noose they are putting around their own neck.

3) The true cost of owning a car. When you factor everything in (insurance, repairs, gas), maybe it isn't such a great money saver to commute 50 miles each way to college every single day.

Personal finance for graduates would add mortgages, investments, etc as well.
Credit cards were never my vice. Yes, I've carried balances at certain points over the years, but TBH, I knew exactly what I was doing.

Student loan debt, OTOH, was/is my thing. My parents lived frugally when I was a kid, so it's doable. And it didn't suck *that* bad. My dad discouraged me from borrowing for undergrad, but I did it anyway. (Read: east coast private school vs in-state public).

One thing that should be required as part of financial aid entrance counseling (er, loan counseling) is students putting together a mock budget. Look at realistic expenses vs income and help them make an informed decision. I can't say I would have done anything differently had I done that, but I would have been able to make a more educated decision.

As for the reason students mix loans with grants, it's hard not to. With college getting as expensive as it is, many schools are marketing themselves as being able to provide a financial aid package that covers X% of a student's "need." Marketing wants students to believe that they can afford the school despite its high price tag, and yes, they've given you "aid" to do that. But when that "aid" is simply money you have to pay back later, did they really make school cheaper for you?

We have a culture that promotes borrowing for school, plain and simple. That needs to change.

Your argument doesn't follow. You advocate taking out a car loan to build credit, with the justification that if your credit is already good, you can get really low interest rates.

If your credit is already good, you really don't need to "build" it. So I don't see the point.
"Your money is your life." You trade your time for money. So how much of your actual LIFE is that whatever-it-is worth?

Which means you should track your spending closely because it's your life you're watching go out $20 at a time.
I teach a one credit course in this area and we cover federal taxes. I was shocked, just amazed, at how many graduating seniors had never completed an income tax form and knew zero about the topic. The most important take-away lesson: do not pay someone to do your tax return if you earn under $57,000 a year. At that income level you can get the service for free. Second most important lesson: federal taxes are not rocket science and you can learn to do your own.

-I'm accounting as fast as I can
Sometimes I wish all of my students were required to take a personal finance class before coming to college, but then I remember that they'd need to get through my basic algebra course before they could understand things like compound interest.

At my school, we have a very real problem of students seeing all financial aid as grants and not having a clue how these loans will impact the rest of their lives. They don't know what compound interest is. I once gave an extra credit project that had students writing word problems based on what they would encounter in their majors or in the real world, and one student "calculated" how much he'd have to pay on his loans based on a simple interest rate.

They don't understand that the $2,000 they're spending on the class now (and the $2,000 they'll spend on it next quarter when they fail) will really end up costing them significantly more in the long run. And most of these students won't be making much money anyway, so they're literally making decisions that will make the next 10 - 20 years of their lives much more of a struggle.
They're kind of depressing. The personal financial planning ones suggest a life of austerity where you have a small house, a very low grocery bill, buy cars with cash and buy clothes at thrift stores. While I recognize that it's a financially sound way to live, that's unrealistic for most people.

Personally I find it horribly depressing that someone thinks that driving a Civic, forgoing a "home office" and/or separate rooms for every single child, and not eating ourselves to death and then kill our joints trying to work it all off is "unrealistic for most people"!

But it sure does explain a lot about how our country ended up in its present predicament.
I really liked Robert Shiller's online lectures on Financial Markets hosted at Yale. I think it's the only time I've ever seen someone explain what the hell FICA/OA stands for. He talks about the function of insurance and the factors that decide its pricing. The obvious important one is the deductible.

For most 18 year olds, the main thing is to actually generate a budget and it's relationship to debt. They're very young and their income is lower than their lifetime average, so it's important to learn about credit. If you don't build a budget, you will crash. Credit cards and store credit can make it very easy to skip the budget step. One day you hit a credit limit, forcing you to sit down and discover you've been spending more than you earn, and not only can you not afford to make your CC payment, but you can't afford the lifestyle you've been financing. You are in the hole this month, and on the hook for the past X months to boot. For some FT students, their budget is going to be 0 so they shouldn't even be thinking of anything but student debt.

There's a time and a place for credit. Student loans can be great investments (sorry history majors). Credit cards can be a cheap way to finance a large purchases, or to smooth your finances if your income is bouncy (tips, unstable schedule, bonus or commission). I like them for the cash back, and the interest free short term loan (I pay in full every month).

But personally, the Great Recession has been Great for me. Very cheap car loan rate, sales tax deduction on that purchase, and I consolidated my student loans at 2.25 percent fixed interest. I hear the younger generation doesn't have that option anymore. And my IRA is about where it was when I started. I guess it helps that I witnessed the .com crash in high school and engineers have an innate distrust of business people.
Budget, Budget, Budget.

Those are the three magic words that all young adults need to learn.
I've never had a car loan. We have one new car (paid cash) and one older minivan (also cash, cost more than the new car). I don't feel deprived. Car loans don't make sense since the asset depreciates so fast.

The trap I fell into was an extended life insurance policy - eventually cashed it out for less money than I'd paid in to it.

My IRAs date to 1990. They made money until the late 90s and are now worth about the same as then. No-one except the venture capitalists gets 8%, that's one of the Big Lies.

I'd recommend Andrew Tobias' book.
As he says,
"Live beneath your means, get off the debt treadmill, minimize your transaction costs, trust no one. "
Yeah, I don't think it's depressing that people pay cash for cars; I think it's depressing that people have car loans!

My husband and I live in a small house; many of our friends bought at the max they could borrow. We bought about 1/3 of what we could borrow (at the time). Many of those friends have rooms and rooms with no furniture b/c they're paying for the house. That's not depressing at all! Our little cottage is a little overstuffed since the wee ones arrived, but it's cozy, well-furnished, cheap to maintain, cheap to heat, and allows us to save and to spend on things we like.

Five years out of school, we've paid off about 1/3 of our six-figure student loans; about 1/4 of our house; we own two cars; we have two pets; children; $20,000 in the bank; $15,000 in a Fidelity investment account; and retirement accounts.

We do all of this on a single income -- a healthy middle-class income, but nothing spectacularly high. (When I worked that income mostly went to the student loans. Now I'm just at home.)

I don't really see how I'm deprived. We could buy a bigger house in a more expensive neighborhood, but think how much more time I'd have to spend cleaning!
Just remember that all financial advice is worth what you paid for it.
-"Neither a borrower or a lender be."

Shakespeare and Andrew Tobias taught me everything I needed to know about financial literacy personally. Live within my means, don't pile up debt (especially credit card debt), treat your house as a home rather than an investment, avoid car loans. I also don't invest in anything I don't understand.

The other tricky part about financial literacy comes when you get married or decide to share your life with someone. Even when both partners are financially literate and share similar views on risk, they can still have different ideas of what money means. It's absolutely critical to discuss what money means to each partner, whether it means freedom or security or indulgence or what. Then you can decide whether joint accounts work or not.
Two words: Suze Orman.

Otherwise, I would reinforce the comment about compound interest being both friend and enemy, and needs vs wants. I would add the novel idea of "save for it". Even if your savings don't earn much interest, you will earn all of the interest you DON'T have to pay by not borrowing. An example is depositing a car payment after the car is paid off.

One important lesson should be that a house is an expense, not an investment. The advantage of buying over renting kicks in if it reduces your long-term expense, and this is a function of price/value and rates as well as specific local tax laws. Example: There is a big difference between starting a 30-year mortgage at age 60 (watch Suze sometime!) and paying one off at age 60 so your monthly "rent" is under $200/month.

Finally, be careful what you learn from recent events and be careful of what you didn't learn from past events. Recent events: the mistake people made was not in buying a house, it was that they had no idea what its intrinsic value was and "loan originators" had a financial interest in closing a loan they would not have to collect. Don't refuse to buy a house at a good price and good interest rate just because of what went wrong in 2005. Not so recent events: High inflation can be your friend if you own real property and certain kinds of stocks or buy high-interest bonds at the END of the inflation cycle. (It would be great for all of you with student loans!) Inflation is your enemy if your money is in cash or the equivalent and horrible if you rent.
Speaking of save for it...

Don't buy stuff you can't afford
Some of the best advice I received:
-Start investing early, you are young and compounding interest is your friend.
-Later on I learned the basic; contribute enough to your 401k to get the company match, and then as much as you can above and beyond that to a Roth IRa.
-Don't borrow to go to school. If you don't get scholarships, stay at home and stay in state. In five years, for most jobs, no one will care where you went to school.
-Major in something practical, with a job at the end. You can always double major in a passion but you might find you'd rather work in your non-passion field for more money than survive off lower wages.
-Pay off as much of your car in cash as you can, if you can't afford payments for a loan longer than three years then don't buy, or buy something used. You don't HAVe to have a new car, if it's important you can save ahead of time.
-If you use a credit card, pay off the balance at the end of every month.

Lessons I learned the hard way:
-Buying a home, while a good long term financial plan, is not for everyone. Put 20% down. Have another 10% stashed away for expenses. You will always need more than you plan and YOU figure out how much you can afford, don't let the banks tell you.
"You advocate taking out a car loan to build credit, with the justification that if your credit is already good, you can get really low interest rates."

Those were meant as two completely separate reasons to show why it isn't *always* in your best interest to pay cash. The second was not meant as a "justification" for the first. Sorry that wasn't clear.
Never mind college students, what can you teach a 40 year old mother of three? :)

I read this yesterday, and just by coincidence had a conversation with my husband about a chat he'd had with one of his 18 yr old students. She said she would be late handing in her end of year project because she had to work so many extra hours this month. Knowing she lives at home and that her schooling was mostly covered by the province, he asked if she were saving up for a summer trip or something similar.

"Nope," she replied in the tone of one who has long suffered on the topic. "I have to work at least 30 hours a month to cover my cell phone bill because my parents won't pay the bill anymore."
This is world-class write up on Financial Literacy, which is to be shared with every citizen!

Financial Literacy Questionnaire
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