Want to minimise the chance of living off nothing but a meagre age pension in later life?
There’s a great proverb that I heard many years ago and have never forgotten “a fool and his money are easily separated”.
So how do you ensure you’re not the fool? The solution is to have at least a basic understanding of the financial world. We call this Financial Literacy. That doesn’t mean you need to become an expert – you can hire people for that. But you need to know enough to be able to sniff out a bad deal, and to avoid those big missteps. You need to be able to understand the risks you are taking, and gauge whether the likely return adequately compensates for that risk.
So, today’s post takes on a question and answer format. Let’s see how you fare when it comes to financial literacy.
You log onto your internet banking and your credit card shows an available balance of $7,400 and an account balance of $2,600. Should you make any repayments on this account?
The answer is YES. The account balance is the key element here – this is what you owe, and if you don’t repay it, you will pay significant interest.
Many, many people look at the available balance and think in terms of “well I’ve got that much still to spend”. I very much suspect banks present this figure hoping you will do exactly that. This available balance mentality is what traps a lot of people when it comes to credit cards. Focus on what you owe, and get this down.
Let’s stick with credit cards for a moment longer. Say you have a credit card where you owe $2,000, with an interest rate of 18% and you pay only the minimum repayments each month. Assuming you don’t spend any more on that card, how long will it take you to fully pay it off: less than 5 years, between 5 and 10 years, or more than 10 years?
The answer is that it will take you over 15 years to pay off your credit card if all that you do is make the minimum repayments each month. You’ll pay a fortune in interest too.
Just like with the available balance mind tricks, the banks requirement for a minimum repayment is not because they are your friend. They want you paying as much interest as possible for as long as possible.
Ideally you would repay your credit card every month in full so that you avoid paying any interest. If you aren’t able to do that, then certainly ensure you pay considerably more than the minimum suggested by your bank.
And of course if you find credit card debt to be a problem, have your limit reduced to minimise the potential damage. You could have the limit reduced to $1,000 for instance – enough capacity to buy some concert tickets online, or deal with a short term emergency, but not so much room that you could dig yourself into a really deep hole. You could go the whole hog and do without a credit card altogether, though in the modern online world I would certainly find that challenging.
Your Gross salary last month was $6,000 and your Net salary was $4,500 – how much was paid into your bank account?
The answer is $4,500. I find a lot of people get confused between gross and net salary, and I guess they are quite jargon sounding terms.
Your gross salary is what you employer pays out. If you’re sitting down for a pay review and your boss talks about giving you a pay rise, they’ll be talking about your gross salary – how much they pay to have you on the team.
But what is more interesting to you is your Net salary – how much actually goes into your bank account. The difference between Gross and Net salary is mainly deductions for tax and superannuation, though you may have other deductions as well, which leads nicely into the next few questions on the most common other form of deduction from your gross income – Salary Sacrifice.
You catch the train to work in your office job. You have a 3 year old car which you own debt free, and it’s meeting your needs. One lunch break you listen to a presentation about how you could salary sacrifice to buy a brand new car. They suggest you will save tax. Should you take up this opportunity?
Whilst there will be circumstances where salary sacrificing to buy a car might make sense, this is certainly not one of them. For starters, you don’t need another car! When you salary sacrifice to buy a car you are borrowing money to finance the deal, and then paying it back through your normal pay each fortnight. That means you’re paying interest on a loan – a cost to you. Also, because they always focus on new cars, the amount tends to be a lot, usually far more than you would spend if you were just going out to buy a car on the weekend. I’ve seen so many times where people buy a car via salary sacrifice for say $60,000, when if they were just out shopping for a car with their savings, they’d never spend that much.
Cars are really bad investments, in fact they’re not investments at all. They cost you money to keep, and they decline in value from the moment you take ownership.
Whatever marginal tax benefit you might get is well and truly swamped by the interest you’ve paid for a car that you didn’t need, and will be worth a fraction of what you paid for it in 5 years time.
You work full time as a veterinary nurse, and have recently paid off your home loan resulting in you having some money available to save. You’re 50 years old and are wondering if you should work on adding to your super given you’d hope to retire in 10 years at age 60. Should you look into salary sacrificing into super?
The answer here is a clear Yes. Now superannuation in Australia is complex. There are limits as to how much you can contribute, limits on how much you can convert to a pension in retirement, and of course whatever money you put in their can’t be accessed until you satisfy a condition of release – typically over age 60 and retired.
So adding to your super is something to think through thoroughly, and I would suggest, get some professional advice on. But for many people, salary sacrificing to super in the scenario presented would be a great idea.
When you salary sacrifice, the money is coming out of your gross salary. So remember, this is the higher amount, before any tax has been deducted. Now it’s not a total tax free situation, because when your contribution hits your super fund it is taxed at 15%, and more if you earn over $250,000. But paying 15% is likely to be less than the tax you would have paid had you not salary sacrificed and simply taken the money as cash.
So salary sacrificing to super is typically a financially sensible thing, whereas salary sacrificing for a brand new car that you don’t need is typically not financially wise.
Which of these is an investment asset? A new leather jacket, a new Mercedes SUV, an $8,000 carbon fibre road bike, or an ETF?
Whilst the first 3 options here may well give you pleasure, and of course that has value in its own right, none of these should be considered an investment asset. Only the ETF – Exchange Traded Fund is an investment asset.
So what is an investment asset and why should we care? The core distinction is that investments are expected to either increase in value over time, or produce income that you can use. Often investments will do both.
The jacket, the new car, and the bike will achieve neither of these. I find some people, especially when buying very expensive items like luxury cars, try and justify that it is an investment and not an expense. And whilst I’m sure there are some cars that are truly collectable and will rise in value over time, these are not the type of vehicle most people are talking about. They’re making a lifestyle purchase and trying to fool themselves into thinking it is financially sensible.
If you want the luxury car, fine. The goal isn’t to be the richest person in the cemetery, and so if that makes you happy, and you can afford it, go for it. But do recognise that you are buying something that is losing value all the time, and costs money in insurance, registration, fuel, and maintenance, during its life time.
In a financial literacy context, recognise the difference between an investment asset, and something that is really an expense.
If you bought a share for $2.00 and it rose in value to $2.50, is it true to say it has risen 50%?
Sorry to stress your brain with a little maths here, but one of the most common ways that people get taken for a financial ride is that they don’t understand percentages. The answer here is no. The share has risen by 50cents, which given an initial purchase price of $2.00 means it has risen 25%.
We’ve all got calculators in our phone so there’s no need to be a maths wiz. If someone is putting a financial proposition to you in percentage terms, and you can’t easily turn that into dollars and cents in your head, then pull out the calculator and do the numbers.
Let’s say you were listing your home with a real estate agent and expected to get $700,000. One agent quotes you a flat $10,000 to sell your property and the other quotes 1.9%. Now the less financially literate will think “gee $10,000, that’s a lot of money. But only 1.9%, that’s not very much, I’ll go with that guy.” Yet actually the percentage option will result in a cost of $13,300, more than the flat fee.
So recognise that percentages can deceive and don’t hesitate to pull out the calculator if you’re unsure.
I think that’s enough of me being quiz master for today. Financial literacy can include a whole lot more – budgeting, being able to calculate your net worth, understanding compound interest, and having appropriate insurance in place to name a few. The Money Smart web site is a great resource and I’d highly recommend checking that out to further educate yourself on the basics of financial literacy.
General Advice Warning
Want to minimise the chance of living off nothing but a meagre age pension in later life?