Keeping Focused: Saving for the Long Term

by Magical Penny on March 17, 2010

Focus is important when it comes to growing your pennies. In the first article on ‘Focus’ Magical Penny explored different strategies of paying off debt. In the second article the subject was on how to focus on medium term goals with a time frame of 1-5 years. We now move onto how to stay focused on longer term saving plans!

plant the seed of wealthFor most of us, just staying focused on things right in front of us is hard enough. The first challenge is to consistently spend less than your monthly expenses. Then you need to pay off costly debt and start saving for emergencies and opportunities and irregular expenses like a holiday every once in a while.  With all these different priorities it might seem impossible and even pointless to save for yet another goal: your long term future.

Maybe you find it hard to focus on it because it’s so undefined, or you think that you’ll never retire. But you should focus on planting the long term seeds of wealth: even if you’re in your 20s.

If not now then when?

The number one reason to focus on your long-term savings is because of the potential impact you can have by making progress today. It really is huge thanks to the magic of compound interest. There will always be things to save for and expenses to be paid but if you make a commitment to yourself today then you won’t wake up 40 years from now with nothing to show for your efforts.

There’s always something that makes demands on own finances in the present.
Perhaps it’s saving for or paying off a car, or saving for a house deposit or paying off a mortgage. And I’m sure my readers with children will confirm that raising them isn’t without cost. Do it now when your expenses are likely to be lower than at any other time in your life.

A small income shouldn’t stop you: You can still have a big impact because of time

By starting to save for long-term needs in our 20s we have the luxury of time. We also have a chance to work out the best ways to save our pennies and find what works for us. The impact that saving and investing over the long term was the primary motivation for founding Magical Penny. If everyone understood and appreciated the power of compounding returns I’m positive that more people would make an active decision to take control of their finances. At this stage, don’t worry about the specifics of how to save over the long term –that’s coming soon, but if you’re reading this, I really hope that you begin to make a commitment to save for the future now, before life gets any more complicated….and it will!

How to keep Focused -Visualisation

Medium-term saving, perhaps for a house or a car, can be hard but at least it is easy to visualise as the ‘destination’ is only 1 – 5 years away. Visualisation is a powerful tool to remain focused and you should use it when you can to reach your goals.

However, when it comes to long-term saving, visualisation is harder for some. But it’s worth thinking about as it will help if you decide what you want your life to look like in decades to come. Do you want a big house, an early retirement or a shiny sport-car? Maybe none of the above, but believe me you’ll want to have options. Even if your dreams are less grand, having a clear vision of what your life will be like in the future will help you plan to get there. If you do have a vision, write it down for reference. Having it down in black and white will cement your ideas and help you save for it month in, month out.

That said, I have a confession: I find it difficult to imagine what my life will be like in 5 years, let alone 40! I feel I have so many different paths I could go down. Maybe you feel the same? Don’t get decision paralysis and a lack of long term vision on the specifics stop you though: If you’re like me just remember that long term savings have huge potential to turn your pennies into significant sums if saved and invested properly. Even if you don’t have a good idea now, I’m sure you’ll be able to find something to spend your pennies on when the time comes. And you’ll appreciate that you have given yourself a head-start when you see an opportunity or more specific dreams begin to form in your mind.

Make it automatic

set it and forget itSurprisingly the best way to stay focused on long term savings is actually to not focus on it at all. Your motto should be ‘set it and forget it’. It really should be ‘set it, forget it and review it from time to time’ but that’s not quite as catchy is it?

Decide on a certain amount of your monthly budget and set up an automatic standing order into a savings account. In the coming weeks Magical Penny will also walk you through the process of setting up a direct debit for investing as well, putting your long-term plans on auto-pilot. But don’t worry about that for now: just get used to giving yourself a minor reduction in your income each month and channel the pennies destined for long-term savings away from your current account into a seperate savings account. Remember the first point though: don’t wait for a better time to begin, do it today (or next pay-day).

As a bonus remember this previous post and take advantage of any employee pension schemes (or 401ks in the US) to get extra pennies from your employer in the form of a company match: they really are the true magical pennies!

How does everyone else stay focused on long term goals?

Recommended Reading:

Carnival of Personal Finance – Tour of Ireland Edition

Magical Penny is editors pick this week for Are 0% interest Loans Really Free Money?

Financial-priorities: focus-vs-diffusion @BalanceJunkie

A great article on a similar theme to Magical Penny’s Focus Series:

“My personal preference is to choose focus over diffusion. I feel better when I can see significant progress on one goal rather than a little progress on many goals”

Why 20s somethings should open Roth IRAs @PersonalFinanceNinga

Best Rate for Roths @PT Money

Are you Young and American? You should definitely be reading why Roth IRAs are awesome.

UK readers -it’s worth a read too: Just  replace the word: Roth IRA with ‘Stock and Shares ISA‘ and think how lucky we are- we get all the tax benefits but are not limited to saving only for retirement! If all that went above your head don’t worry, Magical Penny will be moving onto ISAs shortly -just in time to embrace ISA season and the end of the tax year.

Exciting times.

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Dominate the Game of Life

by Magical Penny on March 10, 2010

dominate the game of lifePlaying a team sport like football, as I do with my friends each week, is about finding the right balance between offensive and defensive play. Yes, some teams manage to dominate the game by focusing their efforts on a strong offensive strategy, but in almost all teams there must be a basic level of defence to ensure that the game is won.

Similarly if you are serious about growing your pennies, you need two strategies: an offensive plan to earn and grow your income, and a defensive one to protect your earnings from every-day spending.

Be the striker

Playing a strong offensive game, by making a conscious and sustained effort to grow your income as Rightly Knightly advocates, is an obvious way to grow your pennies. It can be a daunting prospect for many but for those with ambition and drive, it certainly is within reach and can be a success strategy for financial success. If you put in place a plan to develop a good income you have the potential to both spend and save more. It will make budgeting easier too as there will be more pennies to go around.  Remember there’s only so much you can cut back or deprive yourself, but there’s not strictly a set limit to how much you can earn.

Increasing your income is the less talked-about side to personal finances but most people who have grown wealthy have not done so exclusively by making small chances to their lifestyle (like bringing their lunch from home into work each day for example). Rather, they have done so with strong career moves or through building successful businesses.

Like the football team with  top strikers delivering goal after goal to win the game, sometimes a good offence is the best defence.

But fortunes can change quickly

You may have a good offence  but having a great striker in the team is of little good if the opposition gets the ball and can run all the way through the field to score a goal, or your main striker breaks their metatarsal! Similarly, having a great income now  is of little real use if every last penny trickles out of your hands towards the end of every month, or worse, you lose your income for any reason.

Being young, most of us have high hopes for the future but there’s a lot of things out of our control and without a good defence, any success in the offence part of your strategy could be lost. In the same way that you can’t tell how good a goal-keeper is until a player shoots at the goal, you can only truly judge a financial strategy by how it holds up in a time of trouble or crisis. How would yours hold up?

Setting Up a Defence

Some might think its overly cautious to build up a savings account with thousands of pounds for no obvious purpose. Many find it hard to save for any purpose let-alone a ‘what if’ scenario! But doing so is one of the most important things you can do. Start today.

The best sports related marketing phrase to live your life by: “Just do it”

Start putting away something, anything. Make it separate from your goal off paying off debt; separate from saving to buy a house or a car. Doing so might seem strange and might make your other savings goals seem painfully far away. You might think it better to pay off debt or save for something more tangible.

Perhaps.

But having a separate ‘emergency’ fund is one of the best defensive plays you can make. In fact once it’s set up you can be even more aggressive in your offensive moves. A good defence strategy gives you options. It could give you the confidence to change the direction of your career or make you feel more comfortable taking on more risk when it comes to investing for a possible higher reward (more on investing on Magical Penny in the next few weeks and months).

Dominate the Game of Life

When it comes to the game of life in your 20s and 30s it’s less important whether you’re having a good game or currently down on your luck at the moment: It’s more important to have a vision of where you want to be. Have a think about your own strategy, look at your offensive and defensive plays and ask yourself if it’s working. Then start to put in place a new and improved strategy that works for you.

Remember, if you do this now it won’t matter so much if you’re currently winning or losing because the real winner is football your future self!

Disclaimers:

#1 Adam is not the best footballer in the world, nor even that good compared with most of his friends. But thankfully he’s a little better at being defensive with his spending so he can be can be confident and be on the offensive when it comes to growing his pennies over the long term. Are you?

#2 American readers: I’m talking about ‘soccer’ but I’m sure it applies to your ‘football’ too! I’m also aware of the confusion on the spelling of defence/defense -it’s all part of the fun of writing to an international audience! 🙂

Further Reading:

Magical Penny is thrilled to be featured in 3 blog carnivals this week:

Carnival of Personal Finance

Magical Penny is also talking to young people about a concept called consumption smoothing. Hmm…I think I get it.

Best of Money Carnival

Magical Penny presents The Treadmill that Does Not Get You Fit (financially) – a neat entry from a new blog I just came across – check it out!

Festival of Frugality with my post Lifestyle inflation -the silent killer of dreams

A huge thanks to all the Carnival editors this week for including Magical Penny posts from hundreds of submissions. These carnivals are a great way to learn about different elements of personal finance from lots of different persepectives so I strongly encourage everyone to have a good read!

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Are 0% interest Loans Really Free Money?

by Magical Penny on March 8, 2010

Welcome Carnival of Personal Finance – Tour of Ireland Edition readers. I’m thrilled that this post was selected as the top Editor’s Pick.

I’d love it if you would subscribe and follow Magical Penny on Twitter and Facebook


 

Free loan

 

There are many different types of loans: personal loans; payday loans; mortgages….they all have different interest rates -the cost of borrowing.

But wouldn’t it be amazing if all loans were set at 0% interest?

That’s right. ‘Free’ money.

It would mean that loans wouldn’t cost you anything. In fact with inflation the loan value would decrease in real terms because £1 of debt would soon be worth 90p, then 80p and so on.

Sound good? It’s certainly one of the benefits of student loans.

However in most cases a 0% interest rate is not amazing. It makes debt more tempting. And in the case of consumer debt, buying ‘stuff’, succumbing to that temptation, would make growing your pennies very hard.

I’m sure you’ll all seen 0% loans advertised on certain products to make them more tempting:

“Double discounts, 3 years interest free credit and nothing to pay for the first year”

So why not take advantage of free money?

Even though the cost of borrowing is free, you are still ‘consuming’ the product: using its value in exchange for the promise that you will pay for it in the future. For companies selling the product it makes sense to offer such financing deals because, even though you are not paying for the product in full, it encourages you to take action and buy the product when you might otherwise have not, allowing them to add your flow of money to their revenue stream.

Of course this doesn’t mean that you shouldn’t ‘consume’. Spending isn’t bad in itself. In fact, it’s great, and useful, and, to be blunt, essential. Rather I’m encouraging you to spend your money more consciously.

I want you to understand that buying things with debt, even 0% interest rate debt does interesting things to how you perceive the purchase: you may even feel smug that you have somehow got away with using someone else’s money for free; That it’s ok because the monthly payments are really low. But remember the obvious point: You still have spent the money: Pennies that you may not have; pennies that you may need to pay back if your income unexpectedly drops and you can’t afford any of the payments.

 

Be smart, don’t outsmart

In your 20s and 30s rather than ‘outsmarting’ the banks and finance companies by getting to enjoy spending ‘their’ money for free, you really should simply be saving more. Not because saving is fun by itself but because any money you channel into savings and investments has the potential to grow exponentially and have a massive impact in the future. If you have taken out loans, even 0% ones, the payment is going to be make saving more difficult as you now have more outgoings each month.

Should I pay off my student loans then?

For the purposes of this post, UK Student loan debt falls outside my demonization of debt, because it doesn’t have risk attached to it (if if you lose your income you are under no obligation to keep paying on your debt). As the only debt that I have, however, I can certainly attest to the way that even an interest-free student loan debt changes the way you feel about spending:

Spending a penny without the  pain, flushing money down the drain?

When I went to university I did what almost every student does, and opted for the maximum loan possible. I then spent almost the entirety of my student loan each semester on living in the best student accommodation available. It was great. My part-time job and summer jobs paid for my living expenses and my parents and a singing scholarship covered the tuition. I loved my comfortably sized room and the 24 hour security. I also met some great people, including very generous international students who allowed me to see some of the corners of the world for free

Although this spending was hardly wreckless, looking back the cost of living was much larger than it could have been.

cautionBecause the student loan would make it cost ‘nothing’ to access the money I never considered the option of taking less than the maximum amount of student loan. And because I had not worked for the money I could spend it without any feeling of pain. It wasn’t real to me. It was just a form that I could tick and money would appear in my account.

That’s the problem with 0% loans –It’s too easy to rationalise them, because they are free. But there are not really free if it allows you to buy something you wouldn’t have bought otherwise. Or it means that you then can’t afford to invest in the market, where over the long term gains of over 7% can be achieved.

By taking away the cost of carrying debt, a 0% interest rate might seem great at first but it takes away the financial incentive to be debt free, an important step if you are to keep your lifestyle down and make an impact with your savings goals: the goals that ultimately can define your future.

 

This is a Magical Penny post in the Debt series making sure that you understand the implications and to prepare you for investing. Don’t miss a post: sign up for free updates.

 

 

Further reading:

A cute story of compounding @Financial Tales

Lifestyle inflation @Four Pillars

 

 

Before you comment that if all loans were 0% you could leverage money in the markets I’d like to add a caveat that the 0% loans would only apply to consumer goods…Hey! My imaginary scenario, my rules! )

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Consumption Smoothing

by Magical Penny on March 5, 2010

retirement nest eggThe over-riding reason why I started Magical Penny was to evangelise the power of compounding returns. In more simple terms it was to tell people that if they save a little now, then over time they have a chance to end up with a lot. And the increase that can occur over time when a good annual rate of return is achieved is more than you would imagine.

The idea of saving today to leave you with a lump sum for your ‘golden years’ certainly isn’t original. It’s fundamental message of traditional retirement planning strategies.

*Yawn*.

Don’t worry. There’s another strategy to make sure you live a full life without having to save so much in your 20s and 30s and still have enough when you stop working. You’re probably already doing it to some extent to allow you to get the things you want and need today when you can’t afford them. What is this wonder strategy? It’s called consumption smoothing.

Saving Rules OK

Regular readers will know I’m a big fan of saving money to buy things with cash. Not only is it less risky but I don’t think people give much thought to the financial cost of how much buying things on credit can be.

When it comes to buying bigger things like a house, however, not even I am willing to wait until I can pay cash for it! Sometimes debt is worth the price because, as Sean reminds us, the opportunity cost of waiting can be too high.

A place to call home

In the case of mortgage debt, it’s often a win-win for both the borrower and the lender. The borrower gets to enjoy their own house, as it provides a form of stability in their life and gives the owner the comfort of being able to paint the walls any colour they want. The lender is also happy because they can be confident that they won’t lose their money because the house is ‘secured’ against the debt –if you can’t pay the mortgage, the lender gets the house.  It is therefore a lower risk for the lender- the reason that mortgage debt interest rates, the cost of borrowing, are so low compared with other debts. There are also many Join the Facebook group that make buying a house easy.


Consumption smoothing the practical way

Taking out a mortgage is a simple example of consumption smoothing in practice because rather than making one huge payment to buy a house at the start, you can pay for it gradually over time. Not only are your payments smooth, but your lifestyle level is smoothed too as you get to enjoy living in your house for the whole time of your mortgage. I’m sure you’ll agree that this is much better than living on the streets for 20 years as you save up to buy a house before moving into a mansion once you’re reached middle age.

‘Consuming’ Education

Other forms of debt allow you to take advantage of  consumption smoothing too. Student loans for example, allow you to attend university at a time in your life when you most likely don’t have any money at all. You get to ‘consume’ a university education without paying for it until after graduation. Students do this (or should do this) because they have the expectation that the degree will help them pay back the loan and achieve a higher income (although as Andy reminds us it is not always true). Like in the mortgage example, consumption smoothing through debt has the potential to be a great strategy for students because of the opportunity cost of missing out on years of graduate earning potential if they were forced to save to pay for tuition out-right.

So consumption smoothing is testament to how the use of debt can be helpful. However, should consumption smoothing be taken to the next level?

Living the Perfect Consumption Smoothing Lifestyle

ProfitIf you’re ambitious, student loans are just the start.  Why not really take advantage of consumption smoothing? On the assumption that you’re going to be earning much more in the future than you do now, you could take out all manner of loans: perhaps car loans, home improvement loans or even just maxing out your credit cards. By doing so you can raise your consumption, and therefore your lifestyle, above your current earning level.

Next, the plan would be to increase your income until you reach a point when your income and expenses are equal. At this point, if you are following the consumption smoothing strategy correctly, you would continue to attempt to increase your income but any raises achieved should be channelled into paying off your debts. Over time your debts are gradually paid off as, despite an increasing income, your lifestyle and consumption levels have been kept at the same level. By the end of your career you are earning much more than your ‘smoothed out spending plan’ allowing you to accumulate funds for your retirement. The extra funds saved then help you maintain your lifestyle when you income drops at retirement.

Sounds too good to be true?

In principle this plan is brilliant as it allows you to consume more when you’re young when you’re not making much, safe in the knowledge that your future self can easily afford to foot the bill.  Why live like a pauper then a king when you can simply live comfortably all your life?

Are you up for it? Try this simple test

I encourage you to try out extreme consumption smoothing if you can pass the following test. Walk through the steps outlined below and if you get to the top of the 3 steps then you have my blessing to live the consumption smoothing dream!

Step 1

Are you disciplined with your spending? Some people might find it hard to spend lots of money when they are young. After all, there are not many things to buy are there? 😉 Could you manage it? If you think you could struggle through spending lots of money when you’re young, move on to the next step.

Step 2

Congratulations, you’re one of the rare people that like spending money! Let’s try to get you to the next step. It’s quite easy. All you have to do is promise me that you’re sure that you’ll never lose your job and you will never be without an ever-increasing income. I’m only asking because one day you’ll need pay back the expensive debt that you would have got yourself in in step one, buying those new cars perhaps, or going on those expensive holidays. If you are sure that you’re a value-creating machine and nothing will go wrong in your life, then go ahead, move up to step 3.  You deserve it.

Step 3

Wow, you’re awesome! With an indestructible career that’s always on the up and up you deserve great things. Now you have to promise me that you’ll continue working hard to increase your income even more, but that you will also keep your spending at the same level that you’ve had since you started this journey. Doesn’t sound so good? Well, get used to it because you’ve come this far and you can’t go back. Keep working hard and pay off that debt otherwise it will keep growing with interest and fees. And when you’re done cleaning up that mess, you have retirement to save for too!

Life is all about balance and unbalance!What do you think of consumption spending now?

Although it can be really helpful for student loans and houses (traditionally known as ‘good debt’)  it soon becomes hard-work when other expenses come into play. Like many things, it’s a question of balance or rather in this case, unbalance. By saving a lot more in your 20s (and if everything goes well) you can always be increasing your consumption and lifestyle.

The only way is up!

Also, you would be in a much better position if and when thing in your life don’t go to plan too.

Making the commitment to build solid finances today might not seem as fun as the ‘consumption smoothers’ at first but I think it’s worth being a little less comfortable in your 20s. If not now, then when?. Over time you’ll catch up with those ‘consumption smoothers’, and your ascent to wealth will be made easier still through the power of compounding returns.  How about you?

We are nearing the conclusion of Magical Penny’s foundational series on Debt. You can find other articles in the series here.

There’s been some exciting things happening behind the scenes here at Magical Penny. Twitter feed and read the Twitter feed to get in on all the action. Also don’t forget to sign up for the newsletter which is launching shortly. If you have already subscribed to the email post updates you don’t have to worry as you’ll automatically receive the newsletter when it launches.

Have a great weekend everyone.

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The Treadmill that Does Not Get You Fit (financially)

by Magical Penny on March 3, 2010

When most people think about the subject of personal finance they think about cutting back; that a budget is all about not spending any money; that saving for the future stops them from truly living in the present. I’ve certainly heard this recently when some of my friends began hearing about what I’m doing here at Magical Penny:

“Oh Adam, you won’t like this but I’ve just bought a new laptop”

“Why are you saving so much when you could save a little less to allow yourself to live more in the present”

For many, saving money is perceived as something that deprives them of every day pleasures and happiness. They think that those who do save their pennies must be living boring lives, depriving themselves by avoiding spending money on fun things. Of course this isn’t true.

Avoid the Treadmill

One useful theory in psychology that I’d like to share is called the ‘http://mnmlist.com/letting-go-of-desires/’. It’s used to describe how no matter how much we progress in our lives, be it in a career, or in the size of our bank account, we remain largely at the same stable level of happiness. For almost all of us, even if we are always increasing our standard of living, our happiness will not increase with it. We get used to it, in the same way that lifestyle inflation makes what we have seem ‘normal’. Rather, our happiness is more influenced by relative measures: are we doing better than the people around us or better now compared with how we were doing recently?

Does Spending Money Make You Happy?

I’d like to take this idea and apply it to spending. It’s common knowledge that money doesn’t bring happiness so why do so many people think spending brings meaningful happiness? Of course most of us get a buzz out of something new: for me I think of things like a new camera or a computer. Perhaps for you it’s clothes or shoes, or something bigger like a car or a new house. It’s only human to enjoy getting something new, something better than what we had before or better than what our friends have!

However, soon after the purchase, perhaps over the course of the following few weeks and months you’re not likely to be more happy in your everyday life. A newer car or a faster computer may make our lives a bit easier, or more comfortable, but does it really increase our happiness over the long term? Not so much.

So if you are not going to any more happy after purchasing perhaps you may as well begin saving more! And when you being appreciating the true price that we pay for just being ‘comfortable’ or for the ‘convenience’ it becomes even easier to get excited by the idea of saving and investing in your 20s and 30s, due to the power of compounding.

The Search for Real Happiness

Although the hedonic treadmill theory tells us that our basic level of happiness stays the same  it is still important to seek out happiness every day. We already know this and a lot of people look to make themselves happier through their spending habits.

However, I encourage you today to have a think about what makes you memorably happier.

Think specifically.

What were you doing in your favourite memories? Who were you with?  If for example your best memories are from holidays with friends, then make it a priority and recognise that in order to afford to do it again perhaps you should cut back on things that don’t matter so much to you.

To give my own example, I’ve not found a car to be a priority to me (yet) but when I do, I recognise that over the long term my level of happiness is going to be relatively stable whether I have a new or an older car.  I’ll take the second hand car and make a commitment to save more both for my future self and for an adventure holiday to Rio De Janero for Carnival. Going on this holiday won’t affect my base level of happiness over the long term either, just as a new car wouldn’t, but I’m sure it will create happy memories that I’ll be able to call upon in years to come. For me that’s a better trade than being ‘comfortable’ in a new car. It’s just not my passion. How about you?

If Money Doesn’t Bring Happiness Why the Focus on Growing Pennies?

Saving and investing for the future is not about a quest for happiness. And I’m certainly not the first to write about money not bringing happiness! As I wrote above, we have to seek out happiness every day in our own way, but when we do, I suggest you make sure to avoid the hedonic treadmill and focus on authentic experiences.

So what is Magical Penny ultimately about? It’s about growing your pennies to give you options. Options like the choice to retire early to allow you to more control over your schedual, or being financially secure enough if you decide to change careers or take a break to start a family. Or for any other reason you may have.

I hope you’ll join me in making a commitment to disconnect happiness from spending, to avoid the hedonic treadmill and get financially fit at the same time!

This article was partly inspired by:

@Creditcards.com

In other news, Magical Penny was featured in 2 blog carnivals this week and I’m understandly excited and honoured to have been selected. Reading the articles featured in both carnivals is a great way to learn about the many different facets of personal finance.

Carnival of Personal Finance @PTMoney

“Over at the Magical Penny, Adam presents something to look forward to: a really spiffy car for your midlife crisis. Plan for the crisis now, he says, and you’ll be able to afford it.”

The First International Personal Finance Carnival Personal Finance Bloggers Map

Magical Penny‘s first guest post article 5 Tactics to Avoid Overspending When Traveling was featured in the carnival that features “top contributions from around the world…from bloggers who are included in the Personal Finance Bloggers Map.”

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Using a Credit Card

by Magical Penny on March 1, 2010

Magical Penny is currently exploring the subject of debt as having debt makes growing you pennies more difficult. Previous debt topics include Student Loans, and Car debt.

If you only learn one thing about personal finance it’s this fact: if any of us are going to be successful at saving and investing we need to ensure that there is a gap (preferably a growing gap) between our income and expenses.

Using credit cardsCredit cards, in some ways, remove us from our spending, making saving potentially more difficult. Using a credit card means that  we don’t have to actually pay for our purchases straight away. A credit card allows you to pay just a small amount each month to ‘smooth’ out the cost. Whilst they can be useful tools for some, for many they act as the gateway to bigger financial problems. Certainly credit card debt is one of the most common forms of debt for most of us.

Understanding Credit Cards

I’ve had a credit card for less than a year. In truth I didn’t see the need for one but decided to investigate my options after reading Ramit’s I will Teach You Do Be Rich. I am by no means an expert on this subject but as part of Magical Penny’s foundational series on debt, this article will get you up to speed on credit cards.

Below are 4 reasons most often given for a credit card and the Magical Penny perspective on each of them.

Credit Card Perks

IncentiveCredit cards are primarily marketed to consumers by highlighting the ‘perks’:  the incentives for taking out and using a particular credit card: ‘air-miles’ , ‘points’ or ‘cash-back’ are the most common. However when you’re searching for credit cards most personal finance information online is very US-centric. In the US it seems that credit cards play a much bigger role in the ‘culture’. The ‘perks’ are better too:

“My credit card offers discounts on most major retailers, plus discounts on concert tickets and a “Make a Wish” service, which recently got me orchestra tickets I couldn’t get anywhere else.”

Ramit Sethi.

When I began looking at credit cards in the UK, I was little disappointed: the perks on UK credit cards are negligible at best, and even the relatively good card perks  have now been scaled back due to the financial crisis of 08-09.

Ultimately I conclude that even if you do have a card that gives you ‘cash-back’ or ‘points’, it’s a dangerous game to play psychologically because you may be encouraged to spend more to get the rewards. No one gets rich from credit cards, (and it’s particularly true in the UK where the perks seem minuscule).

Flexibility

cautionThe flexibility of being able to buy things before you have the money is helpful for many people and it’s this flexibility that makes credit cards so popular for most people. However it’s dangerous way to live.You can never be sure of tomorrow and you may find yourself in a situation where you’ve bought more than you can afford.

It’s also expensive if you cannot pay off the card at the end of each month as the interest rate is typically over 15%. If you have credit card debt yourself, paying it off should be your first priority if you are ever to be able to grow your pennies. It’s more important than paying off your car and certainly more important than saving up for a house. In fact it should be your most important financial goal.

That said, if you are struggling to pay your bills, your credit cards should be your very last priority because they are unsecured: meaning the credit card company can’t take anything away from you if you don’t pay them (unlike a car loan or house loan where if you stop paying them you risk losing them to your creditors).

Consumer Protection

safetyOne legitimate and positive reason for using a credit card in the UK is to take advantage of the Consumer Credit Act, which protects you from defects and problems with the item or service you buy. The act makes the credit card company equally liable along with company you bought the item from. Crucially this is only applicable on items over £100.

I saw the Consumer Credit Act work in practice when my friend booked flights to Hong Kong with Oasis Airlines in January 2008. The airline went bankrupt on 9 April 2008 but thankfully my friend had booked using a credit card. The credit card company was therefore responsible for getting her and her friends on a flight on the exact date of the original flight, regardless of cost. It only took a couple of phone calls to sort everything out. It would have been  a lot harder to get your money back and replacement flights  if you had used a debit card!

Building Credit

building good creditBuilding a credit score is often cited as an important reason to use a credit card. If you do a couple of minutes of  searching online you’ll quickly come across everyone talking about FICO scores. UK readers need not worry. This is a type of American credit score that is used near universally: for mortgages, car loans, even if you’re wanting to rent an apartment or start a new job!

In the UK, there is no universal credit rating. Yes, there are ‘credit reference agencies’: Experian, Equifax and Callcredit for example,  but each financial lender has its own criteria to ‘score’ you when deciding to offer you a financial product. It’s a little less ‘joined up’ in the UK compared with the US’s mighty FICO so credit scoring is less than an issue of life and death compared with in the US.

Having a credit card does help build your ‘score’ in the eyes of many lenders though because it shows potential lenders that you have the ability to pay your bills on time (assuming you do pay at least the minimum payment on your credit card each month!).

Ultimately if you’re serious about growing your pennies, your credit score shouldn’t matter too much:

  • A car loan?

Buy used with so you can afford your mid-life crisis car.

  • A mortgage?

Save up a substantial deposit to get the best mortgage rate

  • Furniture?

Just make do with what you can scrape together and in the process make your future self proud and avoid bringing risk your life.

In the end I decided to get a credit card for the consumer protection it offers and establishing credit-worthiness (although I’m not fully convinced how big an impact it will have when I’m looking for mortgages compared with the impact of a down-payment). I don’t intend to take out any other form of loan as I’ve made a commitment to live below my means and grow my pennies.

My credit card offers no useful perks but as it’s connected with my current account it keeps things simple with my online banking.

Used correctly I’ve come to the conclusion that a credit card is like a power-tool: in the wrong hands it can be hugely dangerous to your financial life but it can be useful too, although seemingly less useful than if I were in the US, where FICO rules supreme and the perks are more tempting.

Do you have a credit card? What have you found to be useful?

Further reading:

The Consumer Credit Act

Credit rating in the UK

Optimising Credit Card useage (US centric but a fun read….well, fun for me at least!)

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Lifestyle inflation -the silent killer of dreams

by Magical Penny on February 26, 2010

As we journey through life, it’s natural to want to make progress: to earn more; to see new things; and to grow personally and professionally. However, as our income hopefully grows, many of us quickly find new and exciting things on which to spend our newly earned pennies. After all, we work hard, we deserve it!

This in itself is fine. However it’s important to understand that once you become accustomed to nicer things it’s very hard to go back: beware of  ‘lifestyle inflation’.

The Silent Killer of dreams

Lifestyle inflation can creep up on you. Perhaps you begin earning a little more and decide to ‘upgrade’ a few things:

  • A nicer car that doesn’t smell
  • A better gym that doesn’t smell
  • A shiny phone contract that errr…you get the point.

If you allow it to continue you’ll be spending all of your income each month, regardless of how fast you can increase your earnings and any dreams that you have to be financially comfortable will never be fulfilled. Avoiding ‘lifestyle inflation’ is particularly important for those of us in our 20s and 30s because we may still have relatively modest lifestyles. You may be a student, or freshly graduated. Or like me, a few years out from graduation beginning to make progress in a career. One of the best tips I read whilst still at university that helped me to where I am today was:

“continue to live like a student for as long as possible”

And no I don’t mean crazy drunken weekday nights, or take-away pizza every day! Rather, continue to live conservatively like you did when you were a student. Most importantly, avoid finding new ways to spend your newly aquired income, (or that much anticipated raise for those of us already with an income).

Being in our 20s and 30s we are uniquely placed to be in a position to make a huge impact on our future wealth largely because we have so much time to let our pennies grow. We have also had less time to develop expensive habits. Ultimately, avoiding lifestyle inflation by keeping expenses low is a great way to leave you with enough pennies each month to begin investing.

The threat of lifestyle inflation is one of the reasons I gave for avoiding the purchase of a new car in Wednesday’s article on ‘How to afford your mid-life crisis car’: If you start off with a shiny new car, you’ll never want to drive an old ‘banger’ again. After all, no-one wants their life to get more uncomfortable; only better. That’s lifestyle inflation at work. It is one reason why so many people find themselves in debt, as acquiring debt allows us to make purchases to make our lives more comfortable, to ‘inflate’ our lifestyle without any increase in income!

Opportunity Cost

Magical Penny has been exploring the topic of debt this week, most recently: car debt. Sean, a Magical Penny reader and long-time friend, made his case in the comments that I was missing something: the opportunity cost paid when saving for a car rather than financing. Sean explains that hypothetically, during the 2 years of saving of a car, savers would miss out on:

“2 years of fault free motoring and the pleasure of owning a new car…”

…although he admits that:

“The problem with opportunity cost is that it’s very open to personal interpretation”.

Read the full debate by clicking here.

Sean’s completely right on this. Financial priorities are a very personal thing. For me, living without a car was a ‘big win’ that helped me to begin saving and investing. For others, the benefits of a new car (fault free motoring and pleasure) may seem worth it. The difficult part however is fully appreciating how much an experience is truly ‘worth’. The Magical Penny car post seeked to explore this from the perspective of  those of us at the beginning of our adult lives, where I believe that the cost of buying a new car is more than most people would think: particularly considering the different opportunity cost of not investing (missing out on stock market gains) having made the car debt a priority.

‘Live like no-one else so later you can live like no one else’

Dave Ramsey (US personal finance personality)

The first ‘Live like no-one else’ means living below your means, something that some of us don’t do very well. Taking out a car debt equal to several months of work is not truly living within your means even if you think you can afford the payments. In Sean’s example, given the huge potential that saving money in your 20s can have, it’s easy for me to accept the ‘opportunity cost’ of mising out on ‘the pleasure of a new car’. That said, some may take my argument to the extreme, lowering their lifestyle to nothing by surviving on ramen noodles and living in a tiny flat-share, all in the name of ‘compounding returns‘, saving a sizable chunk of their income in the hope of huge investment gains. As with most things, however, it becomes a question of finding the right balance for you and remember: Don’t completely mortgage today for the hopes of a pay-off tomorrow.

Personal finance is personal

And so to end this first week of posts about debt here at Magical Penny: I challenge you to think of a ‘big win’ of your own: To avoid spending on something that may seem ‘normal’ to those around you: a car, regularly eating out’, exotic holidays…etc. It’s not about depriving yourself of experiences or nice things, but reconsidering your wants: are they really worth it or is it better to ‘live like no-one else’ so in a few years you could have grown your savings to such an extent that they allow to ‘live like no-one else’.

Follow Magical Penny on Twitter for post updates and other thoughts, and sign up to the newsletter too -some special things are planned soon, only for subscribers! It’s free so join today!

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How to Afford your Mid-life Crisis Car

by Magical Penny on February 24, 2010

Imagine a few years down the line: You’re fat, working a dead-end job and divorced from the love of your life. Let’s throw into the mix that you’re losing your hair too.

The only solution? A midlife crisis sports car of course!

Hopefully you’ll not find yourself in this situation but it always helps to be prepared. What’s a prudent 20 something to do? For the purposes of this post I’ll ignore the fact that we all should be working to improve ourselves, developing and maintaining healthy relationships and finding fulfilling ways to spend our days on the planet.

Instead, let’s focus on logistics of being able to pay for the car!

For many of us, getting a car loan is the ‘normal’ thing to do. How else are we to afford one? When I explain to some friends that I’m saving up for my first car some of my friends really do say:

“But Adam, no-one can afford to buy their first car without help from their parents or a car loan right?”

Avoid your first major debt

Aside from student debt, a car loan is often the first major debt that young people beginning their careers sign up for: certainly a number of my friends bought cars after university using financing, many focusing on the monthly payment rather than the total cost of the loan.

However carrying debt can be costly and adds risk to your life: when you take out a loan you make a promise to pay it back over time but the future is never certain: you may not be able to pay back the loan in the event of a job loss, or you may not be able to afford other things that you need or would like because you are committed to making the payments on the car-loan.

In cases where you buy a brand new car, you could get in even more trouble as the value can quickly fall below the level of your debt so you would not be able to sell the car at a later date without first taking out another loan to cover the difference. With debt you lose both cash flow and flexibility –you are required to keep paying for your purchases even in the event of a change in circumstances.

So what’s the alternative? Here are 4 ways to either avoid or minimise car debt, putting you in a much better position to grow your pennies helping you afford your mid-life crisis car later on in life:

Do you need a car now?

Having a car can provide great personal freedom and for many, getting your own set of wheels is a ‘coming of age’ moment: You no longer need to rely on public transport or lifts from family or friends. However it can also be a financial burden and a commitment that stops you from being able to save money for your future self.

Admittedly it’s easier for some to decide against a car: for example, I love cycling and my trusty bike gets me to work and around my city quite easily. It’s not always convenient but the choice to not have a car makes a significant difference to the amount I’m able to funnel into my emergency, opportunity and future self accounts. Ask yourself:

“Is having a car at this stage of my life really worth it?”

Deciding to wait a little while for a car can mean the difference of tens of thousands of pounds considering how much the pennies you save in your 20s will grow in value over time.

Buy used and older

Most readers of Magical Penny are young 20 somethings just coming to terms with their finances, or at least seeing what all the fuss is about! We already have what almost everyone would pay millions for: youth! Take advantage of being young: you don’t need a shiny new car to enjoy the crazy adventure of early adult life. Not having a car payment (or a very low one) allows more flexibility to travel, visit friends or simply save for other things like a down-payment on a house.

Having an older car also lowers your insurance premiums and it is much easier to purchase an older, lower value car with cash (saved over a few months). Remember, it’s not about depriving yourself: it’s about getting yourself in a position to make a significant impact on your future self’s bank balance: the money you save by buying a old used car in your 20s compared with financing a new car or leasing a car  is not just a few thousand pounds: left alone and invested properly, we’re talking significant sums: tens of thousands of pounds; plenty to be able to afford that Ferrari when your hair starts to thin and you need that mid-life crisis boost!

Cheap(er) Financing

For some, having a new car is something that can’t be avoided: they require a new car as part of their job perhaps: it needs to be presentable for visiting clients or reliable for travelling to meetings and events. In these cases spending the time to find 0% finance deals is the best option. All debt has risk but 0% finance deals at least cuts back on the expense of borrowing.

Pay It Off ASAP

Even if the interest is at 0%, you need to work out a way to over-pay -not having debt has a huge phycological benefit of being master of your own destiny, rather than working for your creditors. Also, if you want to be ready to begin seriously growing you pennies through saving and investing, you need to have significantly reduced your car debt otherwise you are taking on too much risk. Find ways to cut back on your lifestyle and add any money saved into the ‘pay of debt’ category in your budget.

Many people feel liberated when they pay off their debts as 100% of their income can be spent on today’s and tomorrow’s needs and wants, rather than yesterday’s obligations. Sounds good doesn’t it?

Finally…

As you’re reading Magical Penny, the blog that evangelises the power of compounding returns, you may be eager to start investing before you finish paying off your car loan. However it’s not generally recommended as the stock market’ return is not guaranteed. The savings you will make when you pay off debt, however, are. The best plan is often to get the expense and risk of a car loan out of your life before you begin to seriously grow your pennies in the market.

Ultimately if you make the choice to lower your car-debt now when you’re still young and  still (relatively) cool,  you can afford that sports car just in time for your mid-life crisis!


This light-hearted but important post on paying off debt and reducing your lifestyle while you’re still young is part of Magical Penny’s ‘Debt’ series – making sure that you understand the importance of eliminating debt before you begin growing your pennies in the market. Don’t miss any of the action: get free updates by clicking here.

Further reading:

Carnival of Personal Finance #245 @budgetsaresexy
–Magical Penny as a featured ‘editors pick’:

#1) Magical Penny: Financial Lessons of a Cheese Pedlar. Cheese & finance?! AWESOME! 🙂 If you frequent Subway a bit, and like keeping your money, this is a must read. Well done Adam!

Why you must get out and stay out of debt @Monevator

Get out of debt to unleash your inner money maker @Monevator

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The Guy in the Glass

by Magical Penny on February 19, 2010

We’re coming to the end of the first stage of the foundational articles here at Magical Penny. The aim was make you face up to where you are financially and to prompt you to develop a plan with your pennies before you make any other moves.

Magical Penny will be back on Monday with a series on prioritising and eliminating debt – the next stage of the journey towards growing your pennies. Until then I’ll leave you something a little different: one of my favourite poems:

“The Guy in the Glass”

When you get what you want in your struggle for pelf,
And the world makes you King for a day,
Then go to the mirror and look at yourself,
And see what that guy has to say.

For it isn’t your Father, or Mother, or Wife,
Who judgment upon you must pass.
The feller whose verdict counts most in your life
Is the guy staring back from the glass.

He’s the feller to please, never mind all the rest,
For he’s with you clear up to the end,
And you’ve passed your most dangerous, difficult test
If the guy in the glass is your friend.

You may be like Jack Horner and “chisel” a plum,
And think you’re a wonderful guy,
But the man in the glass says you’re only a bum
If you can’t look him straight in the eye.

You can fool the whole world down the pathway of years,
And get pats on the back as you pass,
But your final reward will be heartaches and tears
If you’ve cheated the guy in the glass.

Dale Wimbrow

What are you doing to make the person in your mirror proud?

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Financial Lessons of a cheese pedlar

by Magical Penny on February 17, 2010

The psychology behind saving, spending and selling is useful to know if you’re to grow your pennies. Equally, it’s important to understand what tactics and strategies help you as an individual to save and to identify in which situations you are more likely to fall prey to impulse spending.

Up-selling

As I started looking out for these kinds of things myself, I became much more aware of sales techniques and ‘upselling’: for example when a waiter suggests you have a side dish as well as a main course, or a sales assistant tries to convince you to take out an additional warranty on an electronic device. Such techniques can are dangerous if you’re trying to follow a budget, but I still find them fascinating!

Call me strange but over the last few weeks I’ve been paying particular attention to the ‘sandwich artists’ in Subway stores, specifically how they handle the ‘extra cheese’ question. Here are 3 examples of what I’ve heard:

  1. “Would you like extra cheese in your sub?”
  2. “Double cheese?”
  3. “Cheese on both sides?” [of the open bread’]

Which of those 3 did you find most persuasive? For me it’s number 3. Here’s why:

#1 –‘extra’ –something in addition; superfluous; less important. It’s easier to say ‘no’ to extra: perhaps you’re on a diet or you simply don’t feel like even more cheese on your sandwich. Similarly when it comes to saving, saving your ‘extra’ money is hard work –who has ‘extra’ money anyway?! FAIL.

#2 –‘Double’ –Double is fun –it’s a 100% increase! If you have the option for ‘double’ you generally take it.  But double is also excess, so ‘Double cheese’ was a great up-sell technique amongst the steady stream of drunk customers heading to Subway after leaving the clubs in the early hours, but I doubt it would work so well during the day. Comparing this back to money again, ‘Doubling’ your savings can be even harder than saving your ‘extra’ money –where is it going to come from? Will-power alone won’t be able to help you ‘double’ your savings rate. FAIL.

#3. My favourite technique: the guy using the ‘Cheese on both sides’ line was an up-selling genius. For every customer that I saw, he already had the 4 slices of cheese in his hand (2 standard and 2 ‘extra’) before asking “Cheese on both sides?” His tone of voice made it sound more of fact than a question. Who was I to deny this fact?! Of course I would have cheese on both sides. He made it sound like the thought of cheese on just one side of my bread was ridiculous! WIN.

It’s only a small thing but his success rate at the up-sell was amazing. Extra cheese is 40p and assuming he up-sold to 2 customers a minute, he was increasing revenue by £48 an hour, selling little slices of cheese alone. Over 5 busy lunch-hours he would net an extra £240!

Only one person said no to this technique whilst I was watching, and even then the guy made the customer confirm it: “You don’t want cheese on both sides?” before reluctantly putting the extra cheese in his hand back in the food container.

Connecting this to saving psychology, when it comes to saving your pennies, little decisions can have a huge impact and a strong and certain mind-set helps too:

“of course I are going to save money –it’s obvious! How else am I going to able to live my future dreams: buy a house, go travelling, start a business, if not through saving?”

Will-power is great for getting started but to be certain to save consistently, you have to take the will-power out of the equation and make it non-negotiable. Here are two easy ways to make saving consistently each month a reality:

Pre-tax: Put money in a pension before you see it

If you are a salaried employee you most likely will have the option to join a pension scheme (or 401k in the US). Do it. It’s quite often free money as your employer will ‘match’ what you put in up to a certain percentage of your salary, typically 3%. This contribution will be before tax, so for most of us we can save £100 in a pension but our take-home pay will only seem lower by roughly £78. (Magical Penny will highlight the best ways to invest this pension money and avoid the pitfalls in later articles but for now, just get it set up by talking to your HR department).

Post tax: Automate your savings.

I have a friend who says he’s too lazy to save money each month. But you can still save money and be lazy at the same time: It’s easy to set up an automatic transfer from your current account (‘checking’ account for American readers) to a separate savings account each time you get paid. Before I automated my saving I found that some months I would have an excuse not to make the transfer:

“I’m going on holiday”, “It’s Christmas” etc.

But once it was automated I didn’t have to make that choice: reducing the need for will power or mental energy- You can set it up easily enough using online banking or have a word with your bank. Once set up you just save (and later, invest) automatically and you can go back to being lazy.

Up-sell yourself –the cheesy way

By saving before tax with an automatic pension contribution and automating your post- tax money (your ‘take-home’ pay) you will be saving more, just like the up-selling sandwich artist manages to use psychological tricks to unload more cheese on an unsuspecting public! . By following these two simple tips you can ensure the sandwich of your financial life has cheese on both sides, effortlessly.

Go on, up-sell yourself to yourself!
Adam had a lot of fun writing this cheesy but hopefully insightful post: he’s currently singing in Venice but will return shortly to moderate your comments. Join in the discussion: what other ‘tricks’ help you save or earn money?

Update: Featured by J Money at Budgets are Sexy dot com!

Carnival of Personal Finance #245 @budgetsaresexy
–Magical Penny as a featured ‘editors pick’:

#1) Magical Penny: Financial Lessons of a Cheese Pedlar. Cheese & finance?! AWESOME! 🙂 If you frequent Subway a bit, and like keeping your money, this is a must read. Well done Adam!

{ 15 comments }

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