There are an endless number of mistakes you can make with your finances. Some are small like forgetting to put in your discount code at the grocery and paying full price for items you could have gotten at a discount. Others are big. Like hundreds of thousands of dollars, big. These are the ones that will make or break your financial future. If you can skip making these, you’ll end up with, well, hundreds of thousands more dollars over your lifetime.
To keep you from falling into a giant money pit, here are the biggest financial killers and how to avoid them.
Getting Into Credit Card Debt
Credit card debt is the absolute worst type of debt you can have because credit cards charge you outrageously high interest rates when you hold a balance on them. The average credit card APR or annual percentage rate is about 18%, but many run into the upper 20s or even low 30s. That means you’re paying 18% more every year for anything you buy on your credit card and don’t pay off. For comparison, the average interest rate on a mortgage in the US is around 3%, which is 15% less than the average credit card.
On top of their extremely high rates, credit cards charge interest to your balance daily, unlike a mortgage that charges you monthly. That means every day you’re charged more interest on your initial balance plus any interest you’ve already accumulated. The act of charging interest on previous interest charges is called compounding, and it increases the amount of interest you end up paying. To minimize compounding’s effect on your balance, you should make payments on your credit card as often as you can. And by as often as you can, I mean more than once a month.
The amount of money you’ll lose to credit card interest will vary based on your balance, interest rate, and how long it takes you to pay it off, but it’s easy to get yourself into six-figure debt by holding a balance on your credit card and only making your minimum payments. To avoid getting yourself into this situation, make sure to pay your credit card balance off in full every month. If you already have a balance on your card, make a plan to pay it off in full and make payments as frequently as possible.
Having a Bad Credit Score
You may have heard the debt myth that keeping a balance on your credit card helps your credit score. This is just plain wrong. As I detailed in-depth above, keeping a balance on your credit card is one of the worst things you can do for your finances.
Now that we’ve busted that myth, let’s discuss what does affect your credit score. Making your payments on time has the biggest effect on your credit score. The second biggest factor that’s considered when calculating your credit score is your credit utilization. In simple terms, your credit utilization is the percentage of your available credit you’ve used. If you’re close to maxing out your credit card, you’ll have a high credit utilization which will negatively impact your overall score and vice versa. The remaining three things that impact your score are your length of credit history, the type of debt you have, and how many new inquiries have been made into your credit history.
Credit scores range from 300-850 and you should strive to keep your credit score at least above 640 because anything below that is considered subprime and borrowers in that category get charged the highest interest rates. A person with a credit score near 620 will end up paying $65K more on a $200K mortgage than a person with a credit score over 760. Scores over 700 are considered good and these borrowers are often offered lower interest rates, and borrowers with scores of 800 or higher are considered excellent and are offered the lowest rates.
Having a low credit score means you’ll be charged the highest rates on your loans and end up paying tens of thousands of dollars more in interest. On top of the interest charges on your loans, your credit score is also factored into your utility charges and affects what housing is available to you. With all of these factors, over your lifetime, a poor or mediocre credit score can cost you over $100,000.
To keep your credit score up, make sure you make all of your minimum payments on time every month. This includes your credit cards, loans, utilities, rent, etc. Also, keep your credit utilization as low as possible. If you want to improve your credit utilization you can open a new credit card, but I don’t recommend this unless you’re already paying off your credit card in full every month. Lastly, keep your old credit cards open even if you don’t use them anymore. This will keep all of your old credit history intact.
Investing in High Fee Mutual Funds
Compound interest from your debt may be enemy number one, but investing fees are a close second, and mutual funds are notorious for having super-high fees.
The reason many mutual funds charge high fees, or expense ratios, is because many of them are actively managed. That means their fund manager tries to pick the stocks they think are going to outperform index funds that track the market. The fund manager charges you more for all of the time it takes them to research stocks and find the top performers.
This wouldn’t be a problem except for the fact that after you factor in their fees, most actively managed funds underperform compared to the market. In 2019, 71% of large-cap US actively managed funds underperformed the S&P 500, and 81% have underperformed their target over the last 5 years. So while these funds promise larger fortunes in exchange for their higher fees, they rarely hold up their end of the deal, which can cost you hundreds of thousands.
Passively managed funds, on the other hand, have much lower expense ratios than actively managed funds and on average charge .2%. Investing in a fund that charges .2% will end up costing you $37,964 in fees over 30 years if you invest $450 per month and receive a 10% annual return. If you instead invest the same amount into an actively managed fund with an expense ratio of 1%, you’ll end up paying a whopping $174,788 in fees. That’s $136,824 more you’ll pay in fees with a slim chance that you’ll see higher returns. So the moral of this story is to skip the high fee funds.
There are lots of reasons people put off investing. It’s way less fun than splurging on your favorite things. The messaging about investing makes it super intimidating. Or maybe you think you need to pay off all of your debt before you even think about starting to invest. The problem with allowing any of these scenarios to hold you back from investing is that compound interest needs a lot of time to work on building your wealth, so the sooner you start, the better.
While compound interest is your nemesis when it comes to debt, it is your savior when it comes to investing. Over several decades compound interest will grow your wealth exponentially. If you invest $450 every month for 30 years and receive a 10% return, you’ll end up with over $1 million, but only $162,100 of it will have been contributed by you. You can thank compound interest for the other $865,882.
To make that much money from compound interest, though, you have to give it time to work. It took 30 years for that much money to accumulate in our example. If you shorten the investment period down to 15 years, you’ll only have $188,531 in total. That means over 80% of your $1 million earnings are made in the second half of your investment years. The more time you can leave your money invested, the more it will grow for you, which is why it’s so important to start investing today!
So while we tend to sweat the little things, it’s really a few smart choices that can make the biggest impact on our financial future. By staying out of credit card debt, maintaining a good credit history, and investing ASAP into low fee funds, we can end up with hundreds of thousands more dollars in our pockets over our lifetime.