by Arthur Diaz, faculty –
Studies have shown that more than three-quarters of all college students and young adults have never received any formal guidance or instruction on managing money or saving for the future. s a result, it’s not surprising that so many people in this age group run into such financial difficulties as defaulting on loans, getting in over their heads in credit card debt, or failing to stick to a budget. Five years ago, Pomfret took some initial steps to address that problem by asking me to present what has now become an annual talk on financial literacy and money management. Aimed at seniors and delivered each spring as part of our Tuesday Night Speaker Series, the talk introduces students to some of life’s basic financial rules I subsequently developed a one-term course on the topic; Foundations in Personal Finance, a senior elective, is now in its second year.
On the first day of our course (and at the outset of the one-hour presentation), I introduce three principles that form the basic framework of personal financial literacy: Pay yourself first; Live within your means; and Begin now.
“Pay yourself first” refers to the practice of deliberately setting aside a portion of one’s take-home pay as savings each month. For too many people, savings is what’s left over after they’ve paid all their monthly bills. This is the wrong approach. I tell students they should treat the money that goes into savings the same way they treat rent, the phone bill, and the food budget—it should be a specific, mandatory monthly “bill” that needs “paying.” Except in this case “paying it” means putting the money aside into a savings account or an investment. I explain the easiest way to do this is to have a portion of their take-home pay direct-deposited into a savings account that’s separate from the checking account that holds their “spending money.” By setting aside savings money up front, they will find it easier to adjust their other spending to correspond to the lesser amount being put into your checking account.
So, pay yourself first.
“Live within your means” addresses the dangers of debt – credit card debt in particular. Credit cards are convenient and easy to use, but they can also be very dangerous. With interest rates that are far higher than those for any other form of legitimate borrowing (I’m not including pawn shops, “payday loans” and “tax refund loans” as legitimate borrowing, because their interest rates are even higher than credit cards’), credit cards are the worst possible sort of loan you can get. The example I give the students is not to use a credit card to buy a $1,000 TV unless they know they’ll have $1,000 in their bank account to pay the bill at the end of the month. Students are enticed by the credit card’s “low minimum payments”—usually around 2.5% of the total—just $25 in my example. That minimum payment comes with an exorbitant interest rate, typically between 18-24%. Paying just the minimum balance every month and never charging anything else would still take thirteen years to finish paying for that TV! They might not even own the TV anymore, but still be paying for it. What’s more, the interest would add up to more than the initial cost of the TV, meaning the total payments would add up to more than $2,000.
So, live within your means and use your credit card only for purchases that you can pay for in full at the end of the month.
“Begin now” relates to the time value of money and the power of compounding. Given enough time, small sums of money can grow very large if invested properly. For example, $2,000 a year put aside at age 20 will evolve into a $90,000 contribution by the retirement age of 65. And at a 10% return (not an unreasonable long-term rate for the stock market), that $90,000 will have grown to over $1.5 million! But by starting just one year later, skipping only the very first $2,000 payment, the ending total would be about $150,000 less at retirement time!
So, begin now!! Even if at a smaller amount
One of my students commented that this is just common sense. I agree. But sometimes, it’s not until you see the numerical impact of these rules that their importance really sinks in. I was very pleased to get an email last summer from a 2012 graduate who took my course and wrote to say that she had opened a retirement account with some of the money she earned in her summer job.
Beyond these three principles, the Personal Finance course covers a variety of other topics, including health insurance, income taxes, investment vehicles, balancing a checkbook, using a credit card, building a budget and balance sheet, and more. It’s an awful lot to cover in nine weeks, so in most cases we’re limited to a basic introduction of the topics. However, I’m confident that that limited introduction, along with a thorough understanding of and appreciation for the three financial principles discussed above, can arm our students with enough knowledge to avoid a wide array of common financial pitfalls.