Life Lessons 101

Everything you needed to know, but was never taught in school.

Millionaires spend 25% less on this…

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I’m going to put a link below, because I couldn’t believe it, until I saw it. Now a lot of this is “averages” so a family of 2 spends less than a family of 5, etc, but the basic idea holds true.

Millionaires spend an average of 25% less… on food. This is combined groceries and going out to eat.

Now I’ve always been interested in what do millionaires do. Is there things I could do to be like them. This started way back when I was in college when I read the Millionaire Next Door. (This is a link to the most recent version, it’s been updated a few times since I first read it.)

A lot of people wish they were them, but few know how to be like them. There are a lot of interesting insights into Millionaires, but this one was interesting. It actually came out of research for a similar book, Everyday Millionaires by Chris Hogan.

The idea is simple, a lot of money tends to “slip through fingers” because people don’t know what they are spending. It’s easy to go out to eat because “there’s nothing in the fridge”, but eating out is always more expensive. It’s also easy to go to the grocery store and grab a little of this and a little of that.

But when you “grab a little of this and a little of that” you probably aren’t buying what’s on sale, unless that’s why you grabbed it, and you may not need it. Food goes bad, and in America, we throw out an estimated 30% of our food. That’s not only bad for our environment, but it’s bad for our wallet.

Since food generally is our second biggest expense (only after housing), we should be mindful of controlling that spending so we can be as efficient as possible with it.

https://www.youtube.com/watch?v=PZq1WP3G_O8
The promised video from Chris Hogan

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What is my FICO Score?

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When a lender is about to loan you money, they want to know what is the chance of you paying that money back. Hence the FICO score. Now to be fair, there are different scoring systems out there, each with their own methods for calculation.

The Score

The score ranges from 300 (very bad risk) to 850 (very good risk). The lower your score, the more the system thinks you’re likely to not be able to repay the loan. Where a high score says they believe there is a high chance of you repaying the loan.

The average score varies from year to year, but right now it is estimated to be just under 700.

Typically, the younger you are, the lower your score will be, we’ll talk about why in a little bit. In your twenties you’ll see a score of about 660 and in your thirties, it will be 670 to 680 on average.

However, you can have a high score and be in your late 20s and 30s. I know, I had a 735 at 25, and ~750 at 30.

A good score doesn’t just help you with getting a good interest rate. It can also help you get a good (car) insurance rate, and some jobs will use it to determine how (financially) stable you are, especially if you are going to be working with money.

What makes up the score

Now the actual way it’s calculated is a bit of a mystery, and it is updated from time to time. However, we can give you a basis.

Payment History

Want to kill your credit score – miss paying a bill, or two. The longer it is late the worse the effect will be. Miss a couple, and you can quickly tank your score.

This is the number one contributing factor to your score. Up to 30% for most scoring companies.

Amount Owed

The amount owed, as a percentage of the amount you can borrow, is the second highest scoring factor.

The system can’t tell that you went on vacation, put everything on the card and will pay it off next month, so it drops your score. When you pay it off next month, your score will go back up.

The thought is, if you can borrow $100,000, and you are, then it will be difficult to pay that all back. It might even signal that you are getting ready to “run” instead of paying.

Run can mean physically leaving town, or something like declaring bankruptcy, etc.

Typically this only/mostly looks at unsecured loans (credit cards) not your mortgage or car loan, although it may, just to a lesser extent.

Credit Age

The longer you’ve had open accounts, the better your score will be. Bad accounts tend to get closed, and new accounts, people may not know how to use them.

Your credit age, makes up a big part of your score and is part of the reason why younger people don’t have as good of a score. Opening a card in college helps get people’s credit established, but too many abuse it.

I got a credit card for emergencies, and then didn’t even keep it on me, so I wouldn’t be tempted to use it. It let me build up some history, without it costing much money.

New Credit

Get a new card, and it looks suspicious. Add a bunch of new debt, and the system asks why. Did you lose your job and need to buy food so you got a new card, but that means you’ll have a hard time paying it back…

If you are getting a lot of new inquires, it looks “suspicious”. So your score will drop. To protect you, typically only the first check will count against you. So if you got to three car dealerships and they each run your credit, you only get hit once.

Check on mortgage options, and get three or four quotes, only the first one affects you. The basic idea is that the average person won’t be buying multiple new cars or houses at one time.

However, each credit card inquiry into your account, will negatively effect you since you could get multiple cards at once.

Credit Mix

The different types of loans you have does matter. The more revolving lines of credit (credit cards, department store cards, etc) the worse for your score. These tend to be more risky.

How does Interest Rates Work?

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Albert Einstein once supposedly said that (compounding) interest is the 8th wonder of the world. Whether that wonder is working for you, or against you, will make it your friend or enemy.

The interest rate, sometimes just called interest, is a percentage of a whole that is paid by one party, for allowing another party to use it.

Interest working for you

Consider a savings account. When you put your money in the bank to “save it”, the bank is going to not just lock it up in a vault. They put that money to work. Because you let them use that money, they pay your a portion of what you put in back extra.

For simple numbers, let’s say that amount was 5%, and you put in $100. At the end of a time period, like a quarter, you’d have that $100, plus an additional 5%, or $5, or a total of $105. At the end of the next quarter, you’d have another 5%, but instead of it being on $100, it’s on $105. That means you’d get an extra $5.25. Now your total is $110.25.

At the end of every period your bank account increases. At the end of four quarters, one year, you’d have $121.55. That is assuming you don’t add any extra money (deposit), or take out (withdraw) from the account during that year.

Your money is literally making money.

Interest working against you

Now why does the bank give you money for putting it in a savings account? Well, that’s because of how it uses it. It will take your money, and the money of other people, and loan it out. So let’s say you wanted to buy a car. They go to the bank, and get a loan for $30,000 and the bank is going to charge you interest to use their money.

For simplicity sake, let’s say it’s 10%. If you doesn’t pay off the loan, the loan amount will be $33,000 at the end of the year. Now, each month the bank will want you to pay down that loan, so you’ll pay a little bit in interest and a little bit in the principle – the amount that they borrowed.

The amount you pay will depend upon how long the loan is for and how much they actually borrowed. In a normal loan situation, you will always pay the interest plus some principle for a given year/quarter/month/etc.

Car loans tend to be for between four and six years now a days, while a home mortgage will be for between ten and forty years. Most of the time it is fifteen or thirty.

Why different interest rates?

The rate that the bank gives you on an account will typically be the same as they give anyone else. Sometimes they will give higher rates to people to put a lot of money in the bank (the banks rewarding them for putting extra money into them so they can make money off of it), but generally you have to have a very large deposit amount to make that higher interest rate ($50,000 to $100,000 or more).

You will also notice that you pay a higher interest rate to borrow money than when you put it in the bank – why is that? Well, the bank has certain overhead cost they have to pay. Everything from the teller who takes your money, to the loan officer who gives you the money you are borrowing, to the buildings that they are in, etc. There are a lot of people and items that have to be paid.

Additionally, the bank knows that some people, despite their best intentions (or not) will not pay back all of the money lent to them, and the bank could lose money in the deal. They have to make sure they cover those potential losses.

How to get a better interest rate when you borrow

The interest you pay on a loan however will vary greatly and are based on a couple of factors.

First is your credit worthiness. Your FICO score will tell a lender how much of a risk you are. i.e. does the bank think you can pay the loan back. A low score is a low confidence, and the lender (bank) will charge you a higher interest rate to cover cases where you might skip town without paying.

Second is what is the loan for. House mortgages tend to be cheaper than most other loans because houses typically go up in value over time, you can’t pick up a house and skip town, and if you don’t pay your mortgage loan, the bank can repossess your house, essentially kicking you out.

A secured loan is one where you are buying something the bank can take back – like a car, boat, etc. Generally the bank can take it back, but they depreciate in value over time, especially right away. So if you don’t pay the loan back, the bank takes the car back (repo man), but the car you bought for $30,000 might only be worth $20,000, so they charge you a higher rate in case they have to take the car back, to reduce the risk of loss.

An unsecured loan, like a credit card, has the highest interest rates. That’s because it is often used to buy things that you cannot return, or the bank cannot take possession of. Think of paying for a dinner, or a vacation on a credit card. The bank can’t take those items back, so to reduce their risk of loss, they charge the highest interest rate for these items.

Current Interest Rates

Now I used 5% interest for a savings rate and 10% for buying a car – however, that isn’t always the case. In fact, now a days, if you have good credit, you’ll see rates much lower than that. Why?

Well, banks loan each other money? If they can get money from another bank cheaper than you, they will. So, your money doesn’t have as much value to them. This means borrowing money is cheaper too…but if you’re trying to save, good luck.

If the over night lending rates for banks were to go up higher, that would make savings accounts pay more, but it would also cost more to buy a car, house etc. Due to a variety of complex economic reasons, we’ve had really cheap interest for nearly two decades… it’s like our economy is hooked on it, and I don’t see us breaking that fix any time soon.