Truth: Your bank account balance is not always the most important number in your financial profile. As your spending, borrowing and saving habits evolve, you will also be judged by the size of your credit score.
A credit score is a number that represents the credit worthiness of a person – the likelihood that a person will pay his or her debts. If you take out a loan for school, a car, a house or even borrow from your credit card company to pay for your spring break trip during freshman year of college, can you be trusted to pay it back? Your credit score provides lenders with that answer.
Given the power of that number, it’s shocking to hear that some 43 million Americans believe that if you carry a monthly balance on your credit card, rather than paying off the loan in full each month, you are actually boosting your credit score. A recent report from CreditCards.com found that more than 1 in 5 credit card users in the U.S. carry a balance on their credit card – in other words, they only pay the minimum amount due each month and still owe the credit card issuer money – to help improve their credit scores.
“This myth has been out there for a long time, and lots of people have debunked it,” Matt Schultz, CreditCards.com senior analyst said in an interview with USA Today. “But it definitely seems like it’s one of the cockroaches of personal finance myths. It can’t seem to be killed.”
April is Financial Literacy Month in the U.S. Let’s kill some personal finance myths.
Myth No. 1: Student Loan Debt Is Always Worth It
With the soaring cost of tuition, a summer job flipping burgers or waiting tables will often only scratch the surface of the financial burden for aspiring college grads hoping to save enough money for classes and books. For many students and their families, taking out loans to pay for college is the only way to finance a higher education. Student loan debt is at a record high in the U.S., with 44 million borrowers owing $1.5 trillion, according to the Federal Reserve (the Federal Reserve System is the central bank of the U.S., and includes the Federal Reserve Board and 12 Federal Reserve banks). That colossal amount has more than tripled since 2004 and is now second only to mortgage debt.
Despite the numbers, college debt has long been considered “good debt” because people who hold bachelor’s degrees have a much higher earning potential than those who do not. In fact, a Georgetown University study found that degree holders earn 84% more than high school graduates – or an average of $2.8 million over a lifetime! But there are a growing number of financial experts who question that conventional wisdom, saying not all degrees are created equal. It pays to do some research ahead of time to determine whether your major is worth decades of student loan debt. Some fields or job markets simply don’t pay well enough to offset the financial burden of a costly degree.
“Getting a communication degree today, for example, is less valuable than in the past unless you know modern technologies — for example, SEO — to help with obtaining a good job.” Wharton professor Kent Smetters said in an interview with our sister publication, Knowledge@Wharton.
There are also concerns about college taking longer than four years, students defaulting on their loans, and graduates putting off big purchases like a house or a car because of their debt.
In his book, Will College Pay Off? A Guide to the Most Important Financial Decision You Will Ever Make, Wharton professor Peter Cappelli urges students and their families to think carefully about graduation rates, the cost of private vs. public tuition, job markets and even the importance of extracurricular activities in finding that first job.
“The kind of advice that many of us grew up with — college is a great thing, you all should go, it would be wonderful — might not be completely right in the current environment given the costs and given the realities of the job market,” he told Knowledge@Wharton. (For a deeper discussion on this topic, please listen to our four-part podcast series on the rising costs of a U.S. college education, featuring Peter Cappelli.)
Myth No. 2: I’m Not Worried; There’s an App for That
Rapid advances in technology mean we’re moving faster than ever toward a cashless world, where paper money will be as old-fashioned as taxicabs and CDs. It’s important to embrace financial technology — but with caution. The convenience of paying with your fingerprint and doing your taxes and banking through the internet makes it harder to keep track of just how much of your money is flying out the door. That’s why financial experts encourage young people to learn how to budget using real numbers and real math.
You can start with something as simple as learning how to read your paycheck – the difference between gross and net pay, how much is being withheld for taxes and benefits, all the fine print. Check out the Related Links in the toolbar accompanying this article for more information about that. “Knowing where your hard-earned money goes can empower you to make smart decisions about taxes, retirement savings, health care and even potential paycheck errors,” a CNN article noted.
A big part of budgeting is saving money. Most financial planners offer the 50/30/20 rule, which follows that 50% of your income goes toward necessities like food and rent, 30% toward discretionary spending, and 20% toward saving. That may sound like a lot to sock away, but consider a recent statistic from the Federal Reserve that said 4 out of 10 Americans can’t afford a $400 emergency bill.
Myth No. 3: You Should Get a Credit Card Right Away
No, you really shouldn’t. Even though you can get a credit card at 18 (usually with proof of income and a co-signer), experts encourage you to resist the temptation. “A teen with a credit card is only slightly less dangerous than one with a loaded gun,” financial adviser and syndicated radio host Dave Ramsey wrote in a blogpost.
While it sounds extreme, it’s meant to leave an impression. Younger generations are notoriously poor money managers and sometimes act on impulse. Too many people rely on credit cards for incidental purchases like a Starbucks run, then end up caught in the trap of paying minimum balances each month on their credit card loans and getting hit with high interest charges, which means you end up owing much more than you actually spent on that caramel macchiato. For example, a $1,000 balance on a credit card with an 18% annual interest rate doesn’t seem like much. But if you make a minimum payment of $20 a month, you’ll end up spending $1,880 over the nearly eight years it will take you to pay it off. That’s the black magic of compounded interest.
Credit cards have fast-tracked financial ruin for many younger Americans, making it much harder for them to dig out from under crushing debt or obtain credit in the future.
“The credit card marketers have done such a thorough job that a credit card is seen as a rite of passage into adulthood,” Ramsey said. “American teens view themselves as adults if they have a credit card, a cell phone and a driver’s license. Sadly, none of these accomplishments are in any way associated with real adulthood.” Financial maturity means living within your means. If a credit card is going to get in the way of you developing that crucial habit, you may be better off waiting until you can spend with restraint and pay off your balances on time.
- USA Today: Your Credit Score
- Georgetown University Study on Degree Holders
- K@W: Student Loan Debt Crisis
- K@W: Peter Cappelli
- CNN: Knowing Where Your Money Goes
- Dave Ramsey: Teach Teenagers about Money
- Federal Reserve Education
What questions do you have about managing your finances? Can you think of any money myths that you want to help debunk?
Financial literacy expert and radio personality David Ramsey says, “American teens view themselves as adults if they have a credit card, a cell phone and a driver’s license. Sadly, none of these accomplishments are in any way associated with real adulthood.” As a teen, how do you respond to that observation?
What is debt and how does it connect with each of the myths discussed above? While it is definitely dangerous to be in debt, how might you justify this addition to the above story? Myth No. 4: Debt Is Always Bad for You (Remember, it’s being presented as a “myth.”)
Life has become all about instant gratification. Millennials are not willing to wait for the good things in life. They want them now and will go to any lengths to posses them. And the loan, credit card and EMI system has literally played into their hands.
In the past, my grandfather in India purchased his first apartment at the age of 46. He paid the full amount upfront as there were no loans available for housing at the time. He had worked hard for 25 years and all his savings were used to pay for the apartment. After that he bought a few expensive cars as well (all with full payment). And you know what – he never had a penny of debt on him and was never short of cash even when his business was growing.
Today, the average millennial is in significant debt by the age of 30. He has bought a house on mortgage for his family and a decent car. Apart from that, his lifestyle is great because he can splurge in his credit card and think about how to pay it off later. If he can’t, there is always the option of rolling the credit by paying the minimum amount on the credit card.
The problem with this scenario is not that the credit is available. Credit on housing and even cars is not a bad thing. It enables people to live a good lifestyle RIGHT NOW by leveraging their future earnings. But how does one really come to a figure today about their future earnings? This is where majority of the youth falter – and it’s not their fault. They fall into the trap of the “present moment bias” where they feel it is better to spend now and happily ignore or underestimate the “pain” that could follow as a result of their actions. In general, they assume that they are going to grow their income and money at a certain rate and buy a house or car based on those assumptions.
But there are two reasons why they almost always will fall into a debt trap in the future. One, because they are generally very optimistic about the future when making big and happy decisions, especially those that affect their overall lifestyle and comfort. So they will buy a little more expensive house than they should, or will splurge on an expensive car today, hoping that they will be able to pay for it over the next 10 years. Second, considering the ebbs and flows of the economy and job market, most people find themselves in a tough financial spot at some point in their lives when either their jobs are lost or their income doesn’t grow at the pace they expected them to. And sooner or later they find themselves in the throes of debt with no real solution in sight.
It is indeed surprising that such a great marketing gimmick has actually turned the lives of people into a tumultuous debt hole. The ‘marketers’ are laughing all the way to the ‘bank’.
I think its time to go back to my grandfather’s financial plan, instead of falling prey to the traps of instant gratification and living beyond one’s means.
Hi Hriday, I really enjoyed reading your comments about the management of finances and I was able to relate to the anecdote about your grandfather as well. My grandparents and parents have told me how loans and credit cards were not available for them in India during that time period, so you had to manage your finances very meticulously in order to take care of your family. Families were also larger during that era because people had more kids and lived together with their parents, brothers, and sisters after becoming adults.
You made a great point as to how fortunate we are that we can take out loans to buy commodities that we desire immediately. The marketing campaigns instituted by the companies issuing credit cards are taking advantage of the lack of knowledge that the students have in regards to financial management. Unless an individual decides to delve into the field of finance, students have to rely on independent resources such as the Internet and their parents to learn about finances because schools and colleges have never made it a required topic be taught to students. This creates a nearly infinite loop because if that individual never learns about proper financial management, then he or she will never be to teach his or her children. In 2017, the National Endowment for Financial Education conducted a study in which hey found that only 24% of millennials demonstrate basic financial literacy, but 69% believed they had adequate knowledge about basic finances.
I was actually at the University of Pennsylvania in the summer of 2018 for a summer program when I got to see aspects of this problem firsthand. My friend and I were conducting market research to determine how many people were aware about managing finances, how to file taxes, and knew basic financial terminology. We stratified the students we surveyed by their major and determined that most of the students who were not majoring in Economics did not feel that they had adequate knowledge as to how manage their finances.
There are many resources online that can teach you techniques and provide you with the tools to successfully prepare for financial emergencies, save money for the future, and still allow you to live a pleasurable life. However, many students are not interested and do not take the initiative to learn these skills because they are under the belief that disaster will never hit them. The US Department of the Treasury has released a report recently in which they recommend that universities mandate financial literary courses for their students. Premier private institutions do teach these skills, but this need to be more widespread allowing all students to get this education so they know how important paying off loans and saving money are.
This raises a few questions:
How can college integrate financial literacy curriculum in their programs?
How early should we start educating students about financial literacy?
Should more stringent limits be placed on receiving credit cards at an early age?
As a teen, getting a cell phone, driver’s license, and credit card seem like accomplishments associated with adulthood at first glance. Although these are crucial aspects of growing up into an adult, they should not be associated with them in such a manner. Real adulthood should be defined by the ability to take upon such responsibilities with maturity, taking the initiative to learn these essential skills, and making proper use of these tools to ensure a prosperous future. However, our world is defined by materials at the moment and it is very difficult to dispel these misconceptions. It starts with educating our students about financial literacy from a young age.
I agree with your point, Hriday, that debt is not always bad. It boosts consumer buying power and drives our economy because banks issue loans, consumers have the freedom to purchase more commodities, and businesses benefit from these purchases. People should be able to enjoy luxuries such as their own house and a nice car, but they mist be wary. The debt trap you mentioned is avoidable through a few steps. Individuals across the U.S. must starts saving more money, because people clearly do not save enough money for $400 emergencies. If people simply start saving more money and set a certain percentage of their paycheck aside to save every month, it would allow for much more financial flexibility. Because people do not save enough, 60% of investors between the age of 18 and 34 have withdrew money early from their retirement accounts. If they start saving money regularly to keep aside for short term future use, they will be better prepared when disaster strikes and they will be able to buy luxuries when needed as well without having to compromise on paying more than the minimum amount of their loans.
A misconception that needs to be dispelled and could help young individuals be more financially aware is that only the rich can invest. There are even platforms that allow children to invest in securities with the permission of parents and they also allow people to buy partial shares of a company to invite more people to invest. Only 37% of young adults in the U.S. said they owned a stock between 2017 and 2018. When setting aside money to save, people should also grow their money using different tools and find what they are comfortable with. They can start with amounts they are comfortable with and start learning more about investing so that can have more freedom as to where they can invest. You have to start somewhere, so do you research and you can grow you money in a relatively secure manner.