Everybody makes mistakes, but there are certain areas where you want to do everything possible to avoid them. Personal finance is an important one. The stakes are high – money is what we need to meet our needs and keep our lives moving forward. Being without is stressful.
According to the National Financial Educators Council, a lack of financial literacy cost the average American $1,819 in 2022. Among the most expensive mistakes were credit card interest, luxury spending and overdraft fees.
Unfortunately, most people don’t get educated in financial literacy. They gather what they do know little by little, perhaps by trial and error.
No matter what your financial goals are, it’s important to save and spend effectively – which is possible with a greater understanding of finances. Fill in some of the potential holes in your financial knowledge by learning about these common mistakes and what you can do to avoid them.
Mistake 1: Not having a budget
A budget is one of the most basic (and helpful) financial tools at your disposal. But, many don’t use one (or stick to it) because they find it limiting, don’t make the time to set one up, or don’t know how.
A budget is not a tool meant to control your money or shame you for your spending habits; it’s meant to give you a greater and more accurate perspective of your finances. When you know how much you spend and where you spend it, you can make better financial decisions and plan for your future. If you get hit with an unexpected bill or loss of income, budgeting can help you get through hard times.
Need some more motivation to start one? A budget can help prevent the risk of facing overdraft fees by helping you understand how much you have to spend in each category, and stick to it. The FDIC reports that overdraft fees cost around $35 per transaction. Avoiding even one overdraft fee thanks to setting up a budget can make it worth your time!
Mistake 2: Carrying a credit card balance
One of the most pervasive myths about personal finance is that you should carry a balance on your credit card to build up your credit score. This is, in fact, the exact opposite of what you should do. Not only will you pay more due to high interest rates, but you can actually harm your credit score by doing this, especially if you use a large portion of your available credit. Creditors want to see that you are able to pay back quickly, so you’ll get rewarded with a higher credit score for on-time, in full payments.
However, there is a kernel of truth here. Credit cards can help build a healthy credit score, but you need to follow a few simple rules. First, always pay in full and on time. Second, only use a small portion of your available credit; industry experts recommend around 30%. High credit utilization, even if you can afford to do so, can be seen as potential financial insecurity, which makes you a greater risk to lenders.
Mistake 3: Succumbing to “Lifestyle Creep”
When people get a raise or a sudden bump in income, often the first thing they do is increase their spending. They may treat themselves to higher quality versions of things or more frequent nonessential purchases than they did before. This is called lifestyle creep.
While there is nothing wrong with improving your overall quality of living or enjoying the occasional treat, the problem occurs when people increase their spending but not their savings. How? If someone is making more expensive purchases, that means the cost to maintain those or remedy a problem will likely cost more – but without the savings to match, that can cause financial strain. And, an inflated lifestyle can cause further issues should there be a drop in income later. An emergency fund won’t go as far if it’s supporting more expensive housing, transportation, and lifestyle purchases.
So, how do you combat lifestyle creep? There are two main ways. First, maintain spending relative to your income. Second, if you can, increase your savings disproportionately more than you increase your spending. This can help safeguard you against both overspending but also inflation.
Here’s an illustration of how to combat lifestyle creep. Let’s say David makes $60,000 a year and puts away $6,000 yearly in savings, a healthy 10% of his gross income. Next year, he gets a promotion and now earns $75,000. If David continues to put the same amount – $6,000 – in annual savings, he is now only saving 8% of his income. To combat lifestyle creep, he should now contribute at least $7,500 a year – the same percentage as his old salary.
If David really wants to get ahead, he should increase his savings percentage. Perhaps he can now afford to save $10,000 per year, which would be 13.33% of his gross income. He will still have extra spending money so he can enjoy a higher standard of living as a result of his hard work and career advancement. But, he’s balancing that by carving out a bigger percentage of his raise and overall income for savings.
(One caveat: If someone’s increase in spending is due to “catching up” from having insufficient income before to meet their needs, that’s different from lifestyle creep. We’re not suggesting that those who have had to go without should maintain that lifestyle.)
Mistake 4: Not taking advantage of employer retirement contributions
For most people, saving for retirement is the most significant financial goal of their lifetime and every little bit helps. For many, that means leveraging a 401(k) account – an employer sponsored retirement account that often comes with a matching contribution. Yet an October 2021 survey from Magnify Money found that people are leaving money on the table:
- 17% of respondents with access to an employer retirement account did not contribute
- 12% of respondents who do contribute don’t contribute enough to get the full matching employer contribution
Under a match benefit, companies will match an employee’s 401(k) contribution up to a certain percentage of their annual salary. Vanguard reports that the median match value is 4% of the salary. On paper it may not look like much, but it’s money you get in addition to your salary. Most importantly, it grows over time, because the retirement plan provider invests the money into the stock market.
So, going forward, make sure you understand any retirement plans available to you, and prioritize contributing enough to get the full matching amount from your employer. If your employer does not offer a retirement plan, it may be worth looking for a new job that offers this benefit.
Mistake 5: Overlooking associated costs
Another common financial mistake is buying more than you can afford, especially when it comes to larger purchases like homes and cars. When making a purchase decision, it’s critical to evaluate the whole cost of ownership. Otherwise, you may find yourself backed into a financial corner and overspending.
We use the sticker price as our primary metric for determining if something is affordable, but in truth, that’s not the full price. There are associated costs, which are additional purchases made to support an item or service. For example, here are the associated costs with owning a vehicle:
- Sales tax
- Car title fees
- Vehicle registration
- Gasoline or electric charging
Maybe the monthly loan repayment on the luxury SUV is in budget, but what about the increase to your auto insurance, or the cost of premium gasoline?
Another example of a time when someone needs to consider associated costs is vacation planning. You may see a great deal on flights to a destination – but then the hotels, food, local transportation, or activities at that destination are pricey, and the whole trip ends up out of budget.
When preparing to make a large purchase, it’s important to look beyond the advertised price and estimate the recurring and one-time associated costs to better understand what is affordable. Make some time to get pen and paper or start a spreadsheet and tally up all of the associated costs of a given purchase. Search online and ask around to fill in anything you don’t know. Estimating is okay, so long as you’re realistic.
There is more to finance than spending and earning. Understanding concepts like interest, resource management, investing, and risk management are crucial to making well-informed decisions when it comes to money.
When it comes to finance, the number one tool at your disposal is knowledge. By researching your options, knowing your assets and taking a look at the bigger picture of your life, you can protect yourself against common mistakes.