It's back to school time (yes, already!) and if you're off to college, you're a prime target for credit card companies and loan sharks. Benjamin Feldman of personal finance app ReadyForZero offers these common mistakes?and the best ways to avoid them.
Average Daily Balance
There's a good chance you've never heard the term "Average Daily Balance" (ADB), but it affects over 75% of American adults. And that's because over 75% of American adults have at least one credit card.
In essence, ADB is a formula that determines how much interest you'll pay at the end of your credit card billing cycle. If you think the interest charge is calculated by multiplying your APR by the balance on your card at the end of the month, you are wrong.
It's actually calculated by multiplying your APR by?you guessed it?your average daily
balance. That means you could be paying much more interest than you need to! Let's use an example to illustrate why: imagine you receive two paychecks each month?one in the middle and one at the end. Since you don't know about ADB, you wait until the end of the month to make your credit card payment. That means the average balance on your card throughout the month is as high as possible...leading to higher interest charges.
What if you instead split your credit card payment into two - one in the middle of the month and one at the end? If you started the month with a balance of $4,000 and made a payment mid-month of $3,000, your average daily balance for the month would be $2,500?which is $1,500 lower than what it would have been if you waited until the end of the month to pay. Assuming your APR on the card is 20%, you would save yourself about $3,000 worth of unnecessary interest charges per year!
Credit Utilization
Believe it or not, you can be penalized for using all the credit that has been offered to you. That's because one of the main variables in determining your credit score is how much of your available credit you're using. The term "credit utilization" refers to the ratio of your total debt to your remaining available credit. For example, if you own a credit card with a credit limit of $20,000 and then you put enough purchases on it to reach the limit, your credit utilization would be 100%. As you can probably guess, that's not good for your credit score. Further, if you also had an auto loan for $20,000 that was half paid off, then your total credit utilization would be 75%. Experts usually recommend a credit utilization of no more than 30%, but it depends on your individual situation.
Understanding this concept can help you save money throughout your life. Many people close a credit card once it has a zero balance, but if you're informed about credit utilization you will often realize it makes sense to leave the card open (as long as it won't tempt you to get in debt). As long as it remains open, the available credit on the card will help your credit utilization?and boost your credit score.
Inflation and Renting Cash
Okay, so you're probably not going to buy a house anytime soon, but let's try a little pop quiz anyway. If you buy a house for $300,000 in 2012 and sell it for $400,000 in 2042, how much money did you make?
If you answered $100,000 then you need to read the following paragraphs closely. There's a longstanding debate over whether it's better to rent or own a house. You might even sometimes hear mortgage lenders say that renting is equal to "throwing your money away." While this is true in a certain sense (after all, you don't get that money back), it's also misleading because it implies that when you buy a home, 100% of your investment goes toward equity.
In fact, the reality is that when you get a mortgage you are essentially "renting" money. Instead of paying a landlord for the privilege of using their property, you are paying a lender for the privilege of using their money. And that privilege isn't cheap?on most 30 year mortgages, your interest charges over the life of the loan will amount to almost as much (or more) than the total cost of the house! So if you're going to be "renting" money or property either way, how can you tell if it's a good investment to buy a house?
This is where inflation comes into play. Your house may increase in value from $300,000 to $400,000 over the course of a 30-year mortgage, but the value of $400,000 dollars in 2042 might actually be less than the value of $300,000 in 2012. In order to determine the real increase in value, you have to measure the difference after accounting for inflation. None of this is to say that you shouldn't buy a house, of course. It's just important to understand that buying a house is not necessarily a good investment?and may not be any better than renting.
Trial Programs
One of the most common ways people get duped these days is by signing up for "free" trial periods that end up costing a lot of money. A primary example are the credit monitoring services that charge around $15 to $20 per month. Despite the fact that there is a government website, AnnualCreditReport.gov, where you can get your credit report for free once a year and legitimate sites like CreditKarma.com where you can get your credit score for free (with no "trial period"), lots of people still sign up for these credit monitoring services.
To be fair, people often sign up without even realizing it. The sites that offer a "free credit report" or a "free credit score" purposefully obscure the fact that you are automatically being enrolled in the monthly monitoring service. They require you to enter your credit card information and when you do so, they enroll you in a 7-day trial period. If you don't cancel before the 7th day, you'll be charged at least $14.95 (per month). Don't fall in that trap.If you need to check your credit report, use AnnualCreditReport.gov?and if for some reason you must sign up for a not-free trial period, be sure to call up and cancel it immediately.
Minimum Payments
When you first get a credit card, it's easy to think of minimum payments as the amount you should allocate each month in order to pay off your balance. How nice that the credit card company calculated the number for you, right? Of course, it turns out that the minimum payment is actually calculated to keep you in debt. Most of the time, minimum payments are equal to about 2% of your balance, which is barely more than the amount of interest that's accruing on your card.
The reality is that minimum payments are designed to entice you to stay in debt as long as possible, while continuing to pay your lender monthly until you've paid far more than what you originally owed. So instead of blindly paying the amount you're told, be savvy enough to decide on a higher amount (that works with your budget) and pay that each month until you are out of debt. If you want an automatic plan, ReadyForZero can help you get out of debt by visually displaying your balances and telling you exactly which accounts to pay off first.
Monthly Cost vs. Total Cost
Have you noticed how car advertisements always seem to mention the monthly payment and never seem to mention the total cost of the car? That's because they count on people being simple-minded enough to forget about how much the car actually costs and just focus on whether they can afford the monthly payment.
Too often, people do just that. They say, "Oh, I can afford $400 per month" ? and then 5 years later, they've spent $30,000, including $8,000 in interest, for a car that is now worth $12,000. If that's how you want to spend your money, there's nothing wrong with that. But before you do so, you should be very clear about the total you're spending.
And it's not just cars. This applies to everything from TVs to beds to mortgages?any time you're being asked to focus on the monthly payment, there's a reason. And it's not for your own benefit. When buying a car (or any item), you should consider whether its value is worth it compared to the alternative?in this case, a used car. Which brings us to...
Opportunity Cost
This is a basic element of economic theory. Yet, unfortunately, not enough people apply it to their financial lives. It's funny, some people will expend great effort to save $2.00 by clipping coupons or making coffee at home and then they'll freely spend a hundred dollars per month on a gym membership they never use or pay a thousand dollars for a brand new TV they don't need.
Of course, for some people, a brand new TV or a gym membership are exactly the right things to buy, because those things will make them the most happy. That's why opportunity cost is so important to consider. It requires that you identify the best, most efficient use of your money (and your time) to bring you the most happiness. Because each person is unique in what makes them most happy, and no one can figure out your own "happiness metrics" besides you.
If you learn to evaluate which types of spending make you happy in the long run and which ones don't, you'll be able to evaluate your own personal opportunity cost before making financial decisions. And that will improve your quality of life immeasurably.
Benjamin Feldman is a personal finance expert at ReadyForZero who recently used the tips above to pay off his own credit card. You can follow him on Twitter @BWFeldman and read more of his work at the ReadyForZero blog.
Image remixed from Jef Thompson (Shutterstock).
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Source: http://lifehacker.com/5937342/off-to-college-avoid-these-financial-pitfalls
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