This is a guest post from Terrance Odean the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley.
When I was growing up, there were no personal finance courses. Many people struggled financially. But the financial decisions they faced were simpler than the financial decisions most Americans face today. For example, my parents didn’t have any credit card debt.
Because they didn’t have any credit cards! Nobody did in the 1950s.
When my parents bought a house, they didn’t have to decide whether to get a fixed rate or an adjustable rate mortgage. There were no adjustable rate mortgages in the 50s.
My parents didn’t worry about whether they were saving enough in their 401(k) accounts or buying the right mutual funds. There were no 401(k) plans in the 50s. While less than half of workers had a pension, those who did had traditional defined benefit pensions. And when my parents retired, they didn’t have to figure out how much they could spend without running out of money before they died. Their pension was for life. They simply spent their monthly pension and Social Security checks, or a bit less.
Today people face more complicated decisions, have more responsibility for their own financial security, and confront more ways to make mistakes.
No personal finance course is going to solve the wage stagnation that many Americans—as well as people living in many other countries–have experienced over the last few decades. Nor will a personal finance course reverse rapidly rising college tuitions. However, there are things people can do to gain more control over their personal finances and make better financial decisions.
Develop Good Financial Habits.
One place to start is to develop good personal finance habits and, whenever possible, put those good habits on autopilot. Good habits include regular saving, paying off credit cards every month (or choosing not to use credit cards), never buying things you don’t absolutely need on credit unless you know that you will be able to pay in full when the credit card statement arrives.
Whenever possible, automate your saving. If you have an employer-based pension plan into which you can make contributions, do so. If your employer makes matching contributions, always contribute enough to get the entire match. If you have an Individual Retirement Account (IRA), set up automatic contributions when you get paid. Don’t wait until the end of the month to see if you’ve got any money left over that you could save.
Get Your Credit Report.
Mark your calendar to remind yourself to request a free copy of your credit report at least once a year. (And make sure to read it!)
Simple Products. Low Prices.
Another strategy for both saving money and improving outcomes is to buy simple financial products and shop for low prices. Complexity is the enemy of the consumer. Banks, insurance companies, and investment companies often sell complex products that make it hard for consumers to compare prices. Yet, simpler products often meet your needs while costing much less. Three examples of simple products are term life insurance, index funds, and “no-cost” fixed rate mortgages.
With term life insurance you pay a premium every year; if you don’t die, the insurance company keeps the premium; if you die they pay your beneficiaries. That’s it. You can easily compare prices (i.e. premiums) for policies that cover the same number of years, pay the same benefit, and are from similarly (and highly) rated insurance companies.
Index funds are excellent investments for most people and are easy to compare. Funds that track the same index—such as the S&P 500—are essentially the same product. You pay for your share of the fund (which then invests in stocks or bonds), but you also pay the fund companies a management fee. This fee gets deducted from the return you earn. If two reputable companies are charging significantly different fees for funds that track the same index, go with the low fee.
A mortgage may be the biggest financial product you ever buy. You definitely want to shop! To do so, you need to compare prices, that is, the interest rate you are charged, on identical mortgages. However, mortgages often are saddled with a wide variety of costs and fees. These make it hard to compare one mortgage to another. So get multiple quotes on identical “no cost” mortgages—that is, mortgages for which all costs are incorporated into the interest rate. Research shows that people who shop for “no cost” mortgage pay get better rates.
Some financial products can be inherently complicated. Auto insurance, for example, may provide many types of coverage—liability, collision, comprehensive, uninsured and underinsured motorist, towing, etc.—with different limits and deductibles. First decide the types of coverage, limits, and deductibles that you need and then get quotes for identical policies from different companies. Doing so could save you a bundle.
We will discuss these and other ways to make smart financial decisions in How to Save Money: Making Smart Financial Decisions starting April 15th.