Published: April 2nd, 2023 by Chris McGrath
Last Updated: March 26th, 2023
Note for non-US readers
This is the start of a series of articles on Personal Finance that uses many US specific vocabulary terms. It may still be worth a read by non-US readers willing to determine if some insights could be applicable to similar scenarios within their own country. As many countries have conceptually similar terms, tax systems, retirement plans, and access to similar investments. Any non-US readers would also need to be willing to determine and ignore non-applicable advice.
Vocabulary and Concepts
A percentage fee given in exchange for borrowing money.
- You Receiving Interest:
Banks tend to offer 1% interest to encourage people to leave money in their savings account. If you leave $1,000 in a savings account for a year. By the end of the year it'll grow to $1,010
(1000 • 1.01)
- You Paying Interest:
If you borrow $1,000 on a line of credit for a year without paying it back, and you're charged 10% interest, by the end of the year $1100 would be required to pay off the loan.
A method of paying for goods and services on credit.
(Credit: An agreement that you'll borrow now and repay later.)
Potential Features of Interest:
- The ability to carry a small balance interest free:
Instead of being charged interest daily, you get charged interest at the end of a monthly billing cycle. This nuance is unique to credit cards and is significant in that it makes it possible to carry a small balance year round without having to pay any interest on it. (Explained on the Financial Tips and Tricks page)
- The ability to avoid overdrafting your checking account:
If you need to make a purchase when your checking account has a $0 balance. Using your credit card instead of your debit card, will allow you to avoid an overdraft fee of $10-35.
- Purchase Protection: (credit cards have it, debit cards don't)
- Example 1:
If your credit card becomes lost or stolen and someone makes a fraudulent purchase. As long as you report it in a timely manner, you can be refunded for the charge and won't have to pay for the fraudulent purchase.
- Example 2:
If you buy from a website that's selling some goods at a price that seems too good to be true. Then a month goes by without receiving your goods, so you google the site and find it's a fraudulent site. You can inform your credit card company and request a chargeback / refund.
- Example 1:
- 1-5% Cashback on purchases:
Credit card companies charge merchants credit card processing fees of 1.5 - 3.5% of the transaction. To encourage consumers to pay with credit card instead of cash/debit card, some credit card companies offer cash back. Example Scenario:
- You buy $100 worth of goods from a merchant on your cash back credit card.
- The credit card company charges the merchant a $2.74 processing fee.
- The merchant gets $97.26
- You get $2.00 cash back
- The Credit card company still makes $0.74 from the processing fee.
Traps to Avoid:
- Cash Advance option: Never do this with a credit card (outrageous fees).
- Carrying a Balance you can't pay off: High Interest Rates (~18-30%)
- 0% Interest for time period: Makes it easy to fall into trap #2
LOC (Line of Credit)
Basically a preapproved loan.
If you have a $5,000 line of credit. You can choose not to use it, not using it means you pay no interest. The advantage of having one is having access to money with 0 lag time. If your car breaks down, and you need it fixed the same day, but the mechanic only accepts cash, it's not a problem, just transfer $500 from the line of credit into your checking account. Then withdrawal the cash.
How it's different from a credit card:
- There's no penalty associated with a cash advance.(reasonable option for short term borrowing of small amounts of cash.)
- You get charged interest daily.
- Tend to have lower interest rates that credit cards (Example: 10% vs 20%)
HELOC (Home Equity Line of Credit)
A line of credit, with a low interest rate
(~4% vs ~10%), because it's secured by the value of your home.
You can usually establish a credit limit of up to 80% your Home's Equity.
(HomeEquity = HomeValue - Mortgage)
Inflation refers to the total amount of money in circulation increasing over time. The increase is the result of the US government printing new money year over year. When more money comes into existence, the relative value of the money goes down. Basically, the purchasing power of money decreases over time. According to worlddata.info the average US inflation rate is 3.8% (1960-2021) .
Example of Inflation:
If this year, a 50 gram bar of chocolate is $1.00.
Then next year, you can expect one of the following outcomes:
Outcome A: The same bar of chocolate to cost $1.04
Outcome B: You still pay $1.00 for a bar of chocolate, but instead of a 50 gram bar, you get a 48 gram bar.
Outcome C: You still pay $1.00 for a 50 gram bar of chocolate, but the factory tweaks the recipe, so the product can be made using cheaper ingredients, so the quality of the product gets worse over time.
Stocks represent fractional ownership of a company.
(Note: shareholder is a synonym for stock owner.)
Two main ways to earn money from stocks
- Buy. Hold until the company grows in value. Then sell at a higher price.
- Some stocks pay dividends to their shareholders.
Taxes Associated with Stock Ownership:
- If your stocks are part of an Investment Account:
- If they offer dividends, then you'll have to pay taxes on the dividends every year.
- If you sell a stock for profit, then you'd pay capital gains taxes.
Note: Since you can choose when and how much of your stock to sell, you can effectively choose when and how much you'll be taxed on the gains.
- If your stocks are part of a Retirement Account:
Then profits will either be tax free or taxed as income, depending on the type of retirement account.
Risks associated with buying individual stocks:
- Unpredictable Volatility: You can't predict an individual company's future stock price. (Both from a short term and long term perspective.)
- You're not guaranteed to make money: A company could experience a permanent decline or stagnation (growth below the rate of inflation).
- It's possible to lose 100% of your initial investment: If the company goes bankrupt, its stocks become worthless.
Capital Gains are profits from the sale of a property or investment.
Capital Gains Taxes Notes
Properties and investments that you sell at a profit are taxed at:
- The short-term capital gains tax rate, which is higher, if you own them for less than a year before selling.
- The long-term capital gains tax rate, which is lower, if you own them for at least a year before selling.
Dividends are company earnings that are shared with stockholders. (These have their own tax rate)
An index fund is an exchange traded diversified bundling of investments. They're Inherently diversified, because they're based on economic indexes, which are statistically significant sample representations of a larger group of funds.
- Vanguard Total Stock Market Index uses a sample size of 4100 stocks, as statistically significant representation of the stock market as a whole. Buying 1 share is equivalent to setting up an investment portfolio diversified between 4100 different stocks.
- The S&P 500 is a collection of ~500 stocks, it's a statistically
significant representation of a subset of the stock market called
large-cap stocks. Buying 1 share is equivalent to setting up an
investment portfolio diversified between 500 different stocks.
Index Funds mitigate the majority of risks associated with stocks:
- Predictable Volatility: While it's still impossible to accurately predict the short term up and downs of the stock market as a whole. You can make accurate long term predictions about the stock market: If you average out the ups and downs over the past 100 years, it works out to at least a 10% annual return. If you average the last 10 years, it works out to at least 12%.
- You're guaranteed to make money in the long term: When a stock market crash occurs, the market tends to recover within 2 years.
- Diversification makes it statistically improbable to lose 100% of your initial investment. If a company listed in the index went bankrupt, it'd be replaced by a new company that better represents the index. Since index funds rebalance themselves over time, they're considered a relatively low risk passive investment.
ETFs (Exchange Traded Funds)
An ETF (Exchange Traded Fund)
is basically a hybrid between a stock and an Index Fund. ETFs and Index Funds
both have low fees.
The following covers how ETFs and Index Funds differ:
- How Index Funds vs ETFs are normally sold:
- Index Fund:
You can usually buy a penny's worth of an index fund at a time. (An exception to this is that Vanguard sometimes has minimum entry requirements for an Index fund. In some cases, they'll require you to save up $3,000 before you can buy the fund, but once you hit that threshold then you could buy a penny's worth at a time as in going from $3,000 to $3,000.01)
An ETF is usually sold like a stock. It has a set price, and you buy it one unit at a time. In other words, you can't normally buy fractional pieces of a unit or a penny's worth of an ETF at a time. So if the ETF is trading for $467.92, you have to save up that much before you can buy one unit of it; Likewise, if you wanted to sell $100 worth of your ETF you can't, you have to sell it as a unit. (An exception to this is that Fidelity offers investors the ability to buy and sell fractional shares of ETFs.)
- Index Fund:
- Diversification of Index Funds vs ETFs:
- Index Funds tend to contain ~100-4100 stocks
- ETFs that mirror Index Funds exist.
- There's also ETFs that can target specific industry niches like GPUs, Artificial Intelligence, and Semiconductors. Since they're more targeted, they can contain ~25-50 stocks. ETFs that are more targeted / have a lower diversification of holdings can potentially have higher ROI and higher risk than Index Funds.
- What high ROI usually means:
The 10-year average ROI for an ETF could be higher than an index fund's 10-year average. (A targeted "hot" sector of the market can beat the market as a whole.)
- Higher risk can mean a few things:
- Risk will be explained in detail on the "Investing vs Gambling" page, but for now here's an introduction to what's meant by higher risk.
- The Highest risk worst case scenario is that you could lose all or part of your original investment after a 10-year investment horizon.
- High Risk can also represent the bad scenario of making less than you could have. After 10-years of investing in a high risk investment, you may end up earning less than if you simply invested in a lower risk surefire bet option, like a US Total Stock Market Index Fund.
- High Risk can also refer to high short term risk, but low long term risk. For example: If you were 100% invested in an index fund, you might see a -20% temporary loss during a bad year. If you were 100% invested in an ETF, you might see a -60% temporary loss during a bad year. If you have the ability to leave your investment untouched during bad years, it can recover risk free (assuming you bought an investment with a high 10-year average ROI). The investment could bounce back to it's pre-crash value within 1-2 years. The risk would mainly apply to the scenario of you being forced to sell the investment during a bad year. (Let's say you started off the year with 100k then after -60% market crash, your 100k worth of ETF was temporarily worth 40k. If you were forced to sell at 40k. That'd be equivalent to losing at least 60k, plus the future accelerated growth that usually happens after a bad year.)
Bonds, CDs, and Laddering
Bonds are loans issued by governments and corporations that pay interest once every 6 months. (Federal government bonds are called Treasury Bonds. State and local government bonds are called Municipal Bonds. Corporations offer Corporate Bonds.)
- It's possible for the entity that issued the bond to default on the loan (fall behind on payments) or even go bankrupt.
- Bonds are categorized according to the issuer's credit worthiness.
- Government bonds have very low risk as they can raise taxes as needed.
- Corporations have credit scores.
- Corporations with good credit are said to offer Investment Grade Bonds.
- Corporations with bad credit are said to offer Junk Bonds, as there's
a risk of bankruptcy.
CDs (Certificate of Deposit):
CDs are offered by financial institutions like banks, credit unions, and brokerage firms.
- They're less risky than bonds because they're insured by the FDIC up to $250,000 per depositor, per insured bank, and for each account ownership category.
- Interest can be paid daily, monthly, quarterly, or yearly depending on
Laddering is where split your purchase of Bonds and CDs into parts, and try to spread the purchase date of those parts over time.
- Many Bonds pay out twice a year. If you buy them all at once, you'd get 2 large payments a year, which can cause cashflow issues.
- Splitting a purchase into multiple purchases has a few important benefits:
- You can spread out the payments to stabilize your cashflow. Rather than
getting 2 lump sums a year. You can get interest paid twice a month or
as often as you like.
- Buying pre-existing Bonds/CDs with different maturity dates, or
- Spreading out new purchases into 12 parts, then buying each 12th on the 1st and 15th of the month for 6 months.
- The interest rates and maturity dates of Bonds and CDs change over time. Buying over time helps smooth out interest rate fluctuations.
- Purchasing over time makes it easier to implement Manual Diversification
of Bonds and CDs.
- You should avoid Bond Index Funds as they're diversified with low ROI bonds that brings the 10-year average ROI below the rate of inflation.
- You're better off cherry-picking Bonds and CDs that offer at least 4% interest to keep up with inflation.
- Brokerage Firms make it easy to cherry-pick good fixed income assets.
- You can spread out the payments to stabilize your cashflow. Rather than getting 2 lump sums a year. You can get interest paid twice a month or as often as you like.
FI (Financial Independence)
Financial Independence is half character traits and half life achievements, it can be described in terms of varying degrees existing on a spectrum. A person at the far right of the spectrum of Financial Independence would be confident that they have enough money management skills, financial knowledge, and wealth to cover their living expenses indefinitely without having to depend on others. They wouldn't need to depend on a job for income. Nor would they need to depend on roommates, family members, their significant other, or any government programs to help them manage their finances, supplement their income, or help lower their expenses.
How does a financially independent person pay for their living expenses?
- They use their financial knowledge to leverage their wealth to generate enough passive income to cover their current living expenses.
- They use their financial knowledge and money management skills to control their expenses to be less than their passive income.
- They aim to maintain a long term surplus of net income
(NetIncome = Income - Expenses). The surplus is used to build wealth and grow their passive income so that they can maintain an indefinite cycle of financial independence regardless of future cost of living increases, small mistakes, and unplanned events.
FF (Financial Freedom)
Financial Freedom also exists on a spectrum:
[Debt --- Debt Free --- Investing --- Financial Independence --- Financial Freedom]
After you've mastered Financial Independence, you start to enter the territory of Financial Freedom. It's basically where you have Financial Independence + an allowance of play money and some degree of freedom to choose where and how you want to live while being able to maintain your Financial Independence. It also means you have the freedom to safely leave relationships with minimal impact on your life. You can choose to continue working for or living with someone because you want to, and not because you feel you have to in order to survive. You'd have the freedom to work for free or work at a job that you enjoy, but that wouldn't normally pay enough to live off of.
Digital currencies secured by cryptography.
Traps to Avoid:
- The United States IRS considers cryptocurrencies to be taxable:
- If you earn crypto through mining or staking it's considered as taxable income.
- If you buy crypto and leave it on an exchange or move it to a private wallet, then you don't need to pay taxes.
- The trap that blindsides crypto noobs is that IRS Notice 2014-21,
says cryptocurrencies are taxed like stocks.
In layman's terms:
- Converting your crypto back to cash is a taxable event.
- Using an exchange to trade / convert from 1 crypto to another is also a taxable event.
- It's gets worse: That "taxable event", is a "capital gains" taxable event. Also, if you haven't owned the crypto for at least a year before selling or exchanging it, then you'll pay the short term capital gains rate, which is higher than the long term capital gains rate.
- You'll also probably need to buy crypto tax preparation software like cointracking.info to generate a crypto tax report that can be fed into your normal tax prep software (Spoiler: They're all hard to use).
- You'll need to start using the more expensive premium version of H&R Block or whatever you use to do your taxes, since capital gains taxes are involved.
- ~99% of Cryptocurrencies and 100% of NFTs are scams. The 1% that aren't are in an overvalued bubble.(This message is brought to you by someone who understands cryptography, owns a small amount of cryptocurrency, and believes that cryptocurrency has intrinsic value and unrealized potential.)
- Why it's worth explicitly calling this out:
- Diversifying stock holdings, is a strategy for mitigating risks associated with investing in stocks.
- It's very easy to mistakenly think of cryptocurrencies like stocks and think that you can apply the concept of diversification to cryptocurrencies to mitigate risk. The thing is, diversification works for stocks, because they're legit. Trying to mitigate risk associated with owning crypto by diversifying your "Crypto Portfolio", isn't very effective, because there's a high risk of diversifying between multiple scam coins.
- Best Case Scenario: After spending 1 week of research per crypto you plan to invest in, you find 3 that look legit and try to diversify between those 3.
- Note: "Crypto Index Funds" tend to be scams as well. It'd be very difficult to find enough legit cryptocurrencies to put together a proper crypto index fund. Whoever sells that will likely do things like hold the "private key" of a cryptocurrency wallet "on your behalf", to simplify things for you. They'll often leave you in the dark about how risky that is, and often have you miss out on forked currencies that are only accessible to private keyholders.
- It's also very common to lose 100% of your cryptocurrencies in scenarios where you don't own the private key to your wallet. The majority of Crypto Exchanges offer the "service" of holding their client's private keys. Yet hundreds of exchanges have closed due to hacks, negligence like storing private keys unencrypted, scams, fraud, and shady practices like gambling with (and subsequently losing) their customer's cryptocurrencies. Even if you use a crypto exchange deemed trustworthy due to regulations and years without issue. There's still the possibility of a government forcing an exchange to freeze or seize your cryptocurrencies. The only way to protect against that is to own your own crypto wallet and manage the private key or secret seed phrase yourself. (A secret seed phrase is basically a long password that can be used to deterministically generate a public private key pair.) The most realistic way to do that in a manageable and maintainable way is to own a few non-diversified cryptocurrencies.
Asset vs Liability
Owning a house isn't always a good thing.
The author of Rich Dad Poor Dad explains why in this video.
To Summarize: "An Asset puts money in your pocket. A liability takes money out of your pocket." (So a house can be an asset or a liability depending on circumstances.)
Note: The definition of asset and liability varies based on context. A financial accountant would define these words differently. The above definitions are intended to be applied to the context of personal finance.