4 Personal Finance Concepts All Students Should Know was originally published on Firsthand.
Given the widespread adoption of Covid vaccinations, college students are increasingly heading back to college campuses and attending classes in person again. Naturally, the desire to overindulge in collegiate events and festivities could lead to splurging beyond your means. So, here are four personal finance concepts to remember as you break out of the monotony of attending classes virtually and embrace the in-real-life, back-to-school lifestyle.
1. Opportunity Cost
Opportunity cost is the cost of alternatives that are forgone when you pursue a certain action. In other words, it’s the cost of what you would’ve done if you didn’t make the choice you did. For example, the opportunity cost of spending $25 during one week on coffee with friends at Starbucks is you’d be unable to afford that new novel by your favorite writer, or two months of your Spotify subscription. And spending $25 for four weeks straight on coffee, totaling $100, could be your monthly cell phone usage expense.
Note that the crux of this economic concept is not that buying coffee at Starbucks is necessarily a financially irresponsible behavior, but that there’s an opportunity cost associated with everyday choices we make in our lives, and we should have the self-awareness to know what that is.
2. Compound Interest
In the words of Einstein, “Compound interest is the eighth wonder of the world; he who understands it, earns it; he who doesn’t, pays it.” Compound interest refers to the idea of getting interest on interest, or, in general terms, a growth multiplier that builds upon the previous growth.
For example, say you have a savings account that offers 10 percent compounded annually deposit and you deposit $2,000 each year from the ages of 19 to 25. If you don’t touch that money until you cash out at the age of 65, how much do you think you would you end up in your account? $50,000, $500,000 or almost $1 million? If you guessed almost $1 million, you’re on your way of appreciating compounding.
So, make a habit of saving a portion of your earnings every month. Those savings may appear meager and not meaningful at the moment, but thanks to compounding, with time, they have the potential to grow significantly.
3. Credit Utilization Rate
Whether you like it or despise it, lenders consider FICO credit score a ubiquitous measure of your financial health. Consequently, whether you go to a car dealership to finance a car purchase or to a bank to get a credit card or mortgage, the probability of your application getting accepted with favorable credit terms highly depends on your credit score. The higher the credit score, the less you pay to borrow, within reason.
While people, in general, know that paying bills on time positively improves the credit score, they don’t know that lower credit utilization rate also improves the credit score. Credit utilization rate is the measure of available credit you have to avail each month. Therefore, someone who consistently utilizes 33 percent of her available credit has a better risk profile and thus higher probability of attaining favorable credit terms than someone who regularly utilizes 90 percent of her available credit—even if she is disciplined about making payments on time.
So, now that you are back on the college campus, don’t splurge so much that you’re maxing out on your credit cards every month, even if you’re paying your credit card bills promptly. It could come back to haunt you later.
4. Good Debt
While “good debt” seems like an oxymoron, it’s a real and better than “bad debt.” Good debt encapsulates the idea of owing money for things that can build wealth and/or increase income over time, such as buying a home using a mortgage or taking on student loan to attain new skills that have the potential to improve your professional marketability over the long term.
However, if the degree program you’re about to embark on requires you to borrow a significant sum of money without the prospect of a higher paying job or higher professional marketability, student loans can be considered a bad debt. Other examples of bad debt include taking on an expensive loan to buy a new car, which would depreciate precipitously during the early years of ownership.
A Final Note
According to Chinese philosopher and Tao-Te-Ching author Lao-Tzu, “A journey of a thousand miles begins with a single step.” And so, just like every college course you complete brings you one step closer to graduation and thus a professionally-enriching life, embracing each of the above personal finance concepts will bring you one step closer to financial independence and an economically-enriching life.
Recipient of the Presidential Award from The White House, Vibhu Sinha is an intrapreneurial and bottom-line driven senior management professional with experience in leadership roles across banking and capital markets, advising institutional clients on corporate strategy, idea generation and pitching, financial planning and analysis, M&A, investor relations, and ESG. Vibhu developed his acumen in Behavioral Psychology at Harvard University as part of a master's degree program, and also earned an M.B.A. from UCLA Anderson.