Monday, April 25, 2011

Five Things Every Musician Should Know About Personal Finance

Dealing with one’s finances can be a daunting task. However, learning the basics and using a consistent approach to managing your personal finances, the task is not all that difficult after all. Below are the five most important finance concepts every musician should know.

1. The Time Value of Money 

Despite recessions, deflation threats and falling house prices, a dollar today is worth more than a dollar tomorrow.  This is really one of those big dilemmas in the world of finance because you have to make a choice between something of value (your cash) for another thing called time.  You can’t have both at once. You either spend your money now or you save your money and spend it later. If you wait and spend it later you want your money to grow over time and be rewarded for not spending it right now. Otherwise, why bother waiting knowing that your dollars will buy you less over time. Can you see that time has value?  How much value is better understood once you appreciate the power of exponential growth and how it applies to interest.

2. Compound Interest

Albert Einstein once said: "Compound interest is the greatest mathematical discovery of all time." Yet, everyone seems to memorize his famous E=mc2 in favor of the good old compound interest formula. What was that formula again?  Here it is:  Pn = P0 (1+r)n

Where, Pn = Future Value, P0 = Present Value or Principal, r = interest rate (per year), n = time (in years) a.k.a. compounding periods

To really appreciate the power of compound interest let’s call it by its real name: Exponential interest.  Exponential interest is based on an exponential function with the value for time being the exponent. For longer periods of time, the exponential increase of the interest amount becomes all the more clear when comparing it to a linear growth rate, the much more intuitive way of looking at increases over time. 

This can have particularly devastating effects when underestimating the power of exponential interest for credit card and other debt.  Understand the exponential function to get a sense of how the power of compound interest can make or break you.

3. The Rule of 72 

The Rule of 72 is a simplified way to estimate how long an investment will take to double, given a fixed compound interest rate. Here’s how it works: 
72 ÷ interest rate =  # of years it takes to double your money
For instance, if you could earn 6% return on an investment each year, it would take approximately 12 years  (72 ÷ 6 = 12) to double your money.  If you are a guitar player, the number 72 should ring a bell.  In case it doesn’t, please consider the Guitar Player’s Rule of 72.

4. Understand Credit, Debt and Leverage 

Consumer credit, credit cards and various ways of financing have become an essential part of today’s economy. No industry has been untouched by the pervasive use of credit and the global economy would come to a standstill if credit were to dry up completely. During the financial crisis of 2008/2009 we saw a glimpse of what could happen when the well of instant credit dries up.

It is essential to understanding how interest and financing charges on your credit cards and loans work. But it is equally important to limit the amount of overall debt.  Credit can be a tool just like a lever; it can multiply your purchasing power.  The downside however, is also clear.  If you use leverage to purchase depreciating assets like consumer goods and electronics, you may find that the amount of debt you took on can be overwhelming.

I use credit cards for their convenience and for some of the benefits they provide.  In essence, credit cards give you about 20 days to use their money without any interest charges.  The tricky part though, you should be prepared to pay back any outstanding balance in full when it’s due.  That takes a lot of discipline.  More often than not, you may only have a partial amount of the payment available and try to catch up making installments as you go.  Credit card companies are banking on your inability to pay back the money they lend you.  Be very careful when you purchase goods with a credit card.  Only ever charge something to the card when you know that you can pay it back in full at the end of the month.

5. Plan Ahead, Budget and Live Within Your Means 

Planning and budgeting are essential concepts when it comes to managing your personal finances.  It’s all based on the notion of living within your means.  As they say:
It’s Not What You Make, It’s What You Keep!
Making a ton of money does not mean that will remain financially successful. Just do a Google search for famous bankruptcies or bankrupt musicians. You will get a list of names that rivals any guest list at a red carpet Hollywood event. Their money problems were not primarily caused by an inability to make money. These artists all made plenty of it, often tens of millions each year. Yet, they spent more than they earned and therefore ended up in bankruptcy court.

Learning how to establish and keep reasonable budgets is the key to living within your means and to get financially ahead.  Musicians and independent artists often have highly fluctuating incomes.  They can make a ton of money for a few months only to experience a dry spell and earn substantially less during the following months.  For instance, a musician may go on tour and earn quite well.  When the tour ends, the regular payments end as well.

Who knows, that one project that wasn’t going to pay you until completion 4 months down the road could be the most important musical project of your career.  But without having enough of a financial cushion, you will simply not be able to afford the project that might make you as an artist.

Taking care of your personal finances is not rocket science but it does require some work, lots of discipline and a healthy dose of common sense.  Musicians know all about discipline and hard work.  Nobody wakes up one day to become a great violin player or pianist.  It takes years of practice.  Similarly, it takes some practice and some time to learn how to manage your finances.  Start saving early, spend wisely and always live within your means.  Your financial success depends on it!