Let’s face it: Starting out on your own after escaping the cloisters of your parents’ home or college is pretty great. You can now call all the shots. This new independence is exciting, and there is fun to be had. And with all this newfound freedom also come the first steps to grapple with grownup concerns, which aren’t always fun. They come with anxiety, insecurity, and apprehension.
What I hope to convey with this article is a basic but sturdy approach to help young people get started on the right path financially. It can also be applied to anyone, regardless of age, who finds him- or herself at the beginning of a new life chapter with little or no financial assets.
For younger people, the challenge starts with just making enough money to cover their everyday living expenses. Once there is some momentum in earnings, there needs to be an emergency fund. Most young adults struggle to set money aside for their long-term goals at this stage, but can, through thrift and wise spending, squirrel away money for an emergency fund.
These young adults may want to consider using a Roth IRA for this purpose. If you fund a Roth, it can always be tapped in an emergency. IRS rules allow the contributions to come out first, and they are tax-free when you withdraw them. So if you don’t have that emergency, you have started a small but important effort to save for your retirement. Once they have an ample emergency fund built in the Roth, they can now focus on saving for a real emergency fund.
If the Roth/other savings approach can be achieved, then those savings will now be available to address bigger goals, such as a home purchase down the road.
Live below your means
How people choose their housing arrangements can also have an outsize benefit. If a young person chooses to live near where they grew up, they may elect to spend a year or two actually living with their parents. Yes, I know, living with your parents or relatives isn’t exactly glamorous, but it is smart and can pay off financially. Building up basic savings and emergency funds becomes a lot easier.
If an apartment away from your parents is the way you are headed, then consider getting whatever is cheapest. It may not be cool or impressive to your friends, but it will aid in saving more money.
And as part of that thrift, try to live below your means whatever your income is. There is a certain pride in living this way, and it will serve people well in developing their expectations about what they truly need and want. If that habit is embraced, it will serve people well throughout their lives.
Oh, did I mention retirement savings? I know, I know, that’s 40-plus years away for many young people, and it’s tempting to enjoy more of your hard-earned income right now, but make a commitment to start.
If someone has access to an employer retirement plan, start saving right away. Most plans have an employer match of 3 percent or more. Even if money is tight, find a way to contribute up to your employer’s match. You are literally getting a guaranteed 100 percent return on this money. And you might be surprised at how invisible this minor drop in your take-home pay will be — and it is tax-deductible. You will be amazed at how these small contributions will grow over a 40-year time horizon.
When choosing the investments in your plan, focus on simplicity and low expenses on the funds you choose. Lower costs are the easiest way to assure you that your returns will be better than more expensive options. You can choose from many different index funds to build a diversified portfolio, or use a preset strategy such as a target-date fund or an asset allocation fund. (These are premade mixes of stocks and bonds based on when you want to retire; the mix gets more conservative as you age and approach your retirement date, with less money being allocated to the higher-risk stocks, and more to the lower-risk bonds.) This kind of simplicity will help you stick with your investments, by avoiding confusion and increasing clarity.
And if you never needed to spend that Roth IRA money for an emergency, you have that too.
Life moves on for everyone, and people start settling down a bit for the first time. They find spouses or partners as they move along their path. And with it comes some financial relief but also more challenges. This is when people start thinking about homes and possibly families.
I would offer the following thoughts for when people are in a position to buy their first home.
- Put down the full 20 percent for a down payment. This will mean saving for longer, or possibly asking for some family help. But you will be borrowing less, making your payment more affordable.
- Don’t buy the starter house if you are married or will be, and kids are in the discussion. If you outgrow the starter house, you will need to buy again, and get a new mortgage. That means you were paying mostly interest for those years in the starter house, and built very little equity.
- When buying the house with a family in mind, as described above, go for the house you hope to be in for the next 20 years. Give yourself room to expand. And look for something that is more of a fixer-upper. You can chip away at the improvements while working on your other goals. And when kids do arrive? You’re not going to have the time or inclination to worry about those dated lighting fixtures or funky shower.
For many younger people, debt management is a primary concern. As we can see, there are quite a few things younger people will need to deal with, and student and other debt competes for their money. These student loans can carry interest rates between 4.5 percent for federal loans and as high as 8 percent for private loans. So how should someone prioritize between paying down debt and other savings? Like most other debt, the higher the interest rate, the faster you want to pay that down. Whether federal loan or private, you will realize a return equal to the interest rate when you pay extra toward principal each month. Realizing a return between 4.5 and 8 percent is pretty good for a no-risk proposition. This is especially true currently, as returns from stocks and bonds will probably be underwhelming over the next 10 to 15 years. This is due to higher valuations — stocks and bonds are currently expensive, so may yield lower-than-normal returns going forward — and a 5 to 6 percent return with no risk looks appealing.
And with that thought in mind, how should you prioritize between paying debt and saving for retirement? Pay the majority of your savings toward higher-interest debt, and gain that guaranteed return. If you are able to put money into a retirement account while paying down debt, consider using most or all of that retirement money for buying stocks. The gains you get on paying down debt will act as the guaranteed “bond” part of your investment mix, allowing you to be more aggressive with your retirement savings.
Have a financial plan
One thing that will be critical to your chances of success at this stage is having an actual financial plan. This will help you understand how much you should be saving, where the money should go, and when you can expect to reach some of the shorter-term goals, like a house. What a financial plan does is act like a map to where you want to go. Starting a long trip without a map, to a place you have never been, increases the odds that you end up off-track and lost. The earlier you start a plan, the better you can see results, and avoid getting off-track.
A little bit of money spent working with a planner will pay for itself many times over. It’s a good investment.