First Financial Steps for Young Adults

Most young people enter the work force with quite a bit of debt. Even those without debt have ambitions for cars, homes, clothes, and other things. The issue for most young adults is how to sort out their spending and saving goals. Should they pay debt first? Save for the down payment on a home? Begin retirement savings? How can these conflicting goals be reconciled?

Young people need to remember that the most important asset they have is time. The more money they save and invest when they are young, the more investment income and gains will compound over their lives.

In addition, interest rates on at least some student loans are below market rates and less than the returns that can be expected over time from growth investments. Investments in 401(k)s and IRAs are tax deferred, while interest paid on student loans often is not deductible.

Here are some guidelines young adults should consider when setting their early priorities and goals.

• Begin making contributions to a 401(k) account and investing it primarily for long-term growth in U.S. and international stocks. This is especially important if the employer makes a matching contribution for the employee’s 401(k) deferrals. The matching contribution is free money. When the employee fails to defer enough salary to capture the match, he or she is giving away not only the matching contribution but all the investment earnings on that contribution for the rest of the employee’s lifetime.For advice beyond the match, review “The 80%/2% Solution” in the August issue. This article points out that when a person starts investing and saving early in life, the compounded investment returns provide 70% or more of the person’s retirement portfolio. If a person begins saving a small percentage of income at an early age and continues that, he or she might never need to save a large percentage of salary for retirement. But a person who delays saving and investing eventually will have to save much more than 10% of salary in order to have enough for retirement.

• Don’t buy expensive, depreciating consumer goods. One of the strongest urges of a young adult is to buy a new car. It loses thousands of dollars of its value as it is driven off the dealer’s lot. The smarter move is to buy a late model used car. That leaves more money to either pay debt or increase savings and investment. Buy expensive toys only after setting aside savings.

• Don’t view a home as an investment. Many young people strive for homes they can barely afford because they are told that a home is an investment and a tax shelter.Home prices on average increase the same amount as the economy over the long term. In some areas growth is higher; in others it is lower. Before considering a home an investment, consider the costs of owning a home. In addition to interest on the mortgage, there are the repairs and maintenance. There also will be long periods when the home declines in value or does not appreciate.The tax shelter benefits are not very significant. At today’s tax rates for a young person, the home owner bears two thirds or more of the cost of the deductible interest and property taxes. The notion that a home is a tax shelter began at a time when individual tax rates were 50% and higher.

  A home should be considered a consumer good by a young adult, not an investment or tax shelter. Save money for a down payment and plan to buy a home. But do not sacrifice 401(k) deferrals to afford a home or buy a more expensive home.

• Consider likely future obligations. A young adult might not be married or close to it. But most plan to marry and have kids not too far in the future. Taking on large car and mortgage payments soon after school could make it financially more difficult to begin saving for education and other future family expenses.

• Carefully consider debt management. Consult with a financial adviser if help is needed to sort out the options. If an education loan has a relatively low interest rate, don’t rush to pay it off with money that could be invested for growth. This is especially true if the money could be invested in a tax-advantaged account, such as 401(k).Education loans can be consolidated and stretched. Young adults should be careful about stretching debt to the maximum allowable term. That increases the amount of interest paid over the life of the loan. It is better to set a schedule that allows full payment while allowing basic saving.

• Control spending first. Financial advisers generally agree that most financial problems are caused by excess spending, often on relatively small matters. People run up large credit card debt or spend money intended for saving and investing. Electronic goods, expensive clothes, and a high level of entertainment and dining out put most younger people in difficult financial positions. Curb these spending urges during the early years in the work place, and the person’s financial picture will be much brighter a few years down the road.

Most young people leave school with little instruction on the basics of saving, investing, spending, and debt management. These simple guidelines will set them on the path to achieve financial security before their peers.