By Heather O'Neill
December 15, 2009
I remember the moment my relationship with money changed forever.
I was a college senior walking through the student center when a cute young man with a clipboard waved me over to his booth. "Would you like to sign up for an American Express card today," he asked.
I shook my head. "My father will never let me have a credit card," I said.
"If you are 18 you don't need your father to co-sign the application," he said.
Really? Well, that changes everything, I thought. I was 20 years old and I was off to the races, or in my case, to the mall.
I think I was a pretty classic case: My family was comfortable but I was expected to work during the summers. My parents gave me a modest allowance while at school and I knew that they were serious when they said that the emergency credit card number my father had issued me was not to be used for a "retail emergency". In short, my parents made sure to teach me the value of a dollar. The problem was that they never taught me how to manage the money I did have.
Starting with that first credit card and on into my mid-20s when I was earning a salary and living on my own, I didn't know how to stick to a budget. It wasn't just maxing out my credit cards; I also didn't know the first thing about investing in my retirement or about creating an emergency fund. I had been set loose in a world ruled by money without any real clue of how to manage my own finances. I found out early that you don't need to make a lot, or even spend a lot, to screw up your credit report for years to come. You only have to spend a little bit more than you earn.
I have managed to undo the early damage but my life would have been a lot more simple had someone had sat me down and given me a concrete "how-to" for preparing a budget and sticking to it, and for preparing both my credit history and my finances for the future. I asked three experts their advice on a myriad of financial questions aimed at helping the recent graduate make solid financial decisions. Here are their tips:
Recent graduates may not have landed a plum job yet and instead may be waiting tables or doing odd jobs to makes ends meet. How do you stay out of debt when you aren't making a lot of money?
Kevin O'Reilly, president of Foothills Financial Planning, has one hard and fast rule: "Live below your means. Obviously, that means something different for graduates who start at $30,000 a year than it does for those starting at $60,000 a year, but if they develop this habit early, their financial lives (and likely mental well being) will be that much more stable.
To avoid the trap of living above your means, Cathy Curtis, founder of Curtis Financial Planning, suggests creating a post college, pre-"real job" budget.
"Just remember, it is not about how much you make, it is how much you keep," Curtis insists. "In our consumer society this is a tough lesson to learn, especially when you are young and want to have fun with your friends and be able to buy the things that others are buying. The truth is if you don't learn this lesson, it really doesn't matter how much money you make. There are people who make $250,000 who are deep in debt and people who make $50,000 who save and retire as millionaires."
Curtis suggested that young adults fresh out of college should start with the following budget to keep them debt free while they are building their professional status.
"First start with your income," she said. "Estimate how much you will make over the next year - if you receive gifts of cash for birthdays or Christmas add that to your income as well."Next, she said. itemize your expenses in this order:
- Necessary expenses: rent, utilities, phone, groceries, medical insurance, car insurance.
- Discretionary expenses: clothing, entertainment, dining/drinking out, travel, gifts, etc.
"Finally," Curtis continued, "subtract all of your expenses from your estimated income. If you have a positive number - deposit that money into a Roth IRA and invest it in an S&P 500 index fund. If you have a negative number, review your discretionary category and reduce or cut our expenses until your budget balances. Also, look at your necessary expenses to see if you can negotiate (even temporarily) lower rent, utility or phone bills."
Whatever you do, Curtis warned, do not fund your lifestyle with credit cards.
"This is a trap that is very hard to dig out of," she said. "Debt can accumulate so fast it will surprise you.
What is responsible credit card use for the post grad?
According to Curtis, the same rule applies to recent college graduates as to the rest of the country. "Responsible credit card use for everyone, including post grads is to pay the balance off every month," she said.
Aside from keeping you out of immediate financial danger, Curtis adds, simply paying off your credit cards every month will positively impact the future of your finances.
"This is a great way to build a good credit history early making it easier for you to do everything from securing good rates on insurance and mortgages to giving you a leg up when filling our an apartment rental application. If you don't feel that you can use credit cards responsibly, don't use them. Debt management affects your FICO score which is a very important measure of your creditworthiness. And late payments or defaulting on payments will have an immediate adverse affect on your FICO score."
Kevin O'Reilly agrees, adding that every dollar of credit card debt a person accumulates is potentially two or three dollars they will have to pay out in interest to finance the charges.
"What ends up happening is that over the life of the credit balance they could be paying double or triple the price for everything they purchase. It is very hard to keep your head above water when a significant piece of your incoming cash flow is dedicated to simply paying interest on purchases made long in the past. This is a tough cycle to break, and the easiest way to cope with it is to avoid it altogether."
What are the long-term repercussions of not managing your credit well?
According to Catey Hill, money editor for the New York Daily News online and author of the new book Shoo, Jimmy Choo! The Modern Girl's Guide to Spending Less & Saving More, there are plenty. Hill listed in an email the three major pitfalls she sees:
- You will take a serious hit to your pocketbook as interest costs you big time.
- Your credit score could take a big hit, costing you thousands of dollars over the long term.
- You may have a debt-to-income ratio that is too high
Here's an example of just how much interest will cost you: Let's say you buy a $1,000 television set on your credit card, and never buy another thing with this card. Your card has an 18% interest rate and your monthly minimum payment is 2.5 percent of your balance (so your first month's payment is $25) or $10, whichever is greater. This interest rate and minimum payment are pretty standard for credit cards. You pay the minimum, no more, no less each month. How much will this TV cost you? Drumroll, please... a whopping $2,115.41, more than double the TV sticker price. You'll have paid more in interest than the actual cost of the television! And it will take you more than twelve years to pay it off (and by that time, I'm sure you will have gotten a new one!). All this money you're paying to your credit card company, is money you are NOT saving. You'll have less in your retirement fund, less in your emergency savings fund, and less in your bank account to buy the things you want. In short, you'll have paid the fat cats at MasterCard or Visa rather than paying yourself. And who wants to do that?
If you carry a balance on your credit card and miss payments, you're going to hurt your credit score. While this might not seem like a big deal now, it will hurt you big time in the long run. Here's why: Your credit score tells anyone who wants to lend you money - like your credit card company - or anyone who needs you to pay your bills on time how likely it is that you will pay them on-time. And if you seem risky to them, guess what, you'll have to pay! A lower credit score means you could pay thousands of dollars more in interest on your credit cards and loans that you would have had you had a high credit score. And that's thousands of dollars that you're paying to someone else, not to yourself. I mean, why on earth would you want to do that?
If you have significant credit card debt, you may have a debt-to-income ratio that is unsavory to lenders (meaning you are carrying too much debt relative to how much income you bring in). This can affect your ability to take on more debt, which you will need to do should you want to buy a home, car, etc.
Scared off credit cards yet? Good. Now onto saving. Once you get a good job you'll have more disposable income. You may be tempted to hit a sample sale but the experts recommend hitting the bank.
The experts agree that creating an emergency fund in savings and investing in a retirement fund should happen as soon as possible.
Curtis is a fan of the Roth IRA, calling them "the best saving vehicle offered up by the Federal Government." Here's why:
"Money invested in a Roth IRA grows tax-free forever. There are no mandatory withdrawals in later life like there are with traditional IRAs," she said. "If you need the money for an emergency you can withdraw what you invested -- but not the earnings -- with no taxes or penalties due. When you pass on, you can leave a Roth IRA to your heirs and they can continue to maintain the tax-free status as long as they don't withdraw from it."
O'Reilly and Hill agree that if your employer offers a 401k matching program, that contributing to it should be your first order of business.
"This is free money, and it is significant," O'Reilly said. "I'd love to see new grads factor their 401k contributions into their budgets even before finding a place to live, if it is logistically feasible. If they do not have a Roth 401k at work, I would strongly consider saving enough to capture the employer match, and then putting additional retirement funds into a Roth IRA. They will generally be eligible to make Roth contributions, and doing so will allow their retirement funds to grow tax-free forever."
Hill offers up a simple "schedule" of financial tasks for the new graduate.
"In an ideal world, the recent graduate would save about 13% or more of his/her income," Hill said. "In the real world, I realize this is often tough. So, here's what to do:
- If your employer matches contributions to your 401(k), you MUST participate up to what they match.
- Then, I suggest starting an emergency fund that contains 3 months pay.
- Put this in a relatively safe savings account that allows you easy access to the money (you don't want it tied up when you need it for an emergency) and earns interest. A high-interest savings account or an MMA work well for the emergency fund.
- Once you have built up three months of savings, open a Roth IRA.
- Max it out.
- Finally, once you have done all of the above, max out your 401(k) and build up an emergency savings cushion of 6 months pay."
When you know better, you do better, as they say. Now you have no excuse not to do a better job with your money than I did with mine.