If you’ve graduated and are looking for your first “real” job, or you are still in the first couple of years of your chosen career, this is the time to develop healthy spending, saving, and allocating habits.
Following these five essential financial practices will ensure that you are living well now, providing for yourself in retirement, and well-prepared if you suffer a financial emergency between now and then.
Practice #1: Invest in Your Employer’s Retirement Plan
If your employer offers a retirement plan, enroll in it as soon as you can. Many employers require that employees have worked a minimum amount of time prior to enrolling, such as six months or a year, so you may have to wait a bit if you are new to your job.
Once you are eligible to enroll in your employer’s retirement plan, you have to figure out how much to contribute. If your employer offers to match your contribution, then you should contribute at least in the amount of your employer’s maximum matching contribution. If you don’t, you are leaving free money on the table! Divide the matching contribution by the number of pay periods in a year, and plan to contribute at least that much.
Of course you can contribute more than your employer’s matching contribution – that is up to you. The benefit to this type of account is that you are contributing with pre-tax dollars, so not only are you saving for retirement in the future, you are in a lower tax bracket and paying less income tax right now.
Consider Opening a Roth IRA
Many people in your position choose to open their own retirement account, such as a Roth IRA, rather than contribute over the matching amount to their employer’s plan. Why? Because a conventional 401(k) and a Roth IRA have different rules governing withdrawals, and because you are in control, to an extent, of your investment in your Roth account. Having two accounts diversifies your investments both in what you can do with those funds, and what those funds are invested in.
When you create your Roth account, which can be done in most banking institutions, you will be given the choice of several different tiers of risk tolerance in which to invest. The least risky tier will also yield the smallest gains over time. The most risky tier may have much greater gains, but also the potential for big losses depending upon market conditions.
Conventional wisdom suggests that younger professionals should invest subject to greater risk, because it will be many years before they retire and need that money so there is plenty of time for the market to recover should their investments suffer a loss. Professionals nearing retirement should shift their investments into a less-risky tier so that the money they expect to be there when they retire IS there.
Practice #2: Save 10% of Your Earnings in an Emergency Fund
After you deduct your retirement account contributions, calculate what is 10% of your take-home pay. Put this amount into a savings account every pay period until you have saved up 6-8 months’ worth of expenses. This is your emergency fund, to dip into should an unexpected expense arise, such as a car or home repair, uninsured medical expenses, or sudden job loss or reduction in employment.
You might be asking yourself, what do I need an emergency fund for? I’ve got credit cards if I need something I don’t have the cash for.
This is the wrong way to look at spending, much less emergency spending. Ideally, emergencies can be paid for with money you have, rather than money you have to borrow at exorbitant interest rates. See Practice #3 to learn the reasons why.
Yes, it will take time – perhaps years! – to save 6-8 months’ worth of expenses, but your patience and perseverance will pay off.
Practice #3: Avoid Credit Card Debt
There are two important reasons to avoid credit card debt. First, is the interest you will be charged. Second, is the negative effect credit card debt has on your credit score, also known as a FICO score.
How Credit Card Interest Works
Let’s say your car engine seized because a hose blew, and now you have to get another engine installed, or, buy a new car. You’ve weighed your options and decided to replace the engine, at a cost of $7,200 with labor.
You don’t have $7,200 ready cash and you need your car right away, so you put that $7,200 on your credit card. That charge is subject to an interest rate of 18%, which you think is pretty low – and it is, for a credit card. Credit card interest rates can go up to 29% and beyond!
You tell yourself it won’t be that bad, and vow to pay double the minimum payment each month until that $7,200 is paid off. Your credit card statement says $230 is the minimum, so you pay $460 each month, which you grumble about because you could be paying a new car payment with that kind of money.
Paying $460 every month, you will pay off this $7,200 debt in 18 months – but you will have paid $1,067 in interest. If that doesn’t make you feel a little ill, it should. $1,067 is too much money to spend to use someone else’s money for a year and a half.
In contrast, if you had emergency savings available to pay for this car repair in whole or in part, you can avoid paying that much in interest. And while your emergency savings was waiting for you to need to spend it, it was accruing interest (albeit a modest amount) in your savings account. Wouldn’t you rather pay yourself a small amount of interest by saving, rather than paying $1,067 to your credit card company to use their money?
Here’s another take on this $7,200 credit card balance. Let’s say you can’t afford to pay $460 a month toward it, but can only afford to pay the minimum of $230. Paying $230 a month, it will take you 43 months to pay it off, and you will have paid $2,595 in interest.
$2,595 in interest on a $7,200 debt – you will have paid $9,795 for that car repair. You probably won’t even have that car any longer by the time you pay that debt off.
If this example does not inspire you to save for your own emergencies rather than relying on your credit card, nothing will – excerpt perhaps what comes next.
How Your Credit Card Balance Affects Your Credit Score
The credit bureaus weigh many factors about your financial behavior to determine your credit score. One factor is your debt-to-income ratio, which is the amount of all of the debt you carry divided by your monthly income. All of your debt will include mortgage or rent, car payment, and credit card balances, among other things.
The higher your debt-to-income ratio is, the lower your credit score will be. The lower your credit score is, the more a creditor will see you as a risk to lend to. You’ll be able to borrow money, such as getting a mortgage or an auto loan, but you won’t be offered the most favorable interest rate available.
For example, let’s say when that car engine seized you decided to buy a new car rather than dropping a new engine in the old one. You have an eye on a car that is selling for $20,000, and you’ve applied for dealer financing. You have rent, student loans, and some credit card balances, and your credit score is 630, which is considered non-prime – not terrible, but certainly not the best. You are offered a 60-month loan at 7.55%.
Your friend is also buying a new car costing $20,000. She has a credit score of 670, only forty points higher than your score, but she is considered a prime borrower and is offered a 60-month loan at 4.75%.
You might think that’s not much of a difference, but at the end of the 60 months your friend will have paid $375 a month for a total of $22,508, while you would have paid $401 each month for a total of $24,074.
That’s right – because her credit score was forty points higher than yours, she paid $1566 less than you for a car sold at the same price as yours.
Improve your debt-to-income ratio by paying off your credit card balances, then use your credit card for things like gas, groceries, and the like, and pay it off each month. This sort of responsible credit card use also helps improve your credit score.
Practice #4: Pay all Recurring Bills In Full and On Time
This is next because it also has an impact on your credit score. If you are late paying monthly bills, your creditors will report that to the credit bureaus and it will negatively impact your credit score. As you already know, those with a higher credit score can borrow money when necessary at a lower interest rate than those who have higher credit scores.
The simplest thing anyone can do to preserve and improve their credit score is to just pay all bills in full and on time. If you are having trouble paying a particular bill, contact that creditor, as there may be a way to make the payment more affordable.
For example, if your monthly mortgage payment is too high, you can ask the mortgage lender or servicer if you are eligible for a loan modification to lower the payment.
If your electric bill is too high in the summer, call the electric company and get on a monthly plan whereby you pay the same amount every month. This is much easier to budget for.
If your student loan payment is unaffordable, look into loan consolidation or into an Income-Based Repayment (IBR) plan to lower that payment.
Practice #5: Craft a Budget and Stick to It!
Between retirement savings and your emergency fund, you probably have 80% of take home pay left to live on. Resolve to live on it, and live well.
First, write down the nature and the amount of all of your current monthly expenses, things like:
- Rent or mortgage
- Renters or homeowner’s insurance
- Car payment
- Car fuel, maintenance, insurance, and registration
- Health insurance
- Student loan (or contributions to your children’s 529 plans)
- Utilities like heat, AC, water/sewer, electricity
- WiFi and Cable
- Cell phone plan
- Personal care like haircuts, manicures, etc
- Gifts on holidays
And anything else you regularly spend money on, like tithing to your church or giving to charity.
Next, add it all up. If 80% of take-home pay does not cover these expenses, you need to cut back somewhere, because the temptation will be there to incur credit card debt to meet those expenses and we know where that gets us.
Where can you save? Can you turn the heat down and put a sweater on? Can you go out to eat three times rather than four times a week? Can a less expensive cell phone or cable plan still meet your needs?
Where there is a will, there is a way. Hopefully, as you grow into your career, you will be receiving raises in salary or rate of pay. When this happens you can make different choices, but for now, you must live on what income you have.
Having the discipline to employ these five financial practices will literally pay off in time. You will enjoy knowing that you have enough money to pay your expenses, you have an emergency fund to fall back on, you are saving for retirement, and if you need to borrow money your credit score will help you get the most favorable terms. Good luck!
About the Author
Veronica Baxter is a legal assistant and blogger living and working in the great city of Philadelphia. She frequently works with David Offen, Esq., a busy Philadelphia bankruptcy lawyer.