September 2009

What You Need to Know: The Financial Basics

Author: Lew Wessel

The question I’ve been posing to friends all month is what basic financial advice to give to a 22-year-old who is fresh out of college and facing the stark reality of separation from the First Bank of Mom and Dad. Here are their consensus thoughts:

No credit card debt. These four words of advice were offered passionately by every savvy veteran of parenthood with whom I spoke. If my editor would let me get away with it, I’d just repeat it 250 times and satisfy my 1000-word contract. Stay out of credit card debt and you’ll be 90 percent of the way to financial health.

“No credit card debt” means paying off your ENTIRE balance EVERY month. Making just the minimum payment is a losing proposition. A case in point: One of my credit cards (a MasterCard) charges a typical 16.99 percent annual interest or 1.42 percent monthly and yet requires a minimum monthly payment of only 1 percent of the outstanding balance. If I use my credit card to buy the HDTV I just “have to have” and diligently make my minimum monthly payments, then 10 years from now—long after the TV has become junk—I will have paid the credit card company $3,170 and will still owe the original $2,000 plus $1,305 in accumulated interest. How stupid is that?!

Many years ago tobacco company ads were banned from most media, and cigarette packages had to carry health warnings in big bold letters. In my opinion, credit card companies should be similarly banned, and credit cards should be emblazoned with “WARNING: Use of this credit card can severely and permanently damage your financial health.”

Live within your means. Actually this is a simple corollary to the first piece of advice. If you don’t use credit and don’t borrow from your parents, then, by definition, you are “living within your means.” Having trouble paying your full credit card bill is the fiscal equivalent of the canary in the coal mine, but a better strategy is: Make A Budget and Stick To It. Don’t let “budgeting” scare you, and don’t obsess over the details.

A college kid’s budget starts with expenses and then a call to Mom and Dad with a check request. An adult’s budget starts with income—usually your paycheck. Now that you are on your own, your income determines what you can spend. It’s as simple as that. Want to spend more? Make more.

There are plenty of online sites that will give you a feeling for what percentage of your gross pay you can reasonably spend on various items. The largest item, housing, is usually advised to be no more than 25-33 percent of your gross pay, but, be careful when you are doing your housing calculations to include utilities if they are not included in the rent. Similarly, before deciding if you can afford to buy a car, make sure to include insurance, gas and a reasonable repair allowance in your calculations. Since you are just starting out, err on the conservative side; if you are overly conservative the worst that will happen is that you’ll have more savings.

Save automatically. My wise friend, Jeff, advocates strongly for young people to set up a “no-brainer savings program.” Instead of vowing to save what’s left over at the end of each month (just say ZERO), simply deposit your paycheck in the bank and have them immediately and automatically transfer 10 percent of your paycheck into a saving account; you get to spend the rest. Ten percent may sound like a lot, but if you do this from the outset, you will never miss it. In addition, if you are saving 10 percent of your income, you will quickly build up an “emergency fund” to tide you over in the case of a financial crisis such as a gap in employment or a health emergency. Most planners suggest you have three to six months expenses in this fund before you consider long-term investing goals.

One important consideration in your savings plan is to make sure to take full advantage of any 401K matching programs your employer may offer. If, for example, your employer will match all your savings in the company plan up to 4 percent of your pay, then you need to save up to 4 percent in that plan. The next 6 percent of your savings goal can go into your own personal savings account described above.

Just as the power of compound interest will kill you financially when you are in debt, it is your best friend when you’re a net saver. Albert Einstein is actually quoted as saying, “The most powerful force in the universe is compound interest.” Consider: If you stuff your mattress with $250 per month for your entire career (40 years), you’ll save $120,000. Put the same $250 in conservative investments earning an average of 6 percent per year, and you will accumulate a nest egg worth $500,362. It’s a $380,362 miracle!

Buy insurance. “Stuff happens,” and insurance is simply a way to pass off the associated financial risk to an insurance company. As a single 22-year-old, your top priority insurance need is health insurance. Your employer may offer a plan; if not, check the Internet for individual plans. Obviously, if you have a car, you will also need auto insurance. Finally, renter’s insurance covers the contents of your rental apartment in case of fire, theft and other perils. Get it; it’s cheap.

Keep financial records. Get used to saving every bill, paycheck, credit card statement, bank statement, tax return, etc. for at least four years. There are elaborate filing systems available, or you can just keep a shoe box or manila folder for each year’s stuff. Either way, you’ll be happy you have the paper proof if you are ever subject to a tax audit or have to prove you paid for something. To deter identity theft, I advise shredding anything financial that you are not retaining—especially those nasty credit card offers.

Keep track of your credit rating. Your credit rating affects not only your ability to get a loan, but also the loan rate you’ll pay, your job prospects, auto insurance rates, etc. There are lots of games you can play to increase your credit score, but, just pay all your bills on time every month and you’ll be fine. You can obtain a free credit report from the three main credit agencies once per year through www.annualcreditreport.com.

Get financially educated. Most 22-year-olds have been taught almost nothing about the real world of money during 17 years of formal education. Maybe there was a college-level economics class or someone’s parent came into the third grade to do a Junior Achievement thing, but that’s pretty much it. Nothing on budgeting, taxes, balancing a checkbook, negotiating a car purchase, insurance, etc. Today is the time to start getting financially literate. After all, it’s your money now.

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