There are thousands of Americans graduating from college today. As people come out of undergraduate or graduate programs, they are eager to get into their careers, attain a comfortable and enjoyable lifestyle, establish their full independence and ultimately build wealth so they can live the life of their dreams. However, today’s college graduates face a lot of challenges that can make it very difficult to strike the right balance between living for now and living for the future.
Over the last few years, I’ve been advising young professionals who are on the rise in their careers. I’ve watched them struggle to balance competing demands on their limited financial resources. Many of these people feel as if there is not enough money to do everything they want to do. So they have to make tough choices.
There seems to be a lot of advice and conflicting opinions on how to attain a comfortable lifestyle, financial independence and long-term wealth. After counseling people who face these choices, and after reflecting on my own choices, I’d like to share with you the lessons I’ve learned. If you want to realize comforts for today and peace of mind for tomorrow, I believe these lessons will really help you.
Beware Of Where You Get Your Advice
I think it’s important to take a long-term view of things. I was reminded of this importance recently when consulting with a couple who was getting what I would characterize as bad advice.
The wife had recently completed medical school and residency and was now in a good position to earn a high income, likely several hundred thousand dollars a year. However, she also had six-figure student loans to pay off. Most of these loans were at a high interest rate relative to the ten-year treasury rate. This couple was trying to figure out what to do to with their money.
There were all sorts of voices around them giving them advice. Friends and colleagues at work told them that they had earned the right to live a high-end lifestyle, with a big home, expensive cars and all the toys. Go ahead and buy that one million dollar home, they said.
A financial advisor put them into high-commission investments that had a very large front-end sales commission. Insurance agents were advising them to buy expensive (high commission) life insurance, even though they had no children. Everyone seemed to be saying – live for now, spend, spend, spend and worry about those student loans later.
This couple was uncomfortable with this and wanted an alternative perspective. After we spent some time together and I came to understand what they were looking to accomplish, I recommended a different direction. I advised them to live beneath their means, pay off debt first, invest according to their risk tolerances and maximize their after-tax dollars. I seemed to be the only one giving them this type of advice. They loved the ideas and felt that this approach was much more in keeping with their values and goals. My advice helped them feel confident about the future.
My advice to them was based on my own experiences as a young person coming out of college and on the experiences of others who faced similar challenges. If you or someone you care about is in a similar situation, here are 5 strategies I recommend:
- Make smart choices with the four major lifestyle factors you control.
- Create an emergency fund.
- Build your credit standing.
- Be careful with debt.
- Maximize your pre-tax dollars through investment vehicles.
Make Smart Choices With The Four Major Lifestyle Factors You Control
Let’s be clear about something. There are many things you cannot control that impact your financial life. For instance, you could be injured and can’t work or your job might be eliminated. This is one reason you need to create an emergency fund, which I describe below.
However, there are many things you do control that might have an even greater impact on your financial life. I call these the big four and they include housing, transportation, food and fun. These four have a big impact on the fifth key element that leads to long-term financial success: eliminating debt while saving and investing.
Here are my recommended guidelines for budgeting your income:
- Housing – no more than 35%
- Transportation – 15%
- Food – 15%
- Fun – 10%
- Savings and debt elimination – 25%
I used this formula as a young professional, coming right out of college, and I don’t regret it. My starting salary in 2003 was $55,000 per year. I found an apartment to share with a roommate for $300 per month. I could have afforded much more, but I chose not to.
My housing costs were less than 7% of my income because I had two goals. First and foremost, I wanted to have a Nissan Maxima, 255hp, 6 speed manual transmission, with heated seats and heated steering wheel. I loved that car.
Second, I wanted to make sure I could contribute the maximum to my retirement plans. My employer at the time allowed me to put in 20% on my own and they matched 6%, for a total of 26% of my pay going into the retirement plan. I also made a $3,000 contribution to my Roth IRA back in 2003, which meant my total retirement savings was 31.45% of my gross income, starting from the first day I had a career.
In essence, I continued to live like a cheap college student in order to pay off my car loan as quickly as I could, while getting a head-start on retirement savings. Depending on the debt service required for student loans, you might need to adjust this formula. But it definitely works.
Let me address another topic that many young people are grappling with these days: moving back in with mom and dad after college. If this is handled the right way, it can definitely help you get a good financial head start. But there are some pitfalls.
I believe you should pay rent to your parents to establish financial discipline. The rental fee should be in line with what you’d pay in the market where you live. You don’t want the shock to your financial system of having to contribute up to 35% of your income to housing if you’ve been paying zero. That’s a tough transition.
Some parents may not want to charge their adult children rent. But there is a strategy here that can help their children. The parents can collect rent and hold it in an account for their children. Once the child moves out, they can give them the money to:
- Furnish their new apartment
- Pay for a security deposit
- Make a down payment on a home
- Send the money to their student loans
- Invest it in a retirement account
Alternatively, for those with lots of debt I’ve seen the parents and new graduate agree to send their rent money as additional payments on their student loans. This strategy works very well to help young people achieve true financial independence.
Create An Emergency Fund
An emergency fund is a crucial step towards complete financial independence. I believe you need a rainy-day account that is equal to at least 3 to 6 months’ worth of living expenses. This gives you the peace of mind to know that you have the means to withstand the storms that life can throw at you.
I believe this fund should be cash or a cash-equivalent account such as checking, savings or money market accounts that are FDIC protected. The idea is that this is your piggy bank that you’ll only break open if you need to. An emergency fund should not be credit cards.
Build Your Credit Standing
Credit is crucial to getting the best interest rates possible on loans. Interest can either work for you or against you. This has a huge impact on your ability to build wealth long-term. When the time comes to buy a house or a car or something else that you intend to finance, you want to get the lowest interest rate possible. A good credit score pays dividends in all sorts of ways. A weak credit score reduces your options and resources available for other goals due to the higher interest paid on the debt load.
One simple way to build your credit is to get a credit card and then automate monthly payments against low-cost items like a gym membership. Credit agencies look for consistency in making payments on time and keeping your balances low. They also look to the length of your credit report, so consider starting this early in your college career.
If you struggle to get a credit card because you have no history, you can consider getting a secured card where you deposit an amount, say $500, with a bank who holds it as collateral for a credit card. Usually the limit on the card will be equal to your deposit amount. These simple strategies can help build a good credit standing for you.
Be Careful With Debt
Here is my position on debt. I don’t like to borrow money for things that go down in value. For example, cars, boats and planes will almost certainly lose value over time. My recommendation is that you try to pay for these outright if possible or get low-interest loans and pay them off quickly.
However, I do believe that borrowing money for things that go up in value can be a smart move. Here are some examples:
- A college education might buy you a higher future income.
- A house usually appreciates in value.
- An investment in a business you want to start can produce a positive income in the future.
Student loan debt can be a slippery slope. You want to borrow at reasonable levels where you know you can service the future debt. If you end up with $200,000 in student loans and your income potential is only $40,000 a year, it will be tough to eliminate this debt.
Avoid credit card debt. Credit Card interest is very hazardous to financial health.
Maximize Your Pre-Tax Dollars
To really build wealth for the long-term, you need to maximize your pre-tax dollars by investing in retirement vehicles available to you. Above I noted that you most likely build wealth when you allocate 25% of your annual income toward savings and investment. Here are some strategies for doing so.
Make your long-term investment plan a discipline and lifestyle that runs on auto-pilot. Some people make the mistake of promising themselves to invest a big chunk at the end of the year. While this may work for some people, it doesn’t work for most. Saving for the future is best thought of as a monthly discipline, or quarterly at most.
The two primary pre-tax investment options are usually a 401(k) or equivalent and an IRA. I recommend that you max out your 401(k). For example, let’s say your company has a matching program for every dollar you put in. Let’s assume you put in $1,000 and your employer puts in $1,000 which gives you a total of $2,000. If your tax rate is 30%, it only cost you $700 out-of-pocket to build a $2,000 investment. That’s a great rate of return from day 1 that will likely grow over time. See my other article about the impact of compounding interest.
If you max out your 401(k) and still have discretionary income left over, consider setting up an IRA or Roth IRA. These are simple and easy to establish. But make sure you contribute monthly. Put in a fixed amount every month, say $200 or whatever you can afford. This works so much better than trying to put in a lump sum every year. Also, if you are a high earner, be sure to verify you are under the IRS limit to be eligible to contribute to an IRA. If you happen to have this high-end problem, then you can consider buying low cost, tax efficient investments in a taxable investment account.
It is definitely possible to achieve complete financial independence, a comfortable lifestyle and savings for the future after graduating from college. It does require focus, discipline and a good strategy. If you take the steps I’ve outlined here, you greatly increase the odds of success. If you’d like to discuss your situation, let’s have a conversation.
The information contained in this article is provided for informational purposes only. No illustration or content in it should be construed as a substitute for informed professional tax, legal, and or/financial advice.