There’s only one real requirement when working out a financial plan. You have to live on less than you earn. If you don’t, it’s useless to talk about saving and investing because you don’t have the bucks–or the will–to do it.
The first thing people wonder is where to start. Pay off student debt? Open a college fund for a toddler? Buy a house? Invest for retirement? There are so many daily needs (such as food, cell phones and four pairs of spring shoes, in yellow and pink) that major goals sound out of reach. But look at it this way: everyone before you has figured it out, and you’re smarter than they were.
You have to set priorities. Some of them will overlap, but think of that as financial multi-tasking. Here’s a road map to get you going:
First, make a budget. How much money is coming in, how much going out and for what? You have to capture extra cash before you can even pretend to have a plan (OK, only two pairs of shoes this spring).
Put a line in your budget that will eventually build a cash cushion worth $5,000 or more. On your priorities list, this comes even before debt reduction, because cash on hand can save you from piling on even more debt in an emergency. I don’t care that banks are paying only 2 percent. This isn’t your investment fund, it’s part of your safety net. Use your cash cushion for such things as vacations, car and home repairs, moving to a new apartment or paying income taxes due. If your job is at risk, save a whole lot more. The best way to build cash: have your bank switch a fixed sum from checking to savings every month.
Next, look into your credit history. When people first get credit cards, they usually have no idea that they’re being tracked by the Great Computer in the Sky. Every account you open, every transaction and payment is reported to one or more of the three major credit bureaus, Equifax, Experian and TransUnion. They know how large your credit lines are, how promptly you pay and whether you defaulted on your student loan. All these data get crystallized into a personal- credit score. High scores get you loans at low interest rates, auto insurance at a good price and a good apartment rental. So check your report for accuracy. You want the “three-in-one” report containing your credit history and personal scores from each of the bureaus (they don’t all have the same information). You’ll pay $39.95 at equifax.com, 800-685-1111, and experian.com, 888-397-3742, and $39.90 at transunion.com, 800-493-2392. A top score is generally 720 and up. As it drops, the rate you’re charged for mortgages and credit cards gradually goes up. Those who score under 500 may not get any credit at all.
Your next job is to eliminate consumer debt. Hammer away at your credit cards, taking the one with the highest interest rate first. It’s OK to keep on using the card (we all want airline miles, right?). Just pay for everything you bought that month, plus, say, $200 toward back debt. If you can’t follow a program like this, you’re living beyond your means. Ice the credit card and shop with your debit card instead. A debit card takes the cost of your purchase directly out of your checking account, which tends to dampen the urge to spend.
Don’t be in a rush to pay off student loans. You’ve got a low interest rate, so make the minimum payments. Ditto if you have a mortgage. Put your extra –cash toward the consumer debt that’s eating you for lunch.
Even though you’re still in your 20s, start saving for retirement. On the job, sign up for the company 401(k) or 403(b) plan. If you’re self-employed, start a SEP-IRA (Simplified Employee Pension) through a mutual-fund group. Just go to your favorite fund’s Web site and download the forms. The earlier you start saving, the more valuable those savings are, because they have so many years to grow. Nevertheless, if you’re deep in credit-card debt, hold down your 401(k) contributions, putting in just enough to get the full company match (if there is one). Clean up those cards, then add to the money you’re putting into the plan.
As soon as you’re ready to settle down, buy a house. Use that cash account to accumulate the down payment. You’ll find mortgages with down payments of 5 percent or less, which means $10,000 on a $200,000 home. But houses are costly to keep up, so make the commitment only when you know you’ll stay there for several years. A house is more than an investment; it’s a lifestyle choice.
So… pursuing your lifestyle, you decide to have a baby. A sweet little bundle of future college costs. You’re already maintaining a cash cushion, reducing debt and building retirement savings. Where do you get the money for a tuition fund and still keep the lights on and food on the table? At this point, you probably don’t–you just hope the besotted grandparents will kick in. You might put aside your bonuses for tuition and any tax refunds from the IRS. But you have to save for retirement first. Your kids can borrow their way through college, but no one lets gray hairs borrow their way through old age.
A great place to save for college is your state’s 529 plan (page 62). To my mind, the best investments there are the “age-based” accounts available in most states. They put your money into a portfolio of stocks, bonds and cash, with the mix depending on how old your child is. Young children’s accounts will lean toward stocks. As the child gets older, the plans shift money into bonds and cash. By the time tuition is due, your stash should be protected from any serious loss.
In real life, parents more or less muddle through the college years. You’ll have some savings, plus money from your current paycheck, plus loans, plus your child’s summer earnings, plus whatever grants you qualify for, plus a budget tight as a corset. Ask any older parents: they have no idea how they got their kids through school, but somehow those B.A.s arrived.
Now the big question for people starting to invest, whether through a 401(k) or in a separate account. Where do you put your money today??? The answer used to be obvious–throw it all in stocks. But we may be approaching a time when it’s hard to make money in stocks or anything else. Some 401(k)s and mutual-fund groups offer “lifestyle” funds, which simplify your choice. They contain a mix of stocks, bonds and cash appropriate for your age and willingness to take a risk. They’re one-decision funds. Put all your money there and get on with the rest of your life.
Stay away from individual stocks. You have no idea which one will suddenly collapse from an accounting mess or government investigation. The deflating bubble hasn’t yet run its misery-making course. Consider selling the stocks you own (most of them ’90s companies that won’t excel in the decade ahead) and reinvesting in a well-diversified mutual fund.
Don’t ignore bonds. When interest rates rise, the value of bond funds will fall. But high-quality, intermediate-term corporate bond funds are paying a reasonable yield (about 4.5 to 5 percent). Tax-free municipal funds are yielding about as much as taxable Treasuries–really amazing. Stocks do better in the long run, but how long a run are you willing to take? Bonds roughly matched or outperformed stocks from 1966 to 1982 and 1990 to 2002, and with less risk. They belong even in a Gen-X portfolio to give you a lift whenever they outperform again. Subtract your age from 110; put that percentage of your savings into stocks with the rest in bonds. If you’re 30, for example, bonds would make up 20 percent of your retirement fund.
Don’t get discouraged just because today’s market stinks. Markets do, from time to time, and this is the first bear market that you’ve ever seen. Eventually, each cycle turns back into peaches and cream. That’s a nice thing about being young. You have time to wait.
