Recent college or high school graduates entering the workforce for the first time often question what they should be doing with their money -- paying down debts, investing in retirement funds, buying a home? How do you prioritize your debts and what investments should you make? Here is some guidance on how to manage your money as you enter the working world.
Prioritize Your Debts
The first step is to list your debts. Then, make any required payments first (for example, the minimum monthly payment on your credit card).
If you can't meet your current payment obligations, you need to figure out which debts are essential to pay first and at the same time, which expenses you can reduce to get back on track.
If you can meet your current financial obligations and still have money to spare, consider whether you should prepay any of your debts, and if so, in what order. Here are some guidelines as to which debts to pay off first:
Start with the highest interest rate. First, plan to tackle the debt with the highest interest rate. This is usually a credit card, but could also include a private student loan or auto loan. If you're not sure what the interest rate is, read through your loan agreements carefully, or call the lender directly. Some rates are variable, which means they can change. Find out when and by how much.
Keep in mind that your lowest payment might not have the lowest interest rate -- for example, your minimum payment on your credit card may be small, but your payment could be mostly interest. And while it's satisfying to get rid of a small debt quickly, reprioritizing without taking your interest rate into account can mean paying more overall.
Pay principal first. When you make a prepayment, make sure it goes to principal only. This will reduce the total amount you owe, and thus the amount of interest that will accrue going forward. Write "pay to principal" or something similar in the subject line on any check you send in, or if you pay online, make sure you get to choose how the payment is designated.
Pay off student loans last. Federal student loans offer much more flexibility than other forms of debt if you hit hard times.
Prioritize Your Investments
Once you've got your debts organized, it's time to look at your investment and savings options. Here are some common ones:
Keep an emergency fund. It's a good idea to keep at least a couple months' worth of expenses in your bank account, in case you lose your job or have an unexpected large expense, like a major car repair.
Save for a house. If home values where you live are increasing, you may be motivated to buy soon. On the other hand, if prices are stable or falling, you may have time to buy at a better price or afford more by waiting and paying down other debt.
Save for retirement. Saving early means bigger payoffs in the long run. If your employer matches your contributions to a 401(k) plan, contribute enough to take advantage of the full matching amount.
Invest elsewhere. You may be an entrepreneurial sort who wants to invest in the stock market, or perhaps start a business. Recognize that these options don't usually provide the tax advantages of buying a home or saving for retirement, but now is the time you're probably most able to accept risk, before your cash is committed elsewhere.
Combining Your Debt and Savings Goals
Once you've got your debt and saving goals written down and prioritized, it's time to merge the two. Prioritizing between the two lists can be difficult. You have to balance two competing interests -- reducing debt as quickly as you can versus investing your cash in an appreciating asset. Here are some tips for doing this.
Start with a budget. First, make sure you know where your cash is already committed. This will help you figure out how much money you have to work with. It will also help you see places you might be able to cut corners.
Divide and conquer. Don't assume you have to only meet one goal at a time. If you have $400 extra each month, you might want to put half toward your 401(k) plan and half toward reducing credit card debt, for example. (And remember, the half that goes to your 401(k) will be more than $200, since your contribution is pre-tax.)
Make it automatic. If your employer offers direct deposit, take the opportunity to funnel cash directly to your savings account or retirement plan. Set up automatic bill payment when you can -- you may even get a reduced interest rate for doing so, and racking up a history of on-time payments will boost your credit score too, which can mean better borrowing options at lower interest rates down the line.
Borrowing More Money
To keep your head above water, you may be considering borrowing more money. And even if you're able to meet your financial obligations, by using credit wisely you may be able to transfer current debts to accounts with lower interest rates.
If you are considering a new credit card, car loan, or undertaking another type of debt, follow these tips to make smart choices:
Shop around. Always shop around for the best deal. For example, when shopping for a car, be sure to check car loan options with your bank or other lending institution (which often offer better interest rates than car dealerships). Even if you get a lower rate from a dealership, you'll have less negotiating power on the price of the car as a result of consolidating these services.
Read the fine print. A deal that sounds too good to be true usually is. A loan with no interest or payment for one year usually comes with some catch -- you have to pay the entire thing off in that year or you'll owe all the interest that's accrued in that time, or there's a huge interest rate adjustment at the end of the year. Even if you use these forms of credit, you want to be sure you know when the changes occur and be prepared to handle them. Also, ignore the pressure of salespeople who want you to read without signing. Take the time to read everything carefully first; if you don't understand something, don't depend on a salesperson to help you figure it out.
Be realistic. Don't assume you're going to make a lot more money in the relatively near future. Make decisions based on what you can afford now. If you have more money later, you can reevaluate your plans.
Exercise discipline. Wisely using credit is different than living on it because your tastes exceed your income. Don't open new forms of consumer credit without closing old ones. You'll find yourself deeper in the hole, and it will be harder (and more expensive) to get out.
Borrow from family or friends. Parents, grandparents, and family friends know that it's hard to start a new job saddled with debt. If you need cash for a good reason -- you want to put a down payment on a house, or you need to pay off your credit card debt and want to contribute to your employer's 401(k) plan for the full matching amount -- talk to family members who may be willing to lend you the cash. Don't expect any help if you just took a vacation to Hawaii or replaced your entire wardrobe, though. Instead, have a good reason for the request, show your responsible borrowing history, and offer to pay a fair interest rate.
Give yourself a break. It's unrealistic to forego every pleasurable purchase in the hope of future financial wealth or freedom. Set a budget and stick to it, but include some room for the occasional night out or small shopping spree. Just make these splurges the exception, not the norm, and you'll feel better about your financial future without sacrificing your current comfort level.
To learn more about making a budget, prioritizing debt, and getting back on your financial feet, get Solve Your Money Troubles: Get Debt Collectors Off Your Back & Regain Financial Freedom, by Robin Leonard and John Lamb (Nolo).
Copyright 2008 Nolo