The following originally appeared in DomaineHome.com
If you’re a young professional, chances are you’ve started to think about paying off debt, like a school loan or a credit card, and saving for your future, be it long-term goals like retirement or short-term goals like a new car or a house. You’ve probably heard you should have an emergency fund and contribute to a 401(K), and so on, but when you only have so much disposable income, what should you contribute to, and in what order?
We consulted with Jeffrey Alford of Fidelity Investments LLC to find out how young professionals should prioritize debt and start saving for the future, and he offered seven steps that eliminate the guesswork. Read on below.
Step1: Create a budget
Before you can make any financial decisions on paying off debt, saving, or making purchases, you need to put together a budget that considers important factors like your income, your monthly expenses, and any debt you may have, like student loan debt, Alford says.
“It’s important that you prioritize essential expenses, versus discretionary expenses,” he advises. “Essential expenses are the non-negotiables, and regardless of what’s happening in the economy, you have to pay these bills in order to survive.” Discretionary expenses, on the other hand, are those open-to-discussion items, like tickets to a concert or a new iPhone, purchases that are really just for pleasure.
To create a budget, Alford recommends “taking your monthly income—either on a weekly, biweekly, or monthly basis, depending on how you get paid—and from there, subtract the living expenses—things like your rent, your mortgage, your car payment, your utility bills, medical bills, and other things you have to pay on a month-to-month basis. Then you subtract the monthly loans and debt payments.” Any minimum monthly payments you have should also be deducted, so you don’t get dinged with late fees and the like.
Now that you’ve created a budget, assuming you have some money left over, you need to prioritize how you will spend it. Continue reading to find out how.
Step 2: Build an emergency fund
“Before you start paying off any additional debt besides the minimum monthly payments that you have to pay, you’ll want to build a solid emergency fund,” Alford says. While all of the steps outlined here are crucial, “planning for unexpected expenses first is critical, as it can have important financial implications,” he says.
The predicament of an illness or a job loss can worsen if you don’t have the savings to support yourself, so Alford recommends putting away three to six months of your living expenses for such an event. He also suggests opening a separate bank account for it, so you don’t accidentally dip into it. If your employer offers it, enroll in automatic payroll deductions, so you don’t even have to remember to save. “Setting aside a separate account will also make you more disciplined and make you think twice before dipping into that fund for luxury purchases,” he points out.
Step 3: Contribute to your 401(k)
A tax-advantage account like 401(K) or 403(B) is one of “most critical components of your retirement savings,” Alford says. Unfortunately, many young professionals don’t think they need to save for retirement this soon, but it “can be one of the smartest ways to protect yourself from taxes, so you can keep more of the money you earn,” he says. Why? Any contributions you make can reduce your taxable income that year. “Also, the money you contribute to your employer’s plan won’t be taxed until you withdraw it, helping you generate more growth and interest on the money you’re earning,” he says. Contributing a percentage of your monthly paycheck into your 401(K) each month is recommended.
If your employer offers a matching contribution to the fund (usually in a range of 3% to 6% of your salary), Alford advises contributing up to that point, so you’re taking full advantage. One thing to note, he points out, is that while any percentage you contribute to your fund “is yours, even if you leave the company,” the contribution your employer makes isn’t yours until you’re fully vested. Your vesting period is dependent on your company’s policy, but five years and up is common, he says.
So why do you have to start so young? Compounding, or “the ability for your money to make more money over time,” is “one of the most powerful things out there, especially when you start saving earlier.” Even if you don’t have a lot to save, as a young professional, you do have time on your side. Here’s the way compounding works, according to Alford: “When you put money toward an investment or savings account, you’ll start earning interest, dividends, capital gains, and growth on that money. After a while, those amounts will start to generate more interest, giving your money more potential to generate even bigger amounts. The longer you invest your money, the better chance it has to grow.” It’s a no-brainer, really.”
Step 4: Pay off high-interest credit cards
Be it in college or more recently, you may have signed up for a credit card with an introductory low- or no-interest rate. If so, you’ve probably seen that introductory rate expire, and your interest rate jump to anywhere from 10% to 25 % (or even more). All of a sudden that credit card is costing you big bucks, and you should pay it off as soon as you can (once you’ve tackled the previous two steps). By contrast, Alford points out, “loans such as a mortgage payment, a student loan, or a car loan offer lower interest rates, so they don’t need to be paid off as quickly.” In addition, “some things like mortgages or student loans also allow you to deduct the interest on your tax return, which is a benefit you won’t find with credit cards,” Alford says.
Step 5: Pay off private student loans
“You may have a combination of government student loans and private student loans, but you’ll want to get rid of those private student loans first,” Alford says. These private loans often have higher interest rates, between five and 12 percent. Interest is tax deductible in some cases up to $2500, so “if you earn less than $75,000, Fidelity recommends paying off any debt over eight percent interest first,” he advises.
Step 6: Contribute more to your retirement savings
If you’ve gone through the previous steps and you still have money to spare, “you may benefit more from growing your long-term investments than you would from paying off that lower interest rate debt,” like mortgages, government student loans, and car payments, Alford says.
So how much more should you contribute to your 401(K)? “The goal is to contribute as much as you can, until you’re actually able to max it out,” he says. “The maximum contribution limit for 2015 is $18,000 per year.” That number may sound totally unrealistic, but it’s something to work toward, so every time you get a raise or a bonus, set a higher percentage, or even a hefty chunk, aside into your retirement savings.
Step 7: Tackle low-interest loans
The last step is to tackle those low-interest loans. Until you’ve covered all of the previous steps, Alford recommends making “just the monthly payments on lower-interest loans such as mortgage loans, car loans, and government student loans,” because “these types of debts carry lower interest rates and some are even tax deductible.”
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