Basic Finances

I'm going to take a break from the relationship posts to go in a different direction.  This blog's to be about more that just that one aspect of life.

In your early 20s, there are several things that may be going on in your life financially.  You may have some college debt and after going through a period of your life with little income and lots of means for recreation, you may have amassed some credit card debt as well.  You're probably living in more expensive housing, either renting or buying.  You've also probably either recently bought a car or are thinking of buying one.  Finally, you've probably got a "real job."  One that pays a decent wage and you likely won't lose on a whim.  Here are a couple tips to get you on good financial footing:

Know your expenses
You need not know where every penny of every paycheck is going to go.  But you should have a firm grasp on exactly how much you need to spend to live.  You can get as detailed as you want, but at least know (1) your monthly expenses and (2) your annual expenses.  These should be hard numbers you never exceed.

Know your debts
Make a list of your debts and their APRs.  If you've got any credit card debt above around 15%, call the company's customer service line and explain that another card is offering you a 0% APR if you transfer your balance to them.  Ask if they can give you a better rate to keep your business-- they usually will.

If you have any debts whos interest are tax deductible (mortgages and college loans come to mind) discount their rate.  A quick approximation is to drop them by 25%.  Your exact situation will affect this amount, but we're just looking for a quick estimate and this should do.

Once you have a list of your debts and their rates, you need to decide for yourself what return you can expect to get on money you save.  If you're a conservative spender, choose a low rate-- 3 or 4%.  Or go to 0% if you've got a predisposition against debt.  If you're a higher risk/higher reward type of person, assume you'll get a 7-9% return.  Whatever rate you choose, pick every debt below that threshold and pay the minimum-- the assumption is that you'll make a higher return investing the money than you'll pay to the debt.  Every debt above that threshold should be paid off as quickly as possible.  We'll get to that later.

Start a retirement fund
Or two.  If your company has a 401(k) plan, you should make an effort to max it out.  If they offer matching funds to a certain amount, definitely take advantage-- this is free money they pay you for saving your own money.

If you have long term savings beyond that or your company doesn't offer a 401(k), open a traditional or Roth IRA.

Two keys to retirement are start early and be consistent.  Following both of these, you'll do fine in the long term.

Start an emergency fund
You need money set aside "just in case."  It doesn't have to be in a mattress or a low-interest savings account.  Just make sure it's a stable investment (something that won't lose too much value in the same economic downturn that costs you your job) and accessible.

The general rule of thumb is to have 6-months' living expenses saved.  This gives you time to find a new job if it comes to that, but also should be a substantial amount if something else comes up.  To find this magic amount, take your expenses and minimum debt payments times six.  You won't be contributing to your retirement or emergency fund during that time, so leave those out.

This fund's not going to build up overnight.  Just earmark a little of each paycheck for it, and over time you'll reach it.  A reasonable rule of thumb is to allot 1/40 of its total size each month.  With interest, you should reach it in about 3 years.

Add it all up
Take your monthly and 1/12 your annual expenses, all the minimum payments on your debts, your retirement contributions and your emergency fund contributions.  These need to fit inside your monthly pay.  If they don't, make adjustments.  If they do, use all the excess to pay down the debts above your estimated savings rate.  Start with the one with the highest APR and pay it off completely before moving down to the next one.

After this, you can start building up your savings.  What's a good target net worth?  According to the book The Millionaire Next Door (a book with a great 2-page message spread out over 250 monotonous pages) take your yearly earnings, multiply by your age, and divide by 10.  Reach and maintain this mark, and you're doing great.

Stay disciplined
Unless you're planning to go back to school or aren't taking advantage of your degree, it's very likely that you're at your lifetime peak of your earning vs. expenses right now and for the next 10 years or so.  You have the opportunity to create a financial foundation for the rest of your life.



I'll close with a trick to keeping your spending in line.  First off, get rid of your credit cards unless you absolutely, positively pay them off every month.

To keep your spending inline with your budget, get two checking accounts, A and B.  Make sure they both have zero fees and don't charge you for the services you need (free checking is everywhere right now).  Have your paycheck direct deposited to account A.  Set up automatic payments from A to your retirement and emergency funds, as well as all the minimums for your debts.  If you can, automatically pay your monthly bills from there, too.   Finally, set up an automatic payment of your monthly expenses minus your bills to account B.  This is the part of your budget that's spending money.  Only carry the debit card for account B around.  You'll only have access to the money you've set aside.  If you find yourself running out, you're forced to rebalance your budget rather than just dipping into savings.  As extra money accumulates in account A, you can use it to pay off your high-rate debts or shift it into savings.