Managing your finances can be confusing when you’re first starting out, so we at HM Payson have put together this resource to help young adults focus on a few important lessons we wish everyone could learn early in life.
Learn to budget
You cannot manage your money if you do not understand how much you earn, how much you spend, and what you spend it on. Tracking your expenses for a few months can be eye-opening. Once you know where your money is going, you can adjust categories as needed. Online sites like Mint and You Need a Budget (YNAB) can help; and many are free.
At a minimum, you need to know how much of your income is going to fixed expenses (such as rent, car payments, internet, etc.), how much is going to variable expenses (groceries, utilities, gas, medical bills, etc.), and how much is going to discretionary expenses (entertainment, hobbies, etc.).
Creating a budget also includes planning for major purchases, building an emergency fund, contributing to a retirement plan, and repaying debt. The following paragraphs will look at some of those elements in more detail.
Understand the difference between good debt and bad debt
Not all debt is the same, particularly when it comes to your credit score. Good debt comes from things like mortgages and student loans. Bad debt comes from things like car loans, personal loans, and credit card purchases.
Credit cards have their advantages, but they can easily turn into a financial nightmare for young adults who don’t know how to avoid their pitfalls. Missing a payment will affect your credit score, and a bad credit score can have repercussions for years. For example, many employers and leasing offices routinely check credit scores when making hiring and leasing decisions. A poor credit score can also result in higher interest rates.
The Power of Compounding
If you don’t already know about the magic of compound interest, now is the time to read up on it. Money you save generates interest, and you then earn interest on the interest you just generated. Over time, compound interest can multiply your original investment, but it also works in reverse, making you pay more and more when you rack up debt on which you must pay interest. Give compound interest the reverence it deserves, and learn to make it work in your favor.
Contribute to a 401(k)
If you’re lucky enough to have an employer who offers a 401(k), you should contribute as much as possible as early as possible. The sooner you start contributing, the more powerful the compounding will be over time. If your employer offers a matching contribution percentage, that should be your minimum target contribution; then, if possible, you should increase your contribution rate every year until you’re able to contribute the maximum amount allowed.
Build an emergency fund
One of the biggest tragedies of the global pandemic has been the staggering number of people who have lost their jobs. Having an emergency fund in such circumstances can mean the difference between being able to make it to the next phase and sinking deeper and deeper into debt as you try to stay afloat.
An emergency fund typically covers three to six months of living expenses. It doesn’t need to cover discretionary expenses, but it should definitely be enough to meet your fixed and variable budget line items. Once you have built up your emergency fund, you can have peace of mind knowing that if you suddenly lose your job, have a health crisis, or unexpectedly need to cover a significant expense such as a roof repair, you can do so without endangering your financial stability.
Where to turn for more resources
There are plenty of free financial literacy websites, and you can always visit the Insights page on our website to view the Financial Planning Group’s articles on a wide variety of topics.