Saving for retirement is important at all ages. However, most individuals begin to undertake serious money management responsibilities after leaving their parents to be on their own. This is a critical period in financial planning for young adults, as their spending and savings habits help to set the financial foundation for their retirement years. In this article, we review some of the financial habits that can affect a young adult's ability to save for retirement.
Credit and Credit Rating
While using credit may not be seen as saving for retirement, it does impact an individual's ability to contribute to a retirement account and/or to take other steps toward a financially secured retirement. Improper use or abuse of credit can limit an individual's ability to save and may result in a higher cost of living than that which would apply to someone with good credit.
In general, having a good credit history, or credit rating, means that you pay your bills on time, do not exceed the credit limit on your credit accounts (such as credit cards) and your debt to income ratio is low. A good credit history provides the basis for negotiating interest rates on loans and can result in significant savings on interest paid over time. These savings can increase a young person's amount of disposable income and, therefore, the amounts available to save in a retirement account.
College students are usually bombarded with tons of offers for credit cards from credit card companies. Some inexperienced credit-card holders may see this as a way to buy what's in style or even to pay for simple necessities. However, while having a credit card can be a necessary convenience, college students must consider the pros and cons when presented with offers to apply for new credit cards or offers to increase spending limits for existing credit cards.
As noted earlier, your credit rating affects your ability to obtain credit and may even determine the interest rate at which credit can be obtained. As such, improper use of credit cards can result in lower credit ratings, which can eventually translate into either inability to obtain additional credit or higher interest rates charged on loans. Improper use includes making payments after the due date (late payments) or exceeding the credit limit established by the credit card. The following is an example of how poor credit ratings can affect retirement savings.
|John and Jim both applied for mortgages. Because of his excellent credit history, John was able to get a mortgage loan at a rate of 5.75%. Because of his poor credit history of paying his bills late and exceeding credit limits on credit cards, Jim had to settle for an interest rate of 6.5% on his mortgage loan.
Over the 30-year period of the mortgage, John paid $1,167 per month and paid a total of $220,172 in interest, while Jim paid $1,264 per month and paid a total of paid $255,088 in interest. In total, Jim would pay $34,916 more than John in interest over the 30-year period. Furthermore, consider that Jim also paid $97 more than John each month. This could have been used for other monthly expenses or it could have been contributed to a savings account. At a rate of 2% compounded on an annual basis, $97 per month would have grown to more than $47,000 after 30 years.
In order to properly manage credit card debts, college students should employ proper debt management strategies, which includes the following:
- Compare credit card offers. Usually, the credit card with the lowest annual percentage rate (APR) is the least costly to maintain, as it accrues the least interest.
- Determine whether offers of low APR are actually teaser rates, which will increase after a certain period, if the credit limit is exceeded and/or if a payment is made after the due date.
- Compare fees, if any, and consider whether a lower APR may be a better choice even for a credit card with higher fees.
- Use credit cards only for necessities, and avoid charging consumables like groceries or gas on your credit card.
- Pay more than the minimum payment required when possible. Consider that interest is usually not charged on charges that are paid off by the due date.
The College Graduate or Other Newly Financially Independent
The new college graduate or other young adult is often faced with the decision of renting, buying and even moving back with his or her parents. All of these options will have some impact on the individual's finances, and ultimately, the amount the individual is able to save for retirement.
Living with Parents
Living with parents for a year or two after graduation and/or when the individual first starts working may mean giving up some independence, but could pay off from a financial perspective. This option reduces an individual's overall living expenses, and allows him or her to save up for big-ticket items, including a down payment on a mortgage, a wedding or establishing an emergency fund for when that person decides to strike out on his or her own. Of course, this will work only if the individual designs a budget, saves as much a possible, reduces frivolous spending and keeps track of the deadline that is established for moving out. Additionally, it may be a good idea for the individual to discuss the terms of residence with his or her parents. For instance, will rent be a part of the conditions of moving back home, and will he or she be required to contribute toward other living expenses?
To Rent or Buy
The age-old question of whether to rent or buy is one of the most important financial decisions a person will make. Options for renting can include sharing or subletting an apartment, which allows an individual to save more by sharing of resources and expenses. Someone who is not keen on the idea of sharing living quarters should think about whether the amount paid for rent is the same or close to the amount that would be paid for a mortgage. However, keep in mind that mortgage payments are not the only house-related expenses a homeowner will incur. Other expense includes homeowner's insurance, property tax, repairs and general upkeep of the property - expenses that usually do not apply to rented property. Also, water, power and other utilities may be included in the price of rent - if so, these costs will need to be added to the cost of owning your own home.
On the upside, while not guaranteed, it is very likely that the purchased property will increase in value over time and could serve as one of the individual's primary means of financing retirement, which includes selling the property or using it to finance a reverse mortgage.
A Penny Saved ...
Proper debt management and shrewd decisions about living arrangements are positive steps to increasing disposable income and the amount available to save for retirement. Of course, all that would be for naught if none of it is saved. As a young adult, you want to make saving part of your regular financial behavior as soon as you begin to receive an income. This includes saving in a regular savings account for emergencies and making contributions to a retirement account. Your retirement savings should be treated as a recurring expense, so that it is included your budget. This will help to ensure that you save on a regular basis, and that your savings do not put a strain on your finances.
The Bottom Line
Every good financial program has a solid foundation. For your retirement program, this means establishing good habits and starting to save as early as possible. While these tips are geared toward the young adult, they can apply to any member of any age group that is beginning a retirement planning program. Be sure to discuss your plans with a retirement counselor, who should be able to provide you with the proper guidance to help you achieve a financially secure retirement.