How college graduates approach financial planning during their first years in the real world following college often establishes the pattern for their financial habits down the road. Here are five common financial and budgetary traps young adults can fall into—and how to avoid them.
- It's easy for recent college grads to make financial mistakes.
- Overspending and failing to save money is one common mistake.
- Failing to invest in appreciating assets is another mistake.
- Allowing debt to get out of control and establishing a bad credit history are other common errors.
- Grads with people dependent on them shouldn't neglect life insurance.
Mistake #1: Not Striving to Save
Recent graduates often encounter sticker shock as they establish their new lives. If they leave the comfort of the parental home, entire paychecks can get spent on regular expenses—rent, utilities, car payments—and on furnishing their new nests. Even if they don't, they often still incur expenses, like transportation costs to work or student loan repayments; they may feel obliged to start contributing to the family household budget, too.
Despite all these demands on your newly earned dollars, you should strive to save money, placing extra cash flow in a combination of stock, bond, and money market investments. It's also prudent to plan for contingencies, such as automobile accidents, personal injury, lay-offs, and other unforeseen expenses.
Mistake #2: Money Spent Is Money Lost
Recent graduates naturally equate a steady paycheck with newfound wealth and independence. No longer is money being doled out to them, in the limited shape of an allowance or scholarship or financial aid; it's money they earn—and it's all theirs. The sense of autonomy can lead to unreasonable spending habits: spending money on discretionary items or recreational experiences.
Paychecks provide only the illusion of security; it's how you use your paychecks that determines your financial well-being. In the real world, assets either appreciate or depreciate. The purchase of a car is the purchase of a depreciating asset because the car diminishes in value as soon as it leaves the lot. The same is true for furniture, clothing, and expensive TVs. Flying to Cabo San Lucas over spring break is an expense: Cash leaving your wallet, never to return. The same is true of fine dining and weekend barhopping.
Several actions can help create real financial security. One, as mentioned above, has to do with investing: putting your money into assets that appreciate over time, such as blue-chip stocks, dividend-yielding stocks or growth stocks, and even residential real estate (i.e., buying a home).
While some stocks pay cash dividends as a way to return money to investors, bonds are debt securities or loans issued by a company or government. Unlike stocks, bonds do not provide the investors with ownership of a company. Investors who purchase bonds may, in return, receive periodic interest payments, and at the bond's maturity, the principal—or original amount invested—is returned to the bondholder.
There's also investing in yourself to improve your prospects for growth and increased income. By devoting money each month to improve your performance as a professional, you can expect to earn more promotions and higher pay over the long run than your complacent counterparts. These personal investments can take the form of training, online classes, industry certifications, books, and seminars.
Mistake #3: Letting Debt Get Out of Control
Depreciating assets and reckless spending often lead to only one thing: debt. If a paycheck only provides the illusion of security, debt should provide real fear of the negative things that can happen, especially if unforeseen contingencies occur (like income being reduced or cut off altogether). Debt devours your cash flow and negates your assets, skewing your personal net worth toward the negative side. Establish timelines for eliminating your various debts, including school, car, credit card, and home loans. Ideally, it's best to pay off the debts with the highest interest rates first.
There is such a thing as good debt; you can use other people's money to buy appreciating assets, essentially using other people's money to make money for yourself. That's how the private equity firms do it. But the rule of thumb is to discipline yourself in executing your plan of attack. Kill the debt beast, whatever its form, by a certain deadline.
Mistake #4: Becoming a Bad Credit Risk
If poor habits and consumption behaviors are not kept in check, debt can be financially disastrous. However, large transactions do exist that necessitate the use of debt. After all, the wheels of the economy would grind to a halt if consumers had to bring in sacks of cash to pay the total value of a car or home upfront. That's where credit comes into play.
As a means of establishing a good credit history and acquiring appreciating assets, manageable debt can help recent grads become financially credible to lenders when it is time to take out an auto loan or mortgage. Additionally, extenuating circumstances may require a recent graduate to take out an emergency loan. Manageable debt means that payments and the principal balance are easily affordable and that there is a target timeline for an eventual pay-off. It is not an excuse to throw money at the craps table in Vegas. That's an even nastier rabbit hole.
Mistake #5: Forgetting Life Insurance
Recent grads rarely think about life insurance. And admittedly, from a financial standpoint, it doesn't make sense unless you already have dependents. But if you do, if there are children or a spouse who depend on your income, there's a significant benefit to taking out a policy when you're young. Life insurance for a 22-year-old is a better proposition than life insurance for a 55-year-old. In terms of premiums, it is always cheaper—sometimes substantially cheaper—for a younger person to buy insurance than an older person.
Although term insurance is usually recommended for the young, permanent life insurance—in which a portion of the premium goes towards investments within the policy—has its points. A cash value that builds for decades can amount to hundreds of thousands of dollars in future tax-free income.
The Bottom Line
Personal finance is a critical area for your mental and emotional well-being. Once you graduate, managing your money and building a solid personal balance sheet should become one of your dominant priorities.