What Recent College Grads Need To Know About Money

in Financial Planning by

I’ve just started my senior year of college and it looks like I’ll have to be a real person soon. I’m not sure how I feel about it – part of me is thrilled about not doing homework and making money, and part of me is sad that I’ll never have a summer vacation again. As you can see, I’ve got my priorities straight.

After spending my summer working at Personal Capital, I learned a couple things about financial planning and investing. The most important thing? The power of compounding interest. Compounding interest helps you greatly down the road if you invest your money wisely, and can really hurt you if you exceed your budget and take on credit-card debt.

Three Financial Considerations For Recent College Grads

1. Living

One of the things I’m really looking forward to is finally having my own place. The general rule of thumb for living expenses is to keep it under 30% of your annual salary (the general standard for housing affordability). One way to calculate a good monthly expense target is to take your after-tax salary and divide it by 40. If you make $40,000 a year after-tax, then you’ll probably have to settle for roommates in places like San Francisco and New York City.

Higher taxes and rents make it tougher to live in most of the attractive neighborhoods without having a really well-paying job. Some may opt to live further away from work to save money, but the adverse effects of a long commute time usually outweigh the benefits.

As a result, those living in some of the more expensive cities might have to compromise by spending less money on entertainment. This is a tough proposition – a large part of the reason people move to cities like New York and San Francisco is to enjoy what the city has to offer outside of the office. It takes great discipline and a clear understanding of future financial goals to make the sacrifices necessary to live on a budget.

2. Saving & Investing

Though it’s fine to stretch the budget a little bit to live in some of the more expensive cities, it is absolutely imperative that you max-out your 401(k) contributions and take full advantage if your employer matches. An employer match is free money that can grow! Free money that can turn into a down payment on a house, college education for your children, the vacation house you’ve always dreamed about! Maxing out your 401(k) contributions is a no-brainer.

That being said, putting money towards your 401(k) is only half the battle. The other half is having the right investments. I spent part of the summer helping research 401(k) fund recommendations for clients, and was taken aback by how often I saw actively-managed mutual funds with high fees as the only investment options. It’s well-documented how terrible these funds can be in the long-term: their high fee structures create a significant chasm between your returns and what you keep; their trading costs often aren’t wrapped in; and the high turnover generates a hefty tax bill. It shocked me that these were the only options for a 401(k).

When searching for funds to invest in, look for low-cost index funds. The best options are usually Vanguard and Spartan ETFs, as they provide broad market exposure at a very low cost. For recent college grads, your investment time horizon is very long – somewhere between forty and fifty working years. Therefore, your risk tolerance should be aggressive, meaning primarily equity-driven with some fixed-income exposure for diversification.

Within the domestic equity piece, we recommend diverse exposure to Large-Cap, Mid-Cap and Small-Cap equities. Look for exposure to both developed and emerging markets for international equities. And look for bond ETFs that invest in domestic and international corporate and government bonds. Of course, every individual’s risk tolerance is different, which is why we have one-on-one consultations.

Compounding interest really comes into play the earlier you invest your money. Here’s a chart from Fidelity that shows why:

Screen Shot 2014-09-10 at 8.07.09 PM

This graph assumes an annual rate of return of 7% as well as an annual contribution of $5,000. The maximum annual contribution towards a 401(k) is $17,500 in 2014, more than three times the max IRA contribution. Consequently, the benefits of investing early are even more pronounced.

Another thing to consider: the pronounced difference beginning at 25 versus 35. By investing at 25 years old (assuming a 7% return rate), you could end up with more than double the amount of money at the age of 70 than you would if you invested at 35! Invest early and invest often.

3. Debt

Just as compounding interest can be highly beneficial in building a cushy nest egg, it can be equally destructive in the form of debt. The most common debt for students fresh out of college? Student loans. Balancing student loan debt is tricky because of the opportunity costs associated with it, and some of the federal loan programs come attached with high interest rates that make it tough for recent grads to pay down. Carve out a space in your monthly budget dedicated to meeting your student loan payments. Doing so gets you in the habit of planning to make each payment, putting you on track to pay down all the debt.

The other debt to be wary of is credit-card debt. Student loans are viewed as “good” debt because they are an investment in your future, an investment that pays dividends as you progress in your career. Credit cards, on the other hand, are viewed as “bad” debt because they don’t pay any dividends in the future. Instead, not making all of your monthly payments can put you in a very tough spot due to the compounding interest on your credit cards. Not even Warren Buffet has been able to beat the average annual credit card interest rate of 15% in his illustrious career.

The other day I was talking with my friend who spent the summer working at Capital One working in the credit card division. He said he was shocked at how many people view credit cards as “free money”. Free money as in, “I don’t have enough money in my checking account to pay for this, let me use my credit card to buy it anyway.” When repeated often enough, this exercise can become incredibly deadly.

Credit cards can be incredibly helpful in building a solid financial foundation. Using them for the rewards programs, spending only what you know you can afford, and paying them down each month is the key to generating a good credit score.

Work To Live

We all work hard to enjoy the things we really like. For me, that’s watching basketball. When I start working I plan on buying season tickets for the local NBA team as well as going to the NCAA Final Four every March. We all have hobbies and interests that we would like to actively pursue.

Consider allocating 10% of your after-tax money towards your Fun Fund while continuously maxing out your 401k and being mindful of your spending habits. It’s important we keep our spending rates in check as our incomes grow. We never know when dark days will return.

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Arun Sundaresan

Arun Sundaresan

Arun Sundaresan is a Portfolio Management Intern at Personal Capital. Arun has previously worked at Citigroup in London, and spent time at Personal Capital last summer. He is currently studying Finance at Washington University in St. Louis.

2 comments

  1. Financial Samurai

    Good luck Arun! It’s good you are thinking about these issues now, instead of a decade after graduation.

    Part of me wished I graduated a year earlier in 1998 so I could get one more year of money and experience. Another part just LOVED LOVED college so much I wish I stayed on for another year. College might be the best time of your life! It’s just hard to know when you’re in it.

    Reply
  2. Froogal Stoodent

    One thing I can’t recommend enough–Arun, you said you work hard to enjoy things you really like. But what if your work was one of those things that you really like?!
    My best advice for college students/grads is to find something you really enjoy, and find a way to make money doing that!

    Reply

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