Math lesson for college grads

For new workers, saving is smarter than spending freely and shouldn't be put off until debt is paid.

Kathy M. Kristof
Personal Finance

April 22, 2007

Millions of college seniors are interviewing for their first full-time jobs in preparation for stepping out of the hallowed halls of education and into the real world.

And with it comes a world of debt.

"These kids have it tougher than people did in the past," said Mike Sullivan, director of education for Take Charge America, a Phoenix-based credit counseling firm. "They are graduating with a lot more debt, but starting salaries are not that much higher."

The problem: To a graduate who has never paid taxes or a mortgage, a starting salary of $30,000 may seem like a fortune — plenty to support an elegant apartment or a new car.

But those who go on a spending spree may regret it. That's because even a generous starting salary doesn't go very far when you're in debt. And graduates are more indebted than ever before.

The typical graduate owes $19,000 to student lenders, surveys say, and almost $3,000 on credit cards — and so is paying off past spending while buying necessities such as shelter, professional clothing and a car to get to work.

"I talk to kids all the time, and when I ask them about the biggest challenges they face when starting out, they always say the same thing: They never realized how many things they would have to pay for," said Susan Coleman, a finance professor at the University of Hartford in Connecticut.

Living on your own will require economic trade-offs, experts say, but those who do it right will find it's well worth the sacrifice.

"You end up way ahead of the game if you just start out right," said Don Silver, author of the High School Money Book. "You buy yourself a huge amount of freedom."

What should be the top priorities for college graduates who want to set their financial lives on the right track? Here are a few tips.

• Save. You may think you need to pay off debts before contemplating saving, but experts disagree. They maintain that the first priority is to save, particularly for those who are offered a 401(k) plan at work. Why?

The vast majority of large employers offer 401(k) plans, which allow workers to save up to 15% of their pay in tax-favored retirement accounts. Most offer "matching" contributions, too.

Most commonly, employers will kick in 50 cents for each dollar the employee saves, according to Mercer Human Resources Consulting. So if you put $100 a month into the 401(k), you'll get $150.

Better yet, your contributions are taken out of your pay before taxes are computed. That means your $100 contribution only costs $75 after tax, assuming you would otherwise have paid 25% of your pay in federal and state income taxes.

You'll eventually have to pay tax on that money when you withdraw it at retirement. But getting $150 now for an out-of-pocket cost of $75 is simply too good to pass up.

"You can't say no to that," Sullivan said. "Signing up for the 401(k) should be the top priority — even before paying off your debt."

There's another benefit too. Saving early puts the power of compounding on your side. That's earning interest on the interest on your money. It also applies to dividends and other investment returns.

How much is that worth?

Let's say you save $150 a month, starting at age 25, and your investments earn an average annual return of 10%. By the time you retire at age 65, you'll have $948,611. But during those 40 years, you'll have contributed only $72,000 of your own money. Compounding will contribute the rest.

You think you're too poor to save and want to wait until age 35 to start? If you make the same monthly contribution and earn the same return, you'll have just $339,973 at retirement.

You'd have to save three times as much each month to accumulate as much as the person who started saving a decade earlier.

• Manage your student loans, but pay off the credit cards.

Although all debts chain you to monthly payments, some are much more costly and dangerous than others, Silver said.

Credit cards, for example, often charge interest rates of 20% or more and allow the card issuer to hike your rate at virtually any time. This should be the first debt the graduate pays off.

Student loans, on the other hand, usually have lower interest rates and more flexible repayment terms. While those with the wherewithal give themselves more freedom by paying off all debts, those with limited means can leave the student loans outstanding. It's wise to talk to your lenders to assess your repayment options, though.

Standard repayment plans assume these debts will be paid off in 10 years, but some heavily indebted students can stretch repayment over longer periods.

• Set goals. After two decades or more of being taken care of and told what to do, you are now in charge of your financial destiny.

Because money is finite, that's both a challenge and an opportunity. If you buy something today, you won't have the money for something else you want tomorrow. It will be a lot easier to accept the sacrifices when you're saving for things that are precious, Coleman said.

"If you think about long-term goals, you are probably going to be willing to give up some of the things you want in the short term for the things that are really important to you in the end."

• Budget. There's no shame in driving an old car or living at home when you're first out of college. But if you spend lavishly now and end up in an economic train wreck — as an increasing number of 20-somethings do — it will be embarrassing to explain why you're living with Mom and Dad when you go to your 20-year reunion.

Your first car should be three years old, Sullivan contends. That will probably save you 50% of the price of a new model without dramatically increasing repair bills.

Your first apartment should be economical and shared, Silver adds. Your discretionary expenses, such as clothing and entertainment, also should be modest for at least your first few years out of college, these experts agree.

"We all deserve good things, but they often don't come immediately," Coleman said. "It is all about trade-offs."

kathy.kristof@latimes.com

Kathy M. Kristof welcomes your comments but regrets that she cannot respond to every question. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes .com/kristof.

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