If you’ve ever watched a home-improvement show, you’ve likely got at least a passing familiarity with a wide range of tools, from wrenches and bolts to hammers and levels that can fix the myriad things that might break around the house. The financial world has a tool box too. It is filed with products ranging from Exchange Traded Funds to insurance policies aimed at fixing common financial challenges.
But some financial tools are decidedly better than others, solving multiple problems with ease. Call them the power tools of personal finance. If you are young and just getting your financial life started, it may be time to learn how these personal finance power tools might improve your financial life. Here are three that every Millennial should understand.
The most maligned and under-utilized of the power pack is the budget – a simple listing of how much money comes in each month and how much goes out. Budgets are powerful because they solve so many vexing questions, such as: Where did our money go? How much do we pay in taxes? Can we afford a house? How much do we need for retirement?
But budgets have gotten a bad rap because people misunderstand what they are and how to compile them. A budget is not a listing of what you should spend, designed to deprive you of all luxury. It is what you do spend. They are designed to illuminate whether you are spending your money in ways that satisfy your short and long-term goals.
To do one properly, pull together income and tax information, as well as your expenses for the year. Categorize and jot it all down. Carefully examine the result. Most people find some surprise – expenses not worth the splurge and easy to cut to feed more precious goals. You can budget easily with an automated money-management tool, such as Mint, Quicken or Personal Capital.
FEDERAL STUDENT LOANS
No one should borrow to excess no matter how consumer-friendly the loan. And certainly some students, goaded on by the call to “invest in yourself” with higher education, did just that with student loans, borrowing way more than made sense given their post-graduation job prospects. (The rule of thumb with student loans is to never borrow more than you expect to earn in your first year on the job.) That’s pushed one in every 10 students into default, which is a recipe for disaster. But, used in moderation, there’s nothing quite as valuable to a 20-year-old as a student loan.
That’s simply because these loans, which are backed by the federal government, have favorable interest rates and a variety of consumer protections that come with no other loan. That makes them a great way to finance your education and establish a good credit rating at the same time.
Indeed, the only reasonable explanation for why someone might fall behind in paying a student loan is that they were simply unaware of the borrower protections embedded in the program. What are these protections?
If you go back to school, go into the military or lose your job, you can apply to postpone your payments for up to three years. This process, called “deferral,” can also sometimes be triggered when you’re in the Peace Corps or the National Guard, as well. If your loans were “subsidized” – i.e. the government paid the interest charges while you were in school – it will pay the interest while you’re in a period of deferment too.
Loan payments can also be deferred if you suffer an economic hardship. This can triggered by falling below a set threshold – 150% of the poverty line based on your family size and state – or qualifying for federal welfare benefits.
If you don’t qualify for a deferment, there’s another program, called “forbearance” that’s a bit more flexible. It can postpone your payments – or reduce the amount you need to pay — for up to one year. However, with forbearance, interest will continue to accrue on your loans.
Income-sensitive repayment plans, which you can switch to at any time, can be an even better option. These programs set your monthly loan payments based on a percentage of your discretionary income. If you have no discretionary income (according to the formula), your payment can be set at zero. Even when the payment is set at zero, you get credit for paying on time, however. And, most of these programs forgive any balance still owed at the end of a set period, usually after 20 to 25 years of consistent payments.
Those who go into a variety of public service professions, from teaching school to law enforcement, may also be able to qualify for federal programs that erase all or a portion of your debt.
These company-sponsored retirement plans pack a one-two punch– government tax breaks and company “matching” contributions — that can make a diligent saver rich. Here’s how they work: You contribute $1000, which comes out of your paycheck before taxes are computed. The government acts like you never earned that money,which saves you $250, assuming you pay 25% of your income in federal and state tax.
Your company is likely to match your contributions, too, often at a rate of 25 cents to $1 to your contributed dollar. Thus, your $1,000 contribution costs $750 ($1,000 minus the $250 tax break) but nets you, say, $1,500 in savings, based on a 50% match. Do that for 20 years and you have just shy of $1 million, assuming a reasonable 8.5% return on a diversified portfolio of stocks and bonds. With a less powerful savings tool, your $750 out-of-pocket outlay would net you a nest-egg worth about half as much.