You’re right: For young savers, debt does matter

Posted by on September 7, 2012 @ 2:00 pm in Investing

In several of my previous posts, I’ve touched on the importance of starting to save early. It’s a pretty easy case to make—having the benefit of a long time horizon can make a substantial difference in what you can amass over the course of your life. But, as many of you have told us, it can be incredibly difficult for someone just entering the job market to save anything significant.

Here’s one comment I received last year in response to a post with an example demonstrating the different starting early makes:

Vanguard Blog post comment

Vanguard recently held a live webcast on the topic of young investors. Maria Bruno, a senior investment analyst in our Investment Counseling & Research group, addressed several topics to help guide those beginning to invest. During the webcast, a question was posed to viewers: “Which area of personal finance do you feel is most important for young people to understand?” Thirty-six percent said “investing for retirement,” 20% said “creating an emergency fund,” and slightly over 42% responded with “managing debt.”

It’s no surprise that debt tops the list of concerns for young people. After all, about two-thirds of bachelor’s degree recipients borrowed money to attend college, and with tuition rates continuing to rise, the average student graduates with a debt of about $25,000. Graduating seniors also average more than $4,000 in credit card debt. So it’s no wonder that saving for retirement can seem like an unrealistic idea for those who already spend several hundred dollars a month to pay down their debts.

During the webcast, Ms. Bruno received several questions on prioritizing different goals. For those just starting to earn, the day-to-day budgeting of food and other bills can be challenging enough, especially if coupled with monthly loan payments. So how should a young person decide how to best allocate limited remaining funds?

I can’t offer you an equation with an exact answer of how to allocate between various needs—it comes down to trade-offs and balance. Paying down debt reduces the total interest paid over the duration of a debt obligation. On the other hand, beginning to save for long-term goals such as retirement gives you the benefit of compounding, which may ease the burden of having to catch up later.

I had a chance to chat with Ms. Bruno after the webcast, and she shared some additional thoughts on how to prioritize competing goals. While everyone’s situation is unique, this high-level framework provides some useful guidelines:

1. Save up to your employer match in a 401(k) plan. Once you’re vested in your plan, your employer’s matching contributions provide you an immediate 100% return on investment for every dollar you invest.

2. Pay off short-term, non-tax-deductible debt such as credit card loans. Interest rates on credit cards are usually substantially higher than what you would be earning in the market (based on historical averages), so it makes sense to reduce or eliminate these debts as quickly as you can.

3. Establish an emergency fund. The amount you need in reserve to feel secure in case of job loss or an emergency is a personal decision. A good rule of thumb is to maintain a reserve covering six to 12 months of anticipated budgetary needs. Keep in mind that establishing this fund will likely take some time. Contribute whatever you can on a regular basis; even a small monthly amount can add up over time.

4. Save as much as you can in retirement accounts, before saving in taxable accounts. A webcast viewer asked, “What percentage of your paycheck should be going toward retirement at age 25?” Ms. Bruno said it’s good to strive for 12%–15% of salary (including employer contributions). That amount might seem next to impossible for someone just entering the job market. So what can you do? Think about it as a goal, start with what you can, and make an effort to increase your saving rate over time. In a recent article in the Chicago Tribune, Ms. Bruno provided the following illustration:

Suppose that at the age of 25, you make a salary of $40,000. If you start by saving 5% of your salary and increase your contribution rate by 2% each year until you reach 15% at age 30, you would have an ending balance of $633,500 at age 65 (assuming your salary grows 1% per year and that your savings produce a 4% rate of return after inflation). If, instead, you wait until you’re 35 to start saving, you’d end up with only $435,500—even if you save 15% annually.

Note: This hypothetical illustration does not represent the return on any particular investment.

So, the key is to not let debt payments become an excuse to not save anything for retirement. By creating the habit of starting to invest for retirement, even minimally, you’ll set yourself up to keep it as a priority as your income grows.

Another question posed to webcast viewers: “How capable are the young people in your life at managing their finances?” Slightly more than 15% of viewers answered “very capable,” about 63% said “somewhat capable,” and about 20% said “not at all capable.”

Interesting results. What do you think? If you’re a young investor who would self-identify as “very capable” at managing your finances, what steps did you take to get there?


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