Some Financial ABCs for Generations X and Y
Generations X and Y--the twenty- and thirty-somethings who are still getting their financial lives started--can make their future more prosperous by avoiding a handful of financial myths that have been bedeviling adults for decades.
What’s myth and what’s the truth? A guide.
Myth No. 1: Take any job you can get. You need to work to pay your bills.
Reality: It is better to be working than to be unemployed, of course, but avoid taking “just any job,” says Nancy Dunnan, author of “Your First Financial Steps: How to Manage Your Money When You’re Just Starting Out.”
However, don’t wait for the legendary “dream job”--most entry-level positions are decidedly un-dreamy, she adds. But make sure the job you take has potential to develop into what you want--or gives you pertinent experience. Dead-end jobs can prevent you from obtaining more lucrative and satisfying work. That’s hardly worth the trade-off for a paycheck.
If you can’t find a full-time position doing what you like, consider signing up with a temporary agency that serves your target industry, Dunnan adds.
Myth No. 2: I’m too young--and have too many other financial goals--to worry about saving for retirement. I’ll save for retirement after I buy a house and a car.
Reality: Money saved early will compound over the years so that it will grow to be many times the same amount of money saved later in life.
But regardless, saving for retirement can actually help you get the house or car--if you have access to the right type of retirement savings account: a 401(k) plan that allows participant loans, to be specific.
Most of the nation’s biggest employers--and about half of all employers nationwide--offer such plans. Better yet, many companies offer contribution “matching.”
How exactly does that help you buy your house? Let’s say you work for a company that has a 401(k) plan. You can contribute up to 12% of your income; the company will contribute an amount equal to 50% of the first 6% of your contributions--a fairly common arrangement. The plan allows you to borrow up to 50% of your account value for major purchases and medical emergencies--also fairly common.
You earn $25,000, or $2,083 a month, and contribute the maximum of $250 a month, $3,000 a year. The company kicks in $750 annually--50% of the first 6% you contribute. In five years, assuming you earn 8% on the money invested, you have nearly $23,000 saved and can borrow out $11,500 to buy your house.
You’ll pay interest on the 401(k) loan, but the bulk of the payment--everything but a small processing fee--goes back into your own account.
Myth No. 3: I can’t afford to save.
Reality: Saving is a matter of priorities, not income, Dunnan says. If you want to save, you can cut out small luxuries--daily trips to the vending machine, the expensive cup of espresso you buy on your way to work, or lunch every day in a a restaurant.
If you cut out just $1.70 worth of expenses every day, you’ll have $50 left over each month to save. That’s enough to sign up for an automatic investment plan with a mutual fund--or to kick into your 401(k).
Save just that $1.70 a day over a career, for example, and you’ll have about $175,000 when you’re through. (That assumes an 8% average annual investment return over 40 years.)
Myth No. 4: Buying a home is better than renting because when you buy, you build equity. When you rent, your payments go for nothing.
Reality: Buying can be a savvy financial decision, but not always. In addition to monthly mortgage payments, you incur expenses for insurance, property taxes and utility costs. A home could need improvements and a condominium could mean steep monthly fees.
As a result, a house or condo that could cost $500 a month to rent might cost $800 a month if you bought it. And there are more risks in owning, from uninsured disasters to neighborhood changes that might reduce its value.
A savvy renter can invest that $300 monthly difference and, possibly, end up ahead of the buyer in the long run. But of course, the money must be saved, not spent.
Consider a hypothetical example. Sally, a renter, has $10,000 that she can invest in a mutual fund or in a $100,000 house that’s similar to the home she now rents for $600 a month.
However, if she buys the house, the after-tax cost of her home--taking property taxes, insurance and tax deductions into account--is $850 a month. If she opts to rent, she’ll invest the $250 difference between her rent and the projected mortgage payment in equity mutual funds.
Which gives her the most equity at the end of 30 years? The answer depends, of course, on how fast her rent costs increase and how much each investment appreciates over time--things no one can predict for sure.
However, in the past, houses have tended to rise slightly faster than the rate of inflation. Inflation has averaged 3.13% over the last 70 years, according to Ibbotson Associates, a Chicago-based economic research and consulting firm. Stocks, on the other hand, have tended to rise by 10% a year, according to Ibbotson. So, if you assume the house appreciates by about 4% a year and the mutual fund by about 10% a year, you find that Sally was wiser to rent.
Her house, which she’d own outright after 30 years, would be worth $331,350 in this scenario. However, the mutual fund would be worth $763,495.
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Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or message kristof@news.latimes.com on the Internet.
