Get With The Plan: July 21, 2013

72113Valerie has a pretty clean financial slate. She’s 22, college is over, and she has a salary to count on.

“I’m just getting started with my first real job and I want to be smart about my money,” she says. “I want to stay out of debt, get rid of my college loans and save for the future.”

Eventually, she says, she wants to buy a condo or a house, and her parents are helping in that regard. Valerie lives at home, rent-free, so she has a cushion of cash to save each month.

Valerie, whose name has been changed, has saved $5,600 in a savings account and $2,100 in checking. She has three college loans totaling $31,510 and no credit card debt.

The Star-Ledger asked Brian Power, a certified financial planner with Gateway Advisory in Westfield, to help Valerie set up her finances for success today and long into the future.

“Valerie deserves a pat on the back for searching out financial advice at such an early age,” Power says. “I’m impressed. Many young adults Valerie’s age are more worried about what bar they’ll be meeting their friends at next versus how to best manage their newfound income.”

Power says his advice to someone just starting out is to always live within your means and carry as little debt as possible.

“Living within your means will allow you to handle more things financially in your life as they come up and not have to go into debt to accomplish your goals,” he says. ” In my 20-plus years advising individual and families, people with modest lifestyles and no debt have the highest probability of a successful retirement plan.”

Power says the first thing Valerie should do is to pay off her college loans as quickly as possible. With Valerie’s $62,000 salary, her take-home pay will be significant for a young adult right out of college and still living at home, Power says.

Her base take-home pay should be approximately $3,800 a month, Power says, so Valerie could put $1,900 per month toward her student loans, paying them off in less than two years. If she does get a bonus from her job, she should use it to pay down the loans even further.

“The interest rates on the loans are too high versus what return she can get at the bank, so it doesn’t make sense to accumulate any significant savings while the loans are still outstanding,” he says.

Without rent or a mortgage payment, Valerie can use the remainder of her take-home pay, approximately $1,900 a month, to support herself and to start accumulating a savings account.

Once the student loans are paid, she can start saving for a down payment on a home. Power says her goal should be to put a 20 percent down payment on a home.

“With 20 percent down, Valerie will avoid having to pay private mortgage insurance — PMI,” he says. “If your down payment on a home is less than 20 percent of the appraised value or sale price, your lender will require you to get mortgage insurance.”

Power says mortgage insurance protects your lender in case you default on the payments. You pay the premiums, and the lender is the beneficiary. PMI fees vary, depending on the size of the down payment and the loan, from about 0.3 to 1.15 percent of the original loan amount per year — something Power calls an expensive proposition.

Valerie can contribute to her employer’s 401(k) plan in October, and she has a traditional 401(k) and a Roth option. Power recommends she split her contributions evenly between the two types of accounts.

“Not knowing where tax rates will be during Valerie’s retirement years, it makes sense to have both taxable and tax-free retirement income sources,” Power says.

He recommends she start by contributing enough to get the full employer matching funds.

“The employer match is a generous benefit and is used to entice employees to participate in the 401(k) plan, so you do not want to leave money on the table,” he says.

He says forming good retirement saving habits early on will stick with Valerie throughout her working years. When she gets used to having the money automatically taken from her paycheck, she won’t miss it as she encounters other financial demands.

Power admits some might question a plan to pay off debt before investing, he said, so the decision depends on the individual. If someone doesn’t want debt, they should pay it off.

For starters, he says, the interest rate on her loans is too high to try to arbitrage by directing income toward her 401(k).

“Could she be better off financially by only paying the minimum payments on her loans and taking the difference and contributing pre-tax to her 401(k)?” he says. ” From a tax standpoint absolutely, but her effective tax rate is only approximately 20 percent including New Jersey income taxes, so she is not realizing tax breaks at the upper brackets. So in the long run, the temporary tax savings she’ll be missing won’t affect her long-term financial success.”

She’ll need the tax breaks from contributing pre-tax to the 401(k) more down the road as her income rises, he says.

Looking at the debt-payoff issue from a return-on-investment standpoint, it’s an unknown. Power says our capital market assumptions are expecting stocks to return just over the interest rates she is paying on her loans — and that is not certain whatsoever.

“Paying down debt is a certain return on your money since you’re keeping the interest payment instead of the lender getting it,” he says.

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