Financial decisions come at you fast at the beginning of your career. As soon as you start earning a regular paycheck, you come face to face with some tough decisions about what to do with your money.
The stakes are high. Figuring out how to manage a budget is a critical step during these early years -- but so is learning the best way to invest money responsibly. Get a handle on these two aspects of your financial life, and you can help set yourself on the road to a comfortable lifestyle. Ignore them in the early years, and you may get into financial trouble like a lot of young people.
How to start investing money in your 20s
The following checklist details 10 moves you can make to avoid trouble and start on the path toward success. In the first section, tips 1 through 5 can help position you to take advantage of the investment opportunities you have early in life. Tips 6 through 10 in the second section lay out how to invest money in your 20s.
These 10 steps may seem like a lot to get done, but don't be afraid. They are in priority order, so you can tackle them one at a time and then move on to the next step. Before you know it, you will have set up a solid financial base before even reaching your peak earning years.
1. Get student loan payments under control
If you attended college, chances are that you've taken on a considerable financial obligation in the form of student loan debt. More than two-thirds of college graduates start their careers with student loan debt, and the average debt burden now tops $28,000.
Don't panic. In most cases, the system is set up to help you handle this responsibility by spreading repayment out over a period of many years and allowing for some flexibility in how you make those payments. Here's what to do:
- Obtain a schedule of loan payments when you leave school, keeping in mind that you may have more than one loan outstanding. You may not be thrilled about the scheduled payments you are facing, but you may be better able to deal with them if you can see what's coming and plan your budget accordingly.
For example, the vast majority of student loans are funded by the federal government, and these loans allow for a grace period after you leave school before you have to start making payments on your debt. Also, federal student loans have programs that allow repayments to be limited to a percentage of your income if you are having trouble making payments.
- Cooperate with your lender. If your loan was issued by a private lender such as a bank or credit union, contact that lender if you anticipate any problems with repayments. Lenders are more sympathetic if you cooperate in working out a repayment plan rather than simply trying to hide from the obligation.
2. Establish a positive credit history
Your credit history is important when you apply for things like car loans, mortgages or credit cards; but you may also find that employers, landlords and insurance companies consider your credit history in deciding whether to hire or work with you.
The best way to establish a positive credit history is to:
- Use credit regularly, but in moderate amounts so that you can readily keep up with your payments. Make sure to keep up with your student loan payments as stated above.
- Get a credit card. Naturally, it is most important to avoid missed or late payments, but even having no credit history at all can count against you. So besides making student loan payments, open up a credit card.
If you have trouble qualifying for a credit card, try getting a secured credit card. Though credit card companies do not always report payments on secured cards to credit-monitoring agencies, they will often allow you to transition to an unsecured card once you establish a history of making your payments on time.
3. Find a bank that will pay you, not the other way around
Once you start earning a paycheck, you will need a checking account and, soon after that, a savings account. Even if you had such accounts while you were in school, you should take a fresh look at them after graduation to see if they are the best fit for your needs.
- Do some comparison shopping. The problem with banks is that most charge monthly fees for checking accounts and pay almost nothing in interest on savings. That means that you pay the bank more than you earn from them. However, you can flip that script if you choose your bank carefully. For tips on how to pay fewer bank fees, read MoneyRates.com Bank Fee Survey.
- Online banks may offer better terms. While traditional, branch-based banks usually charge monthly checking account fees, most online banks do not. You will also find that online banks typically pay more interest on savings accounts than traditional banks -- nine times as much on average. So, online accounts are the best place to look for a bank that offers free checking and a competitive savings account rate -- in short, a bank that will pay you, instead of you paying the bank.
4. Build up an emergency fund
Investing money can get quite complex, but it begins simply by accumulating savings. The best way to start doing that is to set up an emergency fund.
An emergency fund is a reserve of money equivalent to three to six months' worth of living expenses. This can save you from taking on costly credit card debt in the event of an unexpected expense or loss of income. Building up an emergency fund is not only practical; it will also help get you into the habit of saving.
- Best way to invest your emergency fund
In terms of the best way to invest an emergency fund, you want the money to be readily accessible but also earning interest while you are not using it. A savings account is the most obvious choice for investing an emergency fund; but if you are confident that you will rarely need to tap into this money, you might also consider a certificate of deposit. The extra interest you earn on a longer-term CD may more than make up for the rare occasion when you have to pay an early withdrawal penalty.
5. Set up savings-first deposit instructions
Many employers will allow you to have your pay deposited directly into a bank account. While the natural tendency is to deposit your paycheck into a checking account for ease of access, consider having it deposited into a savings account instead.
This will allow you to start earning interest on each paycheck immediately; but, more importantly, it will help you develop a budget discipline. It's all too easy to spend whatever is available in your checking account; so if you only transfer a budgeted amount from savings to checking rather than having your entire paycheck going into checking, it will be easier to limit your spending.
Again, the first step toward investing for the future is saving money.
Best ways to invest in your early 20s
6. Start retirement plan contributions
Once you've been able to accumulate an emergency fund, it is a good time to start investing money in a retirement plan.
- Participate in your employer's 401(k) or 403(b) plan. If your employer sponsors a 401(k) or 403(b) plan, that is an excellent place to start investing for retirement. These plans will provide you with a menu of investment choices, and some plans even match part of what you contribute.
- Reach to qualify for employer-matched contributions. Though money may be tight early in your career, if your employer does make matching contributions, try at least to put enough money in the plan to qualify for the full matching amount available. This is extra money on top of your normal pay that you would otherwise forfeit.
Even if your employer does not make matching contributions, you can benefit by putting money in your company retirement plan because contributions are free from income tax, as are investment earnings on those contributions. You will pay tax when you eventually take money out of the plan, but it has the opportunity to grow tax-free in the meantime.
- Start your own IRA account if your employer does not offer a retirement plan. You can get similar tax benefits by starting your own IRA account.
If your income is still modest enough that you are in a fairly low tax bracket, then you might consider a Roth IRA. A Roth IRA is funded with after-tax money, but you don't pay taxes when you withdraw money from the plan in retirement.
If you have already moved into a higher tax bracket, you might benefit more from a traditional IRA, which means you won't pay taxes till money is withdrawn.
Whether it's an employer-sponsored plan or an IRA, keep in mind that any money you put into a retirement plan has to stay in that plan until you reach retirement age or else you would face a 10 percent penalty in addition to any ordinary taxes due. That's why it's good to still maintain that emergency fund outside of your retirement plan and in liquid assets so you have a cushion against needing to tap into your retirement savings prematurely.
7. Allocate investment assets for growth
Once you start putting money into a retirement plan, it's time to start looking at growth-oriented investment opportunities.
- Stocks - Broadly speaking, stocks offer the greatest potential for growth, but also the greatest uncertainty as to their outcome from year to year. They may go up or down in value. If you are investing for the long-term, you have more time to ride out fluctuations in value and benefit from the growth potential of stocks.
- Bonds - Bonds pay a predictable stream of income, but may go up and down in value. Long-term bonds in particular are prone to fluctuations; but if they are from a reliable issuer such as the US government, a long-term investor can wait out those fluctuations.
Bonds from higher-risk issuers, such as corporations or foreign governments, carry the additional risk that the issuer might not make the promised payments on the bonds. While higher-risk bond issuers typically pay higher interest rates, you should think long and hard about default risk when buying bonds because the role of bonds in a portfolio is usually to provide some measure of stability.
- Cash equivalents - A third major asset class is known as cash equivalents. These are liquid investments in money market funds or similar vehicles. They are designed to be stable and available but pay little interest and have no growth potential.
Since retirement is a long way off when you are in your 20s and money you put into a retirement plan is committed until you reach retirement age, it makes sense to have most of your retirement assets allocated toward longer term growth investments. This means a typical 20-something should be allocated mostly to stocks, balanced out by some bonds while keeping cash equivalents to a minimum.
8. Find a discount broker with the right tools
If you participate in an employer-sponsored retirement plan, you will be presented with a ready-made menu of professionally managed investment options. However, if you invest in an IRA or have enough money to make investments in addition to your retirement savings, you will have some important choices to make.
- Shop for your investment broker. Even before you start considering specific investment opportunities, you will need to choose the right broker to implement your investment decisions. Keeping costs down is an important ingredient in investment success, so look for a broker with discounted commissions.
- Manage brokerage fees like a hawk. Besides comparing commissions, look for a broker with no monthly maintenance or inactivity fees.
- Online brokers compete for your business. Online brokers are likely to offer the deepest discounts. A recent MoneyRates.com study found that the average online brokerage commission rate is $6.61 per trade but that several online brokers offer commissions of $4.95 or lower.
Also, think about what tools you will find most useful. Online brokers offer investment aids that range from stock-screening programs to retirement-planning calculators.
9. Use a retirement calculator to set savings goals
Speaking of retirement calculators, once you start saving for retirement you should do some projections on a retirement calculator to see how much you should save each year to meet your retirement goal.
Don't worry if you can't yet afford to save the full amount needed to meet your goal. Anything you can save will help, and you are more likely to beef up your retirement contributions over time if you know what target you are trying to reach.
10. Invest half of each pay raise
A great technique for building up those contributions is to direct half of each pay raise to retirement savings. You may have trouble finding enough money in your paycheck today to save much for retirement; but, over time, you should receive pay raises which will leave more room in your budget.
If you direct half of those pay raises to savings, you will steadily build up your retirement contributions without having to sacrifice any of the money you've grown accustomed to spending.