Between class, studying and social activities, there is not much time left in the day for most students. Saving for retirement is probably the last thing on your mind – if it is there at all. Personal finance is not taught in school along with other subjects. As a result, college students have to learn for themselves how to invest money and use credit responsibly.
Many students are living on their latest paycheck, while others are drowning in debt. In college, expenses can be high and income is often low to nonexistent. Most students have a hard time keeping up with homework, let alone holding down a job, so they resort to credit cards for daily expenses. To make matters worse, many squander the little money they have on needless consumer discretionary items instead of funding retirement accounts.
Although credit cards are convenient, they can come with a high cost. This is especially true if only the minimum payment is made each month. It could take years to pay off the balance at an interest rate of 10 to 20 percent. Instead of paying interest to credit card companies, you could be earning interest for yourself – an investment that could lead to millions of dollars by the time you retire, allowing you to live comfortably and perhaps even retire early.
The first step to investing is paying off all credit card debt. This can be challenging with no income, but it has to be done before investing. The next step is putting money away in an emergency fund. Most people use an online savings account with a high yield linked to a checking account at their local bank.
After these steps, it is time to think about long-term investing. The best way for most college students to invest is with a Roth IRA (named after the Republican former senator from Delaware, William Roth.) There are some requirements you must meet in order to use this account. First, you must have earned income from an employer. Next, your salary cannot exceed $95,000 for single individuals in order to fund the full amount.
If you meet these requirements, then the maximum amount of $4,000 can be funded for 2007. At this point, the money goes in after you have been taxed through your employer and you will pay no tax when you remove the money at age 59 and a half. There are stipulations for getting the money out sooner, but you should not pull money out of this account because of tax issues. Tax law is constantly changing, so consult a certified financial planner before opening your account.
Now it is time to start investing in your Roth IRA. When the word “risk” is mentioned, people get frightened. However, risk is relative, since all investments have some volatility. The risk with a savings account is inflation risk. Your principal – the amount you originally invested – is safe, but the interest earned may not keep pace with inflation.
Most people are aware of how risky the stock market can be in the short term. However, Standard and Poor’s reported that the market as a whole has never produced a negative return in any 15-year rolling period. Investing in a sensible mix of stocks and bonds has paid off in a big way historically.
Individual stocks carry too far much risk and actively managed mutual funds do not beat their benchmark index consistently. Therefore, keep the majority of your portfolio in index funds. If you plan to fund the full amount up front, then use an exchange-traded fund like SPY or VTI. If you want to put money in every week, then use an index fund that tracks the S&P 500 or Wilshire 5000. After you build these positions up, you can think about adding international stocks, commodities, bonds and real estate investment trusts.
While the Roth IRA can be a great tool, you need to start saving early to have compounding interest work in your favor. Starting at the age of 20, investing $4,000 every year at an average 10 percent return will mean around $3 million come retirement at age 65. Starting at 30, using the same calculations you would end up with $1 million. There is no guarantee for these amounts, but the underlying assumptions show why starting early can pay off in a big way.
The best part is that you don’t have to be a finance major. You don’t even have to be a business major. You don’t have to know what a call option is or how to sell short. Just stick with a sensible indexed portfolio for the long run and use some common sense. With a little planning and hard work, even a layman can become a millionaire several times over.
Ryan Ortega is a business finance major.
