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Family Finances

5 Keys to Building Wealth in Your 20s

Just starting out? Follow our advice for tending to your finances and you’ll reap big rewards.

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Wealth may seem a far-off prospect when you’re in your twenties. But the personal finance habits you establish now will help you manage (and accumulate) money in the years ahead.

See Also: 10 Financial Commandments for Your 20s

Know where the money goes. By creating a budget, you earmark for spending money that you’ve already made, not what you expect to make, says Philip Olson, a certified financial planner (CFP) in Austin, Texas. You also set priorities. Track your spending using a spreadsheet or a budgeting tool (see 4 Tools That Make Budgeting Easy), breaking your monthly expenses into a few categories (such as housing, entertainment, debts and savings). Then impose limits based on your spending history and monthly income. If you bust the limit on one category (or fall short on saving), you’ll have to pull money from another. Be realistic: If the limits are overly ambitious, the budget won’t stick.

If you’d rather keep things simple, forget about categories. Cristina Guglielmetti, a CFP in New York City, recommends calculating an overall cap for your variable monthly expenses, including food, entertainment and bills that you could reduce if need be (such as clothing or your cell-phone plan). To come up with your variable-expense cap, subtract from your monthly income all fixed expenses—rent, utilities, debt payments, and savings for your emergency fund or future goals. Use a rewards credit card for the variable charges. That way you can easily track spending, set up alerts when you’re nearing your cap, and earn some cash back in the process.

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Build a credit history. The longer you demonstrate that you handle bills and debts responsibly, the stronger your credit history will be—and the higher your credit score. When it’s time to buy a home or a car, your credit history could help you qualify for lower rates or better terms.

Start by ordering a free annual copy of your credit report from all three of the major bureaus. Make sure student and other loans are reported correctly. One of the most important factors in boosting your score is paying bills on time. Your score will also benefit if you keep your overall charges, or “utilization,” to less than 30% of the limit on each credit card. Keeping your spending low will also allow you to pay off your balance in full each month and not rack up interest charges.

If you have trouble qualifying for your first credit card, start with a secured card (one that requires a deposit), such as the Secured MasterCard from Capital One. Use the free tools at CreditKarma.com and CreditSesame.com to monitor your credit reports and credit score every couple of months.

Start an emergency fund. A cash stash can bail you out if you have an unexpected medical or car-repair bill, or come to the rescue if you suddenly lose your job. “It also allows you to make better decisions,” says Guglielmetti. “You can walk away from a job that’s not right for you.” Ideally, this fund should cover six months of essential living expenses, including rent, food and bills. Keep it out of sight and out of mind in a savings account.

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To get the ball rolling, set up an automatic transfer from your checking account to savings; if money is tight, start with, say, $20 a week. Once you’re in a saving mindset, you’ll be more likely to add bonuses and income from side gigs, says Pam Capalad, a CFP in New York City. If you have debts to tackle, sock away at least a month’s worth of emergency reserves as a priority. Then work on your debts while continuing to shore up your emergency fund, even if that means paying down your debt more gradually.

Invest in your 401(k). You probably won’t touch your retirement account for decades, but seeding it now will pay off handsomely when you’re ready to retire. Suppose at age 25 you put $500 into a mutual fund and then add $100 each month. Assuming the fund earns an 8% annual return (tax-deferred), you’ll have more than $335,000 by the time you’re 65. If you wait until you’re 35, invest $2,500 and then add that $100 a month, you’ll have only about $167,000 by age 65.

Start by contributing enough to snag the employer match. Many companies match contributions dollar for dollar between 4% and 6% of your salary. Increase your deferral over time so that eventually you’re adding at least 10% of your annual salary. Contributions to a traditional 401(k) plan are pretax, but consider using a Roth 401(k) if your employer offers that option. Deposits to a Roth are after-tax, but you’ll be able to withdraw the money in retirement tax-free. (Your employer’s contributions will go into a pretax account.) Or you could split contributions between your 401(k) and a Roth IRA. (For more on Roth IRAs, see Reap the Rewards of a Roth IRA.) Allot most of your portfolio to low-cost index funds, with a mix of U.S. and international stocks. Or invest in a target-date fund, which tweaks your mix of stocks and bonds as you get closer to retirement.

Manage your student loans. Among college students who borrowed in 2014, the average debt was $30,200 for those who attended four-year private colleges and $25,500 for public-school borrowers. A typical monthly payment on $30,000 in federal loans is about $310. That’s not a crippling amount, but it’s not a breeze to come up with that kind of money each month, either. When you’re about to enter the repayment period, take a close look at how much you owe and your interest rates. A loan-management tool, such as the one at Iontuition.com, can help you organize and track your loans. Or you may choose to consolidate your federal loans under one lender and rate.

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The most straightforward option for federal loans is the standard 10-year plan—you pay the same amount each month until your loan is repaid. But if loan payments are taking too big a bite out of your income, you can choose a repayment plan that stretches the loan over a longer period of time or gradually increases monthly payments. Or you can choose an income-based repayment plan, which lets you put 10% to 20% of your discretionary income (the amount by which income exceeds $17,820 in 2016) toward your loans for 20 to 25 years, after which any remaining amount is forgiven. You’ll typically pay more in interest under these plans.

To see which plan best fits your budget, use the US Department of Education's Repayment Estimator, found under “Managing Repayment.” No matter which repayment plan you choose, sign up for automatic debit. You’ll typically qualify for a 0.25-percentage-point reduction on your federal interest rate.

See Also: QUIZ: The Personal Finance Quiz