New graduates entering the working world are welcomed with a salary, quickly followed by a host of expenses that make the new-found earnings seem much less impressive. Covering student loans, credit card debt, retirement savings and living costs is a balancing act, but learning to prioritize and mapping out monthly expenses will make meeting your financial obligations more manageable.
Let's take a look at how a hypothetical new graduate (based on Statistics Canada national averages unless otherwise noted) should allocate her money to see how all the demands play out. Most real graduates won't neatly fit the mould of the student composed of averages, but this outline can be tweaked to help you decide how to handle your own situation.
How much money will you take home?
Let's assume our graduate has a salary of $45,000, the national median income for university graduates with a bachelor's degree. I used this calculator to see how much the graduate would take home each month. Assuming monthly pay periods, filing as a single, and contributions to Canadian Pension Plan and Employment Insurance, the average monthly take-home pay is approximately $2,790.
Priority number one: Tackle credit card debt
Along with that average starting salary, our graduate also has the average amount of credit card debt, which is $2,200.
The first thing to do is stop charging anything new to the cards. Then, see if it's possible to switch some of the debt on higher-rate cards to lower-rate cards. However, watch out for balance-transfer fees. Next, attack the highest-interest-rate balance, followed by lower-rate balances. There are several calculators around the Web, such as this one from Bankrate, that help determine how long it will take to pay off credit card debt.
Interest rates are varied, but I'm assuming a rate of 19%, the average interest rate of credit cards targeted at students distributed by major banks in Canada. If our hypothetical graduate only pays $100 each month, it will take two years and four months to pay off the balance. However, monthly payments of $200 knock the time down to one year and one month. Stretch the money a bit further and it would take $202.74 a month to wipe out the debt within a year, which is a worthy goal for a new grad without a lot of fixed expenses. New grads with higher credit card debt loads should aim to pay even more to service their debts each month.
Priority number two: Set up an emergency fund
Setting aside money for an emergency is one of the hardest tasks for people just starting out and one that easily gets pushed into the future. Between living costs, student loans and saving for retirement, most new grads are stretched pretty thin.
But a margin of safety is essential in case something goes wrong, and it can also keep our new grad from having to rely on high-cost credit card debt when she's in a financial pinch. Actually, the fact that money is so tight for new grads makes creating an emergency fund even more urgent.
Typical financial-planner wisdom says to set aside enough to cover three to six months of living expenses. That's a good goal, but isn't very realistic for someone just starting out. To begin, try to set aside a few hundred dollars each month in case you need to pay for something unexpected, such as a car repair. New grads can also get by without saving as much in an emergency fund because they have more flexibility than a lot of people; getting a cheaper apartment, a roommate or a part-time job are also options for those who need extra cash.
Priority number three: Save for retirement
Regardless of your life stage, it's a good idea to sock away at least 10% of earnings in a retirement plan, whether through your employer or on your own. If that's too lofty a goal for a new grad, investing enough to earn any employer matching contributions is a good starting point. Failing to contribute enough to earn the match is not just short-changing your retirement, but also turning down free money. The tax savings are also considerable and provide an added incentive.
One time when it may make sense to temporarily put retirement savings on the back burner is if you have a large amount of high-interest credit card debt and you do not have the resources to both pay it off and contribute to your retirement plan. Gains for investing in a retirement account average about 8% annually according to most estimates. That's certainly important, but less impressive when compared with paying 19% interest on credit card debt. Paying off credit card debt as soon as possible is crucial to save effectively.
For new grads who have their debt under control and are in a position to sock something away for retirement, investing via a registered retirement savings plan can be a great option. Any amount you put in an RRSP can be deducted from your earned income for tax purposes. You can use Morningstar's RRSP Calculator to see how much tax you would save for any given level of RRSP contribution.
It's also a good idea to check with your employer to see if you are able to make your contributions with pre-tax dollars, which would reduce the amount of taxes deducted from your paycheque at the source.
Priority number four: Pay student loans
The average university student who graduates with a bachelor's degree carries a debt of $20,400. While not an insignificant amount, it's not too terrible given that financial-aid experts suggest borrowing no more than half of your expected starting salary. Still, our graduate will need to balance chipping away at loans with other investments that could make better financial sense. Paying student loans off quickly means paying less in interest over the life of the loans, but that doesn't necessarily make throwing all extra cash into loan repayment a good idea. Interest rates are low compared with credit card debt, and investing could offer a better return.
There are useful calculators at Finaid.org that show what monthly payments are required to pay off your loans within a set number of years and how much interest accrues depending on the length of repayment. Or, in a more positive light, you can also see how much money you can save by making extra payments.
Using a standard 10-year repayment plan with the average debt of $20,400 and a 6.8% interest rate, monthly payments for our average graduate would be $234.76. At the end of the 10 years, she will have paid $28,171, almost $8,000 of which was interest. If she were to pay an extra $50 each month, she could pay off her loans two years early and save more than $2,000 in interest. Don't make any extra payments on student loans until you've paid off all your credit card debt, however, because credit cards have much higher interest rates.
How are we doing so far?
Let's see what her pay looks like now that we've accounted for taxes, debt repayment and retirement savings. Take-home pay is $2,511 after making a 10% RRSP contribution.
Subtract $202.74 to pay off credit cards within a year and $234.76 to pay down student loans on a 10-year schedule, and there is $2,073.50 left for other expenses. That should also leave enough money to store in an emergency fund.
Priority number five: Cover your living costs
Of course, our new grad still needs to pay for housing, utilities, food, transportation and entertainment. These will vary depending on location, but the general guideline is not to spend more than 30% of gross income on housing. That works out to a maximum of about $1,125 per month for rent and utilities given a salary of $45,000, but our graduate should aim to spend much less if possible. If you're forced to cut something to get your debt and savings in order, living expenses should be the first place to look for savings. (If you're still having a hard time after cutting living expenses, temporarily decrease your contributions to your retirement plan until you can get your debt under control.)
Assuming a worst-case scenario where rent and utilities do cost all $1,125, our graduate would have $948.50 left over for all other expenses. Transportation is frequently the next largest cost but varies based on availability of public transportation.
The good news for new grads is that they have a lot more flexibility than other folks in terms of their living situations, such as where they live, whether they have roommates, whether they live with mom and dad for a few years before striking out on their own, whether they have a car, and so on. Strongly consider taking advantage of some of these chances to save money. You'll do yourself a huge favour by getting in a good place in terms of an emergency fund, retirement savings and debt repayment before taking on living expenses that are not necessary.
And if you're lucky enough to have extra money after covering your living expenses, wipe out your credit card balance and then consider contributing more to retirement savings or repaying student loans. Paying down student loans ahead of time offers a guaranteed return (equivalent to the interest rate on the loans, probably about 6.8%), but it's possible to earn a better long-term return by investing.
--With files from Ashley Redmond
