Start Your Financial Life Right

A little discipline and new graduates can pay off debt within a year and still stash cash away while maintaining their lifestyle

Holly Cook 9 July, 2010 | 1:23PM
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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 which to prioritise 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 2009 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 mold of the student composed of averages, but this outline can be tweaked to help you think about how to handle your own situation.

How Much Money Will You Take Home?
Let's assume our graduate has a salary of £25,000, the average starting salary for the class of 2009 according to the Association of Graduate Recruiters. After tax, National Insurance and student loan repayments, our graduate's disposable income, or what she actually takes home, equates to just under £1,524 per month--so she's already 'spent' more than 25% of her hard-earned income even before she receives her pay cheque. Note that this take-home figure doesn't include monthly payments into a corporate pension scheme, health or dental insurance schemes, subsidised gym membership, travelcard loan, or any other perks that may come with securing full-time employment.

Priority Number One: Tackle Debt
Graduate employees' student loan payments are taken care of automatically once annual salary exceeds £15,000. The UK's largest survey of student finance, published by Push.co.uk, reveals that students who started at university last year can expect to owe nearly £21,200 by the time they leave. Average graduate credit card debt statistics are extremely difficult to come by in the UK but a ring round friends who graduated between 2003 and 2010 leads me to an average of £1,700 on the credit card and an overdraft balance of £2,250.

These debts should be top priority for our new graduate--interest-free overdrafts may no longer be interest free once you've graduated. The first thing to do is stop charging anything new to the credit cards. Then, see if it's possible to switch some of the debt on higher-rate cards to lower-rate cards. Watch out for balance-transfer fees, however. Next, attack the highest-interest-rate balance, followed by lower-rate balances. There are several calculators around the Web that help determine how long it will take to pay off credit card debt.

Credit card annual interest rates tend to vary from around 12% to 19% (excluding the extortionate rates offered on credit cards for borrowers with bad credit, which often exceed 30%); I'm assuming a rate of 17%, a common rate offered "low-rate" card providers at present. If our hypothetical graduate pays off £100 of credit card debt each month, it will take almost two years to pay off the credit card balance alone.

Let's include another £100 per month towards paying off the overdraft and our hypothetical graduate should be able to pay off both the credit card and the overdraft in two years. But monthly repayments will need to be upped from £200 to a little over £380 to wipe out the debt within a year. This sounds like a lot and reduces our graduate's remaining disposable income to just £1,200 per month, but removing the financial--let alone emotional--strain of debt could be worth 12 months of frugal living and new graduates tend not to have a lot fixed expenses.

Priority Number Two: Set Up an Emergency Fund
Setting aside money for an emergency is probably one of the hardest tasks for people just starting out and one that easily gets pushed into the future. Between living costs, loan repayment, and saving for retirement, most new grads are stretched pretty thin. It can be difficult to eke out more money to set aside. 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 very fact that new grads are already stretched thin makes creating an emergency fund even more urgent. Save some money in an emergency fund even if it means contributing a bit less each month to paying off your credit card.

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 £100 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; moving to cheaper accommodation or getting 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 company retirement plan. 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.

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. Even a generous assumption that your retirement account gains 8% annually is dwarfed by credit card interest of 17%. Paying off credit card debt as soon as possible is crucial to save effectively.

How Are We Doing So Far?
Let's see what our hypothetical graduate's pay looks like now that we've accounted for taxes, student loan repayment, debt repayment, emergency savings and retirement savings. Take-home pay is £1,424 after making a £100 pension contribution (it's not quite 10% but it's a good start, and this is pre-tax so the amount placed in the pension fund and--hopefully--matched by her employer could well exceed 10%). Subtract £384 to pay off credit cards and overdrafts within a year and another £100 for her emergency fund, and there is £1,000 per month left for other expenses.

Priority Number Four: 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 £625 per month for rent and utilities given a salary of £25,000, 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 company retirement plan until you can get your debt under control.)

Assuming our graduate has to contend with London rental prices, the cost of housing herself is going to slice her £1,000 in half in each, but given that this leaves more than £100 per week for remaining expenses, it's certainly doable. Transportation is frequently the next largest cost but will vary based on availability of public transportation. Cycling is free, once you've got your wheels, and many employers now offer cycle to work schemes.

The good news for new grads is that they have a lot more flexibility than other people in terms of their living situation, such as where they live, whether they have roommates, whether they live with their parents 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 paydown before taking on living expenses that are not totally necessary.

The Small Print
I've forced our hypothetical new graduate to comply with my 'best case scenario' in terms of debt paydown and to contend with London prices. This has left her with around £100 per week for food, clothing and entertainment. It's not much, and it doesn't leave much room for holidays or other luxuries, but it will see her to being debt free (excluding student loan) within a year of leaving university. What's more, she'll be in the habit of making good financial decisions and keeping control of her finances--skills that last a lifetime. It's worth remembering, of course, that our new graduate is hypothetical. I certainly didn't start my career on a salary of £25,000 but I also had considerably less than £21,000 in debt. And when you're used to living on a shoestring budget while studying, it's easier to stick with that lifestyle for another 12 months than to enjoy the high life and then have to give up your much-loved luxuries at a later date.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Cook

Holly Cook  is Manager, Morningstar EMEA Websites