When You're Just Starting Out
Q: My late sister left most of her estate to my daughter, who's in her third year at a pricey college, with the belief that she'd use the money for tuition. But my child is already funding her education with grants and loans, and I'd rather she not spend her entire inheritance right now. How can we maximize the value of this gift?
A: Mom, I'm hard-pressed to think of a better use for your sister's gracious gift than making sure your daughter will enter adulthood free of student loans. Using her inheritance to pay tuition is a sound financial move in today's world of low returns. If your child has federal Stafford loans, their fixed interest rate is 6.8 percent. Think of the cash she'd save if she could avoid paying that interest—it would be like earning money risk-free at a rate of almost 7 percent. These days, no safe investment (say, a federally insured certificate of deposit) provides such a high guaranteed return.
Without the burden of monthly loan repayments, your daughter will be able to make contributions to a retirement fund, like a Roth IRA or 401(k), as soon as she starts her career. By using her money to safeguard her financial future, she'll benefit from your sister's gift for the rest of her life.
Q. I'm a 20-year-old soon-to-be college student, and I have $5,000 to put toward savings or other investments. I plan to add $100 to my account every month until I retire. What financial tool would provide the best immediate return while allowing me to spend any earnings I accrue during school?
A: Time for a precollege class on money, my dear. You can't expect to use the same account for saving and investing. Those goals require contrasting approaches, neither of which should involve aiming for quick returns.
With interest rates on savings accounts stuck at 1 percent or lower, there's really no return to be had other than the satisfaction of knowing your stash could keep you from going into credit card debt, taking out a payday loan, or borrowing from friends should you need extra funds. A savings safety net is a smart—but not a moneymaking—move.
When you invest in order to fund a long-term goal like retirement, on the other hand, you should aim to make a significant return and compound your earnings. Let's say you use your $5,000 to fund a diversified portfolio of stocks and bonds that should yield, on average, an annualized 6 percent return. If you continue to invest $100 every month and allow your earnings to grow, you could have about $452,000 in 50 years. (Keep that money in a Roth IRA and your withdrawals will be 100 percent tax-free.) If you make monthly deposits but spend what you earn, you'll wind up with just $65,000.
I recommend that you split your monthly $100 contribution, earmarking $50 each for savings and your investment portfolio. (Once you've set aside the equivalent of eight months' worth of living costs, feel free to invest the entire sum.) And if you want extra cash to spend during college, find a part-time job. That financial plan gets an A-plus.
Q. My husband and I are both 32, and we have three children under 7. Aside from a $2,500 credit card balance, we are debt-free, having recently paid off our house with an inheritance. With the money we used to use for our monthly mortgage payment, we've been saving for retirement and our children's education. But my husband has $75,000 in graduate school loans coming due soon, and I think we should repay them instead of contributing to the kids' college funds. He doesn't agree. What do you think?
A. The short answer is that you are right. Deal with his debts and focus on your retirement savings before you worry about sending your children to school. Here's what else you should do: Take out a new ten-year, $75,000 mortgage and use it to rid yourselves of his loan.
Let's assume your husband has Federal Stafford Loans that charge 6.8 percent interest. In order to repay $75,000 on a ten-year schedule, you'd owe about $860 a month. But if you took out a mortgage for the same amount and time period and put the proceeds toward his debt instead, your monthly payment would be approximately $720. I'd also like you to buy a ten-year, $75,000 term life insurance policy on your hubby (so that the mortgage will be taken care of in the event of his death), which should cost about $15 a month if he's in good health. And there you have it: You've polished off his school debt and saved a ton in interest. (Compare $11,490 for mortgage interest with $28,572 for the student loan.) This strategy could offer even bigger savings if your husband has private loans, which typically charge higher interest rates.
If your husband wants to continue saving for your kids' education as well, you'll need to have a frank chat about your finances. On my Web site SuzeOrman.com, under Suze Tools, you'll find a free expense tracker that can help you identify potential opportunities for savings—money you could set aside for a college fund.
Next: How to save for retirement now