Make sure your teen has a basic understanding of investing basics, setting savings goals, and responsible use of credit.
Are the young adults in your life making the right choices about employee benefits and retirement accounts? Do they understand how credit ratings and debt-to-income ratios work?
We’re happy to work with your children one-on-one to further their financial literacy. Fortunately, they have time on their side.
The daughter of one of our clients is a bright high school senior who’s preparing to head off to college next year. While her grades and extracurriculars are very good, her parents are concerned about her lack of financial literacy. They asked me to meet with her one-on-one to help her lay a good money foundation for her college years and beyond. Like many of our clients’ children, this young woman was brought up in comfortable surroundings. Her parents were concerned that she’d always expect money to be available whenever she needed it.
Some families impose a harsh reality check on their young adult children, but we’ve found it better to have frank and honest conversations about topics like these in a one-on-one setting:
1. Credit and credit cards. Our client’s daughter had not established a debit or credit card when I first started working with her. She paid for everything in cash or used her parents’ card. We helped her find a good starter credit card in which the limit was not too high. We explained the importance of using the card regularly for necessities such as food, gas, rent, groceries, transportation, etc. – not on splurges. That helped her get used to having a manageable balance every month that was easy to pay off in full. And that went a long way toward building up her credit rating. Once young adults gain a basic understanding of building credit and using credit cards responsibly, they can get savvier. For instance, if they have a card with cash-back rewards or points, encourage them to be the “treasurer” when they go out with friends. They can put the entire meal or bar tab on their card (to earn extra cash back/points) and then have friends reimburse them via Venmo. That way, they’ll always have plenty of cash at the ready to pay off the balance. Not only are they now building good credit, but they’re earning additional rewards in the process. 2. Investing basics. Many teens and young adults we work with think investing is all about finding hot penny stocks on Robinhood or other low-cost brokerage accounts that encourage active trading. We often explain that they’re better off with low-cost mutual fund or ETFs, which may be boring, but are more diversified and thus, safer. We want them to understand the benefits of long-term investing (with specific objectives and goals) versus simply speculating with their friends. Speculative investing isn’t much better than sports betting on their phones.
3. Debt-to-income ratios. Many of our clients’ children in their mid-20s and 30s are considering buying their first home. They must understand how much mortgage debt they can reasonably afford, especially with home prices and mortgage rates still historically high. I bring this up because the debt-to-income ratio for Americans born in the 1980s is higher than for any other cohort, making them especially vulnerable to financial setbacks.
Generally, most new homebuyers will consider taking out a conventional mortgage loan. These loans typically require a down payment of no less than 3% of the property value, a minimum credit score of 620, a debt-to-income ratio of 36% -- the percentage of your gross monthly income that is used to pay your monthly debt-- and a monthly payment that doesn’t exceed 28% of pre-tax income.
When it comes to leasing a home or apartment, one rule of thumb is the 30% rule – they should spend no more than 30% of their gross income on rent. So, if your child earns $3,200 per month before taxes, they should try to spend no more than $960 per month on rent.
4. Employee benefits. It’s important for young adults to understand the value of contributing what they can to an employer 401(k), as well as how the match works and what’s a reasonable amount to contribute at their age, what their investment choices are and how much risk they can afford to take.
It’s also important for young healthy people to understand their options for Health Savings Accounts (HSAs) and Flex Spend Accounts (FSAs). We’ve passed along helpful guidelines and resources to help them determine whether the plans are appropriate for their current needs, how much to contribute and the difference between rollover plans (HSAs) and use-it-or-lose-it plans (FSAs).
5. Saving and goal planning. Young people should learn how to set reasonable long-term savings goals. For instance, if they want to buy a house in the next 10 years, they must understand how much they’ll need to save per month in order to meet their projected down payment and monthly carrying costs. If they need a car to get to their first job, they must evaluate other savings goals before deciding how much car they can afford and whether they should lease or buy. We also want to educate young people about the concept of “pay yourself first.” When their paycheck comes in, they should first make sure they put X% into their 401(k) or other retirement account and Y% into savings for a home or a car. Then any cash left over is their spending money. Finally, it’s about tying in investments to their goal planning. How a young adult allocates their funds is influenced by their time horizon for their funds. For example, if they are looking to buy a car in the next six months, they don’t want to expose that money to stock market fluctuations and risk not having it available for their big purchase. 6. Rainy day fund. Another thing young people often overlook is the need for three to six months’ worth of living expenses stored in a rainy-day cash fund to be used only for emergencies (i.e., job loss, major medical event, or outsize car or home repair). It’s not only a matter of building up sufficient cash for a rainy-day fund, but having the discipline not to tap into it except for true emergencies.
Plenty Of Time To Catch up Three in four young Americans say managing their finances is a strain on their mental health and if you ask the majority of 25- to 35-year-olds feel, they would likely say they feel they’re starting adult life much further behind previous generations when it comes to their finances. It doesn’t need to be this way. We like to remind the young people we work with that they have time on their side. If they start making good money decisions now, they’ll have more than enough time to reach their saving, investing and retirement goals at the appropriate time.
Conclusion As part of our family office service clients, we often talk to their teen and young adult children (without the parents being present if they so choose) about the basics of financial literacy outlined above. If you or a family member has concerns about your children’s financial knowledge or decision-making, please reach out any time. We’re happy to assist.
BRENDEN LEESE, CFP® is an Associate Wealth Advisor at Novi Wealth Partners