A little knowledge now can prevent a lot of heartache in the future.
IT'S ONE THING for husbands and wives to spend freely when they have relatively few responsibilities. But add a small bundle of joy to the equation, and everything changes. In addition to the rent (or mortgage) and car payments, parents must worry about ballet lessons, soccer cleats and, oh yeah, college. It's enough to keep people up at night.
Mistakes are inevitable. The good news is that it's almost never too late to get back on track. Here are six of the most common financial errors that young families make. In this case, forewarned is forearmed: Avoid these mistakes now, and you'll be way ahead of the game later on.
1. 'What's Wrong With a Little Debt?'
The biggest mistake young families make is carrying too much debt, says Stewart Welch, a certified financial planner and author of the "10 Minute Guide to Personal Finance for Newlyweds." "It happens very early on in a marriage," he says. And once couples owe several thousand dollars, they find it gets harder and harder to crawl out from under that burden.
It's OK to carry some debt. Families just need to make sure they don't overextend themselves. Lenders such as Washington Mutual believe that a mortgage shouldn't eat up more than 28% of a couple's gross income. Overall debt, including car loans, student debt and credit cards, shouldn't exceed 40% of gross income. Some financial planners, however, believe that these guidelines are a bit lax. Welch recommends total debt of no more than 30% of take-home pay (not counting 401(k) contributions). That's quite a difference.
Auto debt is a bit tricky. On the one hand, financial planners agree that it's best not to borrow money for a depreciating asset. But sometimes, it just can't be avoided. Few young families can afford to pay cash for a new car — especially if they just used up all of their savings for a down payment on a new home. The solution: Keep your car long after the loan is paid off. That way, you can cut back on auto payments and start saving some money for your next vehicle, says Marilyn Steinmetz, a certified financial planner based in West Hartford, Conn. A good Japanese car, for example, should hum along for 10 years. (For more, see "Help! I'm Drowning in Debt.")
2. Flying Without a Budget
A close cousin to the debt problem is poor budgeting. Young couples tend to underestimate their expenses by 20%, says Steven Kaye, a Watchung, N.J.-based financial planner. The problem: They spend first and plan to save whatever is left. Unfortunately, there's often nothing remaining in the kitty at the end of the month.
Kaye recommends couples make a budget. First, tally all expenses, including savings goals for retirement and college planning. Then families can spend whatever is left. Be warned: This may be an eye-opening experience. "We generally find even the most intelligent people have holes in their (budgeting) plans," says Kaye. (For more on budgeting, see "What's Your Cash Flow?")
3. Retirement Is Decades Away, Right?
Many young couples just can't get their heads around the importance of saving for retirement. While they focus on short-term goals, such as saving for a new minivan, they fail to max out their 401(k), or even contribute enough to qualify for their employer's match, says Steinmetz. That's like walking away from free money.
Couples need to understand that the longer they wait to start saving for retirement, the more they'll need to stash away later on. While someone in his 20s can get away with investing just 10% of his income in his 401(k), someone in his 30s will have to set aside at least 12% in order to fund a comfortable retirement, says Welch. If he waits even longer, he'll find himself working long after his peers have hit the golf course full time. (To see the magic of compounding, try our 401(k) planner).
4. Who Needs Insurance?
Let's face it: There's a lot of bad advice out there on insurance. Perhaps that's why so many young couples are underinsured. The most common error people make is that they buy expensive products, like whole life insurance, for too little coverage. "They might purchase $100,000 of whole life when they could have had $1 million of term (life insurance) for a quarter of the premium," Welch says.
As a general rule, most young people should have a term life policy worth five to 10 times their annual income. The planners we spoke with said parents shouldn't be surprised to find they need at least a $1 million policy. A 35-year-old healthy, nonsmoking male can purchase a 30-year term life policy for roughly $1,000 a year, according to Insure.com. (For more on life insurance, see our story.)
Another shortfall: inadequate disability coverage. Most Americans get some from their employers. But unless you think you can live on, say, 60% of your salary, you'd better purchase more coverage, either through your employer or on the open market, to fill in as much of the gap between your employer's plan and your current income as possible. How much will this cost? It varies greatly based on health, income, occupation and other factors. Just as an example, a 35-year-old healthy male working at a desk job can pick up a policy for about $45 a year for every $100 a month in coverage, according to insurance provider UnumProvident.
5. College Tuition Is How Much?
SmartMoney.com projects that, in 18 years, a four-year private university education will cost more than $300,000. Parents who want to help their children pay for school should start saving now. Fortunately, there are a couple of tax-friendly vehicles, including 529 plans and education savings accounts, that can help get the job done. Setting aside a little bit every month can prevent a lot of headaches later. To find out how much you need to save, click on our college-savings calculator.
Sometimes, of course, there isn't enough money to go around. Yet many parents continue to set aside funds for their children's education when they don't have enough to pay off their high-interest credit-card debt or fund their own retirement accounts. You might not want to hear this, but junior's education should be down toward the bottom of your list of priorities. While he or she can borrow money for college, couples can't borrow for retirement, says Kaye. For more on financial aid, see our story.
6. What Rainy Day?
You've heard it before: Everyone should set aside three to six months of salary for a rainy day. That way, there should be enough to live on in case of an unexpected job loss or medical emergency. Unfortunately, this can feel like an impossible goal for folks with small kids. Who has that kind of cash saved up after buying a new home or car or paying for childcare? Don't let the difficulty of the task dissuade you from trying. In a weak job market, it's more important than ever to create an emergency account. Remember, every little bit counts.
Here's another idea for those with some self-restraint. Welch suggests applying for a home-equity line of credit. Just promise yourself that you won't tap into it unless there's a true emergency (and, no, a plasma television doesn't count). According to Bankrate.com, a homeowner can get a home-equity line of credit with an interest rate below 4%. That's much lower than the average credit-card rate, which sits somewhere in the midteens. And Uncle Sam will even allow most homeowners to write off the interest payments on a loan of up to $100,000.