By Jon Cook
Did you know getting a diploma is worth money? Everyone knows a degree can increase your earning potential, but your degree also is worth money in the short term when friends and relatives fork over cash to congratulate you.
While you probably would like to take your graduation gift money and "make it rain," this money can help you set yourself up for a healthy financial future. Aim to quench your spending thirst with 10% to 15% of the total gift money, and think hard before spending the rest.
"We want to encourage new grads to celebrate, but, at the same time, keep in mind that you want to have a strong financial platform under you," says Virginia Sullivan, vice president of consumer education at Bills.com, San Mateo, Calif.
Once you spend your fun money, keep the following in mind. Financial experts rank these items from most important to least important:
- Bad debt: Pay off bad debt. This means paying off credit cards, because they're probably the worst debt you have when you consider interest rates.
"The average college student graduates with $4,000 in credit card debt," says Sullivan. "If these people aren't able to secure a job right after school and miss payments, it will affect their credit score, decreasing the chance they will be able to secure an auto loan or mortgage in the future." A poor credit score can even affect your ability to land a job—many prospective employers now check your credit history before offering a job.
How can your credit card debt get out of hand? Two words—compounding interest.
Compounding interest means that interest applies to accrued interest as well as to the principal amount. Your credit card balances could have compounding interest of 20% or more.
So, let's say you have a balance of $100 on your credit card with 20% interest, and you pay $10 for the month. The interest will apply to the $90 you didn't pay, and when the next bill comes, you will owe $108. Then, if you don't pay off the balance the next month, the interest will apply to the entire $108 balance, not just the initial $100 balance.
"It's become excessively easy to rack up charges on a credit card and not pay off the bill at the end of the month," says Judith Cohart, president of the Personal Finance Employee Education Foundation, Alexandria, Va. "We just saw the negative side effects of irresponsible credit spending in the U.S. economy."
If you don't already have a credit card from your credit union, now is a good time to get one. Credit union credit cards generally have lower rates and fees than credit cards from banks. Talk to the professionals at your credit union to find out about credit union card options.
- Insurance: Make sure you have auto, health, disability, and renters insurance expenses covered. If you have a significant other who depends on your income, you should add a life insurance policy to the mix.
"Without proper health and auto insurance, you could be one accident away from bankruptcy," says Jim Holtzman, financial adviser at Legend Financial Advisors Inc., Pittsburgh.
- Starter fund: You'll need some money set aside for day-to-day, month-to-month living expenses. This includes items such as rent, groceries, gas, and cell phone.
This account should have two to three months of living expenses all the time, so you don't have to live paycheck to paycheck.
- Emergency reserve: Put some money away for emergencies. Car repairs, doctor and veterinarian visits, job loss, or travel due to family emergency can require money ASAP.
- Down payments: Depending on where you live, if you don't own a car, you may have to think about buying one. You could use some of your graduation gift money as a down payment. But, don't go this route unless you've checked off the other items on this list.
If you have secured a job, and you know you want to stay in the same city for the next three to five years, you might think about using this money as part of a down payment on your own house.
The folks at your credit union can help with vehicle and house buying processes as well.
- Student loans: Take a look at your student loans, which usually carry an interest rate of about 6% to 8% if they are federal loans. The good news is that you can write off the paid interest on your federal taxes.
If you have private student loans, pay them off before federal loans.
- Long-term savings: While you might wish you could go directly from graduation to retirement, you most likely won't be able to. But that doesn't mean you can't start planning for retirement. If you have earned income, a great way to plan is to invest in a Roth IRA (individual retirement account).
If you wait until you've reached age 59 ½, you can take money out of a Roth IRA tax-free. Assuming you start contributing to an IRA when you're young, this could be a sizable amount. This is where compound interest can work in your favor. You'll not only earn interest/dividends on your contributions but on the interest you're earning as well.
Once you're able to secure a job with benefits, look at 401(k) plans that your employer offers and other tools that will help build a healthy retirement fund.
- Vacation: Thinking about going somewhere exotic to celebrate your accomplishment? If you can afford it, there's great value in experiencing the world.
Thinking long and hard about where this money should go can improve your financial situation, and that's important. Remember, using this money to plan for your future can benefit you just as much as making foolish financial decisions now can hurt you.