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3 Personal Finance Tips for 20-Somethings

If you're under 30 and already planning for your financial future, you're ahead of the pack. Basically, at this point in your life, you should think of your personal finances as a company's balance sheet. You need to maximize your assets by saving and investing, and control your liabilities by using credit and debt responsibly.

Here are three simple yet important personal finance tips to adopt while you're young. If you can get these three things right early on, you'll be well on your way to a bright financial future.

Know where you want to be

The best thing you can do is set goals for yourself. If you're just aimlessly saving money whenever it's convenient, it's easy to break that habit.

Your goals don't need to be incredibly specific, but they should be clearly defined and reasonable. For example, "I want to open an IRA and contribute $3,000 this year" is a far better goal than "I want to get better at saving money."

You should set specific goals related not only to savings, but also to debt ("I want to pay down 50% of my credit card debt this year"), spending ("I want to spend 20% less eating out"), and any other aspect of your financial life you need to get in order.

Use the right kind of debt

Before you start saving money or investing, you have to get your debt in order. Not all debts are created equal, and there are three main types.

The best kind is debt with low interest that finances something that will (or should) increase in value over time, aka an "appreciating asset." A mortgage on a home is the most common example of this. A loan that you've taken out to start or expand your own business can also qualify as good debt.

The second category, which I like to call "acceptable" debt, carries relatively low interest and finances something worthwhile, like a car. A car gets you to work, allowing you to earn money, so it's an acceptable form of debt to have. Student loan debt also falls into this category. It's a relatively low-interest "means to an end."

Finally, bad debt is what we want to avoid. This includes high-interest and unnecessary debt, particularly credit cards. Credit cards can charge interest rates well in excess of 20%, and "starter" cards designed for younger people tend to charge some of the highest rates.

Even if you're an excellent investor and can earn consistent 10% annual returns on your investments, you'll still be losing money overall if you have high-interest credit card debt. Paying off your credit card balances should be priority No. 1, and it doesn't make sense to invest any new money until your debt is in check.

It's generally fine to invest while you're paying down the "good" kinds of debt, so long as your interest rate is reasonably low and you don't foresee any trouble making payments on your loans. If you can borrow money to buy a house at 4% and your investments average a respectable 8% annual return, you'll come out ahead in the end.

Use your biggest investment weapon

As a younger investor, you have a powerful tool at your disposal: time. The power of compound interest has been referred to as "the eighth wonder of the world," and it truly is. You also have the power to let your money compound tax-free in an IRA or 401(k).

If your employer offers a 401(k) with matching contributions, that should be your top priority. Contribute as much money as your employer is willing to match. After you've maxed out your employer match, an IRA is a good choice for any extra savings, as it gives you a much wider range of investment options to take advantage of. There are two main types of IRAs: traditional and Roth -- read this for a thorough discussion of how each type works. Both 401(k)s and IRAs allow your money to compound tax-free, which lets you take full advantage of the power of compound interest.

Let's say you want to retire with $1 million in the bank at age 65. Your goal may be higher or lower, but let's stick with a nice round number for the purposes of this example. We'll also assume your investments will appreciate at an average of 8% annually, which is actually conservative on a historical basis.

If you start investing in an IRA or 401(k) at 25, you'll need to contribute $322 per month in order to achieve your million-dollar goal by retirement. If you wait until you're 30 to start, your monthly savings requirement jumps to $484. Starting at 35, you'll need to contribute $735 per month, or 2.3 times the savings you would need if you started at 25. This demonstrates the incredible power of compound investment returns, and you need to use it to your advantage.

A final thought

The average American between the ages of 25 and 32 has $12,000 in retirement savings, and the average 33- to 44-year-old has $61,000. According to Aon Hewitt, the average 65-year-old needs 11 times his or her annual salary in order to retire comfortably and make their money last, so you should aim to save much more than average.

If you simply follow these easy personal finance tips, you should be able to easily surpass those figures and set yourself on the path to financial freedom. The most foolproof way to create a stable future is to take control of your financial destiny and save for yourself. That way, any other sources of income down the road, like Social Security, should seem like a nice supplement to your personal nest egg and will not dictate your standard of living as you get older.

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Matthew Frankel
KWMatt82

After several years as a high school math teacher, Matt brought his love of teaching and investing to the Fool to help people invest better. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!

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