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Student Loans or Stocks?

A few days ago, a friend of mine who recently graduated from college asked me an important question that most graduates have faced at one time or another:

Should I pay down my student loans or invest in stocks?

Before I mention the advice I gave him, let me preface it by noting how this decision is tougher than ever these days. For instance, according to the U.S. Department of Education, the average college student now owes $19,200 after he or she dons the cap and gown. For some, the figure is much higher, especially for those who needed to take out additional private loans, which also carry higher interest rates.

The end of the innocence
That first monthly student loan bill can be daunting. Just consider the amounts of these monthly payments:

Amount Borrowed

Monthly Payment*

$20,000

$230

$40,000

$460

$60,000

$690

*Source: Studentloan.com; assumes 6.8% interest rate and 10-year level repayment

Considering that most entry-level employees make less than $2,000 per month after taxes, you can begin to see how debilitating student loan payments can be. For some, those payments represent 30%-50% of monthly income. In essence, it's a mini-mortgage for many of these young adults.  

After rent, food, student loan payments, and other miscellaneous expenses, today's 20-somethings have very little left over to save or invest. It's imperative, however, that they find a way to do just that.

Make a dollar out of 15 cents
The advice I gave my friend was to try to at least pay down some of the principal on his loans, but to also get into the habit of paying himself first. That could mean just $50 or $100 a month now, but that type of financial discipline today will benefit him down the road.

But what to do with that $50 or $100 per month can also be challenging.

Many financial pundits will advise socking away six months of expenses in a high-yield savings account, but that's virtually impossible for the struggling youngsters. Instead, begin by shooting for $1,000, which should help cover any unexpected expenses (i.e., car breaks down, an insurance deductible, etc.). This cash cushion will also steer you away from bad debt, like credit cards.

After you've built up a $1,000 cash cushion, start an IRA, specifically a Roth IRA. With a Roth, all contributions you make are in after-tax dollars, and being that most college grads start in lower tax brackets, now is the time to make the most of those contributions. What's more, you won't pay any taxes on the withdrawals from a Roth IRA during retirement.

Pay to play
Two of the biggest obstacles when starting an IRA are with whom and in what to invest.

Investment firms like Vanguard, Fidelity, and T. Rowe Price are battling for your retirement funds, but some are more cost-effective for young investors. Vanguard and T. Rowe Price require initial IRA investments of $3,000 and $1,000, respectively, for most of their funds, which may be too high of a price point for struggling grads.

But Fidelity's "Simple Start" IRA plan, which requires just $250 to start (and $200 automatic investments each month) may be a great place to start for those looking to build their first portfolio. One of the funds Fidelity offers under this plan is the Fidelity Freedom 2050 Fund (FFFHX), designed for those expecting to enter retirement age around 2050. As you reach retirement age, the fund will automatically invest in more conservative instruments like blue chips and bonds.

Freedom 2050 is a "fund of funds," meaning it is made up of other Fidelity funds, and gives you broad exposure to large domestic stocks like Johnson & Johnson (NYSE: JNJ  ) , AIG (NYSE: AIG  ) , and Procter & Gamble (NYSE: PG  ) , while also diversifying your assets into international stocks such as GlaxoSmithKline (NYSE: GSK  ) and Toyota Motor (NYSE: TM  ) .

Get in the game
No matter which investment firm or mutual fund you choose, it's important for young adults to get started investing right now. Put compounding interest to work for you as early as possible, and reap the rewards later in life. You'll be glad you did.

Want to learn more ways to improve your financial life? Consider a free 30-day trial to Motley Fool Green Light, the Fool's personal finance service. Each month, the service promises to help you find ways to save at least $450.


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