Hundreds of thousands of Americans were planning, until very recently, to scrimp and save to spend decades to come paying off cumbersome loans. Now, under Biden’s debt plan, that equation has changed, leaving the new debt-free with some tempting options and huge opportunities.
While debates continue over the macroeconomic effects of federal student loan relief, the financial effect for individuals is clear: Millions of federal student loan borrowers will see their monthly student loan payments go down, disappear altogether, or be paid off. ahead of schedule. While it is not known precisely when Biden’s debt plan (to write off $10,000 for individual borrowers making less than $125,000 and $20,000 for Pell Grant recipients) will technically go into effect, the student loan pause will be extended through January, so borrowers can formulate a plan based on their new personal financial situation. Debt cancellation means many borrowers will now have more breathing room to work toward other financial goals. According to Bank of America, the debt relief program will result in an average savings of more than $150 per monthly student loan payment for affected households. Especially for younger borrowers, this cash flow can be very helpful in terms of building wealth.
If you were assuming you’d have to start paying off your loans this fall before Biden’s announcement, figuring out his strategy for where to delegate this unexpected influx of cash is the best way to stretch your money further. “Because student borrowers are already used to this fixed monthly expense, they have a really incredible opportunity to boost their wealth accumulation,” explained Megan Slatter, wealth advisor at Crewe Advisors. “Now, by simply changing the destination of this monthly payment, they can stop using it to pay someone else each month and start using it to pay themselves,” Slatter explained.
start a reserve fund
Slatter says an emergency fund is the No. 1 priority for anyone who has a little breathing room after a loan discharge. For example, if you’re planning to buy a car in a few months or don’t have money saved for rent for three to six months, the most important thing should be to accumulate those savings. “Once you have enough in your savings account satisfied, then it’s really important to start focusing on building that investment account,” Slatter explained.
Marguerita Cheng, a financial advisor at Blue Ocean Global Wealth, agreed, explaining that borrowers who have just learned they will receive debt relief should consider their personal order of priorities when deciding where to put the extra cash. Cheng advised borrowers to pay off any high-interest debt, such as credit card debt, and make sure they have enough cash for emergencies and rent before investing in the stock market.
Prioritize a 401(k) or IRA
Cheng explained that the best way to start building wealth for borrowers whose immediate financial needs have been met is to put extra money into a retirement account. Cheng advised borrowers to open a 401(k) account and fully utilize their employer’s 401(k) match if their job offers one for employees. If you don’t have a 401k match from your employer, another great option to start building wealth is a Roth IRA. The benefit of a Roth IRA is that the money is taxed when it is deposited into the account rather than when it is withdrawn, so the money can grow in the account tax-free. “Everyone can benefit from some tax-free accounts, but especially the younger ones because they are going to be in the market longer,” Cheng explained.
The math is amazing: Take a 25-year-old who in 2019 was putting down $200 a month in loans. If they instead contribute that amount to a Roth IRA starting now, their accumulated savings would be $512,663 by the time they retire at age 65. Loan payoffs or income-driven repayment plan still have the power to compound interest on your side if you put even smaller monthly amounts into a retirement account.
Choose your investments wisely
Choosing to invest is important, but so is choosing where to invest. Slatter suggests starting with low-cost exchange-traded funds and index funds. Index funds are a great way to start investing because they are made up of a group of securities that can include stocks, bonds, and assets that aim to track a specific index, so they are hands-off and lower risk compared to investing. in an action. While mutual funds are typically managed by a professional and include a wide range of mutual funds, index funds are a package of securities that typically track a market index, most often the S&P 500 or the Dow Jones Industrial Average.
Slatter emphasized that consistently investing in the market is more important than the specific sector or fund for investors who may still be building their portfolio. “Focus on gaining exposure to the S&P 500 rather than focusing on individual sectors,” he said. “Really, it’s nothing exciting, it’s just consistent action doing the same thing monthly,” Slatter said. For an investor who puts $150 per month into the market every month for the next ten years, his accumulated balance will be $27,192 with an annual rate of return of 8%.
However, it is important to consider how much fees will affect the performance of your portfolio. Each ETF has an expense ratio, which is the cost the ETF charges for portfolio management and administrative costs, expressed as a percentage of the fund’s net assets. The average expense ratio for a Vanguard ETF is 0.06%; the average passively managed ETF at Charles Schwab is .05%. For an actively managed portfolio, such as a mutual fund, a reasonable expense ratio is in the range of 0.5% to 0.75%.
However, it is also important to consider diversifying your investment portfolio beyond the S&P 500. While the annual return will allow your money to accumulate over time, to create a more complete and lower risk portfolio, investors should also Consider weighting bonds at about 10% to 20% of your portfolio. Another important aspect is to think beyond the US economy. Due to the current strength of the dollar and the fact that international industries are expanding rapidly, weighting international stocks in your portfolio is a smart move if you want to maximize your long-term returns.
Aim for tax efficiency
Beyond your 401(k) or IRA, if you have more money to work with, that’s great, but keep taxes in mind. It’s important to make sure you choose ETFs or funds that are tax efficient, meaning they aren’t buying and selling a lot during the year that will lead to large capital gains tax bills in April. For example, Vanguard caused many investors headaches last year with its target-date retirement funds that, when kept out of retirement accounts, led to outsized tax bills for many investors. According to research firm Morningstar, ETFs were the most tax-efficient funds for both US and international exposure. Morningstar’s most tax-efficient core ETFs for US exposure were iShares Core S&P 500 ETF 500, iShares Core S&P Total US Stock Market ETF, Schwab US Broad Market, Vanguard S&P 500, and Vanguard Total Stock Market. For international exposure, major ETFs included Vanguard FTSE All-World ex-US, Vanguard Total International Stock Market Index, Schwab International Equity ETF, and iShares Core MSCI Total International Stock ETF. Keep in mind that international stocks tend to have higher taxes due to the fact that international companies tend to pay higher dividends.
Another option is to choose a tax managed fund. These funds use tax loss harvesting to avoid high capital gains taxes. Tax-managed funds also hold stocks for a long period of time to avoid taxes on short-term gains and also avoid stocks that pay dividends and generate taxes. However, these funds are often more expensive because they must be more closely managed, making them less accessible to novice investors.
Evaluate your personal situation
Cheng also added that for borrowers who might be thinking of starting a family, life insurance could be a worthwhile purchase. “It may not be an investment in the traditional sense, but you are investing in your peace of mind,” Cheng explained.
Whether it’s an index fund, a retirement account, or paying off debt and savings, making a plan for how you’ll spend the extra money can help you reach long-term financial goals. “I would encourage people, whatever the cash flow is, to put it to work for you,” Cheng said.
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