How Young Investors Can Stamp Out Debt and Start Investing

4 ideas to help you sort out your competing financial priorities

By + More

As if the age-old question "What will I do with my life?" isn't perplexing enough, 20-somethings have even more reason to be confused these days. On one hand, parents and financial advisers are telling them to start saving for a car, a house, a family, and retirement. On the other, it's hard to save when you're already living beyond your means. 

Generation Y is an indebted bunch. According to a 2008 report from the American Savings Education Council and the AARP, only 52 percent of gen Y members—those born between 1980 and 1988—save money on a regular basis. Meanwhile, 57 percent report that they have credit card debt, and 32 percent say they have student loan debt. The 2008 Economic State of Young America from Demos, a research and policy center, says that the proportion of younger households in "debt hardship"—40 percent—is higher than all other age groups.

On top of debt issues, many members of generation Y are graduating into an uncertain job market that makes saving and investing for the future more difficult, says Tamara Draut, author of Strapped: Why America's 20- And 30-Somethings Can't Get Ahead. "It just makes it harder for college grads to reconcile saving for their future and paying off that debt," she says. So how can gen Y balance the debt burden and still save money for the future? Here are four ideas:

Use discipline. In a perfect world, everyone would pay off credit card debt before investing. But that's not realistic for a lot of 20-somethings, especially those who've grown accustomed to spending heavily on things like restaurant meals and entertainment. "The problem is, most people don't have the discipline to pay down debt the way they should, because there are other things going on," says Adam Bold, chief executive of the Mutual Fund Store, an investment advisory firm. The result can be the worst of both worlds: overhanging debt and no progress in saving.

So impose discipline yourself. Bold recommends taking what's left after debt payments and other expenses and plugging it into your 401(k). The advantage of a 401(k), he says, is that the money comes out of your check before you can spend it. If you don't have a 401(k), consider other options, such as an IRA or mutual funds that can be set up to make automatic withdrawals from your checking or savings account, Bold advises. Keep in mind that many fund companies won't let you start investing with pocket change. To find funds with low minimum investments, use a screener such as the one offered by Morningstar to find funds with low initial investment requirements.

Prioritize credit card debt. Experts agree that some kinds of debt, particularly credit card debt, should take precedence over most saving and investing. Credit card companies are cracking down in this recession, says John Ulzheimer, president of consumer education for Credit.com: "They take late payments very seriously, more so than they would a few years ago." This is especially true if you're currently using credit cards to make ends meet. Ulzheimer says paying off a credit card bill with an interest rate of 14.9 percent of higher should be a top priority. Plus, it's unlikely that your investments will return more than you're paying in interest rates (assuming they are high).

Pay attention to the fine print. It's important to fully understand the terms of credit card agreements. "A lot of young people just look at the minimum payments," says Ulzheimer. "They don't realize that just paying the minimum means accumulating debt that rises with interest." The problem goes from bad to worse when young debtors don't realize the consequences of making late payments. Ulzheimer says that because credit is tighter these days, lenders will use even the slightest tardiness as an excuse to hike up interest rates. "Some people just out of college are in this mentality that 'As long as I do well on my next test, I can bring up my average.' But in the credit world, that bad test lasts seven years," he says.

Reconsider picking up the phone. If you search online for advice on how to reduce your debt, a common tip is to renegotiate with your creditors and lenders. You could, for example, call the customer service department of your credit card company and ask about changing the terms of your agreement. That might have been a good strategy before the credit crunch, but not anymore, says Ulzheimer. Renegotiating is trickier now because many creditors are looking for excuses not to loan money. Quibbling with your lenders about the terms of your agreement might make them worried about you as a customer and give them such an excuse. "We hear horror stories about people calling up their creditor and hanging up the phone with a closed account," says Ulzheimer. Sometimes, you are better off not saying anything at all.