Being Young Changes All The (Financial) Rules

growing money

I keep reading general financial advice and disagreeing as it applies to me.

Obviously, every one has a unique financial situation. Overall, it is better to get financial advice tailored toward your own situation. But over and over I notice that financial advice does not really apply to my case simply because I am young.

Your age can make a huge difference on the course of action you should really be taking financially. Just as you need to look at things very differently as you near retirement, when you are young and in your 20s, you have many advantages that the general population does not have. Let me share a few areas where I have noticed this recently.

First, let’s look at the great mortgage debate. Should you prepay the mortgage or invest instead? This one has recently seemed rather obvious to me. My conclusions on this has evolved over time and with knowledge. As a green kid I would have much preferred to just pay off my mortgage, but I have been running numbers and looking more closely at this, and find we will be miles ahead by investing the extra payments we once made to the mortgage. Certainly no one-size fits all answer here, but let me show some of the arguments I have seen for prepaying a mortgage and how they don’t apply when you are very young.

The biggest argument I consistently see is that you need to prepay your mortgage so you don’t have a mortgage in retirement. Considering we bought our first home at 23 and our dream home at 25, as someone young I’m not exactly worried about that one. Sure, if you are just going to buy up in your 40s, maybe it is wise to pay down your mortgage so you have more freedom. But if you start young, overall, you can have your house paid off well before retirement. I have always intended to pay off the mortgage well before retirement, so this argument never really meant much to me overall as a young homeowner. Making extra mortgage payments isn’t going to make a big difference in this regard.

The next common argument is that investing in your mortgage has a guaranteed return. It is much safer than the stock market. I’ll give you that you will know your return on your mortgage, but you haven’t convinced me the stock market isn’t safe. If I was in my 40s or 50s I may be more willing to agree, but I have a 40-year-plus investment horizon which means I should be able to ride out some pretty nasty waves before retirement, if need be. Or put another way, the younger you are, the less exposed you are to market risk.

Basically, the younger you are, and the more you put into cash and your mortgage, the more opportunity you are missing out on the long-term benefits of investing and the power of compounding. I have never understood how the same people who tout the power of compounding and starting young can somehow make an exception for a paid-off mortgage.

Of course, the benefits are only really staggering if you start young. In your 40s or 50s it may just make more sense to pay off your mortgage. But if you are in your 20s, when you probably have less cash flow, you should really consider the long-term benefits of investing your cash instead of tying it up in your mortgage. Running the numbers we can easily be $400k ahead when we retire by simply investing an extra $150/month instead of putting that extra money toward the mortgage. (This is assuming we also invest our mortgage payment once the house is paid; until retirement). If we bought our first home in our 30s though, this $400k difference goes down considerably. Instead we may only be ahead by $100k investing the difference.

My point is if you are younger or older than the average age range most financial articles are geared toward, you need to think critically about how your situation may differ. You can just as much argue on the flip side that if you are older that you really need to prepay your mortgage, as investing will give you little benefit with a shorter-term investing horizon.

While I have always felt this way in the great mortgage debate, I have been noticing the same thing when it comes to other financial discussions. Recently I have come across discussions that ROTH IRAs are not that favorable. For the most part, I agree with some of the logic in these discussions. If you are in a 25% tax bracket now, does it make sense to put all your money in a ROTH with hopes of a lower tax rate? Maybe not. Particularly if you are in your 40s or 50s, I agree that the benefits aren’t exactly crystal clear. Instead it is more of a gamble as future tax rates are really unknown.

When it comes to young people, however, I think this is a complete no-brainer – the ROTH wins hands down. When you are young you have most likely not realized your full earnings potentials and if you have a family, you have considerable tax breaks. All of this means that the odds are you will be in a lower tax bracket early on than you will be during the rest of your life.

Even more importantly is the power of compounding. If you start out at 20 and put $4k/year into a ROTH IRA, and assume an 8% return for 50 years, you would have $2.5 million in retirement. Assume a 10% return, and you would have $5 million. Technically, you would be able to pull out millions of dollars tax-free, only having been taxed on your initial contribution of $200k through the years.

Obviously, the younger you are and the more time you have to compound your earnings, the more lucrative a ROTH can be. I wouldn’t get too excited myself, because tax laws change, and obviously the government is going to have to tax us elsewhere if they never touch ROTHs, and really let us withdraw them tax-free in 50 years. But in the meantime, I am shifting as much into ROTHs as I can because while others don’t see much benefit, I see a huge potential windfall with my long investment horizon.

Until the tax laws do change I just have to play them to my benefit since I don’t have a crystal ball handy. But overall, I never have seen the power of compounding mentioned in these ROTH discussions, and how lucrative this makes ROTHs to younger investors.

As with any financial advice you have to think critically about how it applies to your particular situation. Just take note that when you are in your 20s and trying to formulate a financial plan, don’t get too caught up in some of these discussions dominated by 30 and 40-year-olds. Yes, things change with time, but when you start taking control of your finances when you are young, you will have some great advantages. Always keep in mind the power of compounding and how it changes the rules for you when compared to others who don’t have the time that you have to let their money grow.

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4 Responses to Being Young Changes All The (Financial) Rules

  1. Pingback: Asset Allocation In Your 20s: How Should You Invest? | Online Savings Blog

  2. Pingback: Around the PF Blogosphere: May 29, 2007 | The Sun’s Financial Diary | A Personal Finance Blog on Saving and Investing

  3. mas says:

    Your perfectly right that investing in long time stock market is much less critical and more rewarding for young investors than for old investors.
    Nevertheless the golden rule to not invest lend money is an important one, simply because live doesnt always run smooth. And should live run more “unsmooth” than anticipated at the wrong time, e.g. when your assets are down and while your mortgage is still humming, then you could end up loosing a lot.
    If your willing to take the gamble then its fine but one should be aware of it.
    Mortgage interest rates tend to be much higher than the normal interest you get and they can increase a lot in the wrong moment so reducing them is always a good investment in terms of a diverse investment.

  4. mas says:

    Also keep in mind that all investments into stocks are long time unflexible investments. Good yielding ones on the long run, unless your very unlucky, but still inflexible.
    A diverse investment structure that stands on more than one leg and has also elements that are more flexible may be less yielding for the lucky investor but it will be much more sound in turbulent times. And keep in mind that theres never a guarantee that our world will stay so relatively calm as it has been the last 30-40 year. We all got very accustomed to it but my 94 year old grandma can tell you different stories.

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