You finally have some breathing room in your budget; you’re spending less than you earn and there’s cash left over at the end of the month. Now you want to put that extra cash coming in to work instead of just spending it. That’s terrific! But should you save that money, invest it, or pay off debt? Which is most important and how do you get the best return on your money? Should you start making extra payments on your credit card, student loan, car or home loan? Should you open a new savings account or start investing? There isn’t one right answer; it varies person by person and depends on your individual circumstances.
Paying down debt and saving/investing for the future are both very important financial goals. The right answer for you may be focusing solely on debt, saving everything you can for a specific goal, or it may be a blend of both. If you don’t have a rainy day fund, this is the best place to start. If you begin to pay off your debts first, without any savings in the bank, and you have an unexpected expense come up (it always happens), you’ll most likely have to turn to a credit card or personal loan to pay it off. That’s going to derail your debt pay off plan and be more expensive in the long run. We recommend everyone start with a goal to save $500 for their rainy day fund (that’s the minimum amount.) You would use the money you save for those unplanned small household or medical expenses, and then build a larger emergency fund. This should be 3-6 months worth of your fixed expenses (your must pays – mortgage/rent, car payment and insurance, bills, utilities, food, etc) in the event your income was suddenly gone. If 3-6 months sounds like a lot, think about how likely you are to lose your income and how quickly you could find a similar paying position, which is a good measuring stick.
After these two funds are established, you can start saving money long term by paying down high interest debt ahead of schedule. It could be credit cards or personal loans; these are usually “expensive” debt, especially if you’re only making the minimum payment required, since they have high interest rates. Focus any extra money you have towards paying these off as quickly as possible in order to save money; the faster you pay them off the less you’ll pay in interest. The best action you can take on high interest debt, or any debt for that matter, is pay on time and in full every month. If you can’t pay in full, then always make your minimum required payment and more when possible. A common question is whether you should start by paying off the card with the highest interest rate or the one with the smallest balance. There is no wrong answer, paying off either is a good step, but we recommend paying off the highest interest debt first. This is called the debt avalanche method and it will cost you the least in the long run. An alternate method, the debt snowball, prioritizes paying off the debt with the smallest balance. This may give you a sense of accomplishment when you see individual debts drop off quicker, but it probably will mean paying more in interest (this depends on the amounts and rates on your specific debts) than with the debt avalanche. With either of these methods, you first make the minimum payment on all your debts, and only then focus remaining money on the single “prioritized” debt, repeating every month until all are paid off.
After paying off your high interest debt, a retirement plan is a great place to invest for the future, especially if your employer has a 401(k) Plan and provides a match! Contributing money to the 401(k) plan has great tax advantages and the company match is free money and an instant return on your investment. Contribute at least up to the match amount and more if you can. If your employer doesn’t offer a plan, consider an individual retirement plan (IRA) which can offer similar tax advantages (depending on your circumstances.) Your retirement investments are a long term goal and need time to grow and compound. Start as soon as you can, you can’t go back and make up for the lost time later.
If you still have some extra cash, the next best place to focus is on having adequate insurance. You may be thinking, how does that save me money? Insurance builds a financial safety net to protect you from large expenses you may be unexpectedly hit with – it’s also known as risk management. You should review your insurance to confirm you are adequately covered and that you are protecting yourself and your finances against the unknown. If you are uninsured and face an issue with your health, home, auto, etc, it could impact you financially for a very, very long time. You’re paying a little now to avoid having to pay a whole lot later.
Last, if you’ve got your high interest debt paid off, you’re contributing to a retirement account, and you’re all set on insurance, look at your remaining debt (mortgage, auto, student loans) and compare the interest rates you are paying to current saving rates and investment returns. Paying off $1,000 of debt at 8% is more or less the same as getting a return of 8% on an investment of $1,000 so the interest rate is an easy way to compare your options. For example, when it comes to lower interest rate debt like a mortgage (3-5%) it may make better financial sense to invest the money than paying ahead on your debt since stock market returns on average are higher than 3-5%. This is especially true if you don’t plan to be in your current home forever and you’re early in your mortgage, i.e. still paying mostly interest. If you have student loans, review the type of loan and rates very closely before paying ahead. If you have federal loans that are part of a forgiveness program or income driven plan, again, it may not make sense. Before paying ahead on any debt, check for any prepayment penalties and ensure your additional payment is going towards principal.
“What’s my next best step?” is easy to answer when you’re getting started, but can get more complicated as you make progress. Chat with a BrightDime coach if you need help figuring out what should come next for you.