The Great Recession has drilled home a lesson many people seemed to forget: debt can be dangerous to your financial health. For some, those who lost their jobs and ran out of savings, it was a lesson relearned the hard way. But for those who have managed to hang on or were young and had low levels of debt, it raises the question: is it better to save or pay down your debt first?
The answer depends on a lot of things that are unique to each individual, such as how old you are, how much you’ve already saved, what rate of interest you’re paying, and more. A review of the basics of investment planning is a good way to approach the subject. Here we outline how you should use income not dedicated to day-to-day expenses, in order of priority.
First Priority: Insurance
One of the best routes to financial ruin is to not have adequate insurance, so your first priority should be to have the right kinds of policies in the right amounts that protect you and your family. If you’re young and unmarried, this means having basic health insurance. Beyond that, if you have a family, you need life insurance as well as short- and long-term disability insurance. In each case, you’re looking to provide yourself or your survivors with a replacement for the income you and they count on. The bottom line: if you have debt, make the minimum payments until you’re properly insured and you have the next two priorities covered as well.
Second Priority: An Emergency Fund
Even if you don’t have a family, you need to protect yourself against job loss or a major unexpected expense. The rule of thumb is to create an emergency savings fund equal to three to six months of your income. Not only does this give you breathing space against hardships, it also affords you the flexibility to move should you want to change jobs.
You should make creating an emergency savings fund a priority. If you can’t take care of priorities one and two at the same time you pay for basic necessities, like groceries and gasoline, you’re living beyond your means and need to cut back on your spending.
Third Priority: Retirement Savings
Finally, before you even think about making more than the minimum payments toward your debt, it’s imperative that you start saving for retirement, as soon as possible. Time is both the best ally and worst enemy of the saver. Start saving too late, and it’s possible that you’ll need a rate of return you can only achieve in your dreams in order to accumulate enough for a worry-free retirement. On the other hand, even small amounts ― as little as $25 a month ― put away early enough can grow to sizable amounts by the time you’re ready to retire.
With these three priorities covered, if and when you have money left over, it’s time to consider making extra payments to tackle your debt.
Guidelines for Debt Reduction
There are a number of factors to consider when you’re ready to start accelerating the pace at which you pay down debt:
- Start with the debt with the highest interest rate. Instead of paying more on every one of your debts, concentrate on the one that charges the highest interest rate. In general, these will be store credit cards, followed by bank credit cards like Visa and MasterCard. Use all your spare cash flow to pay down one at a time.
- Is it tax deductible? Debt that you can write off against your taxes is generally considered “good debt.” In effect, the tax deduction reduces the interest rate by your marginal tax rate. In most cases, this means home mortgage interest.
- What rate of return can you expect? The most important consideration is whether you can earn more by investing your money than the interest rate you’re being charged on your debt. If you can earn more in the financial markets than your interest rate, you should invest your money instead of paying off the debt. If not, it’s worth it to pay off the debt.
- How long until you retire? This is a key consideration when you’re thinking of paying off your mortgage, especially if it’s near the end of its term. At that point, the tax benefits are minimal because most of your payments consist of principal, not interest. In addition, if you’re 50 years old or older, the monthly cash flow you’d free up could be devoted to the extra $5,000 a year you can contribute, pretax, to an IRA or 401(k).
On the other hand, if you have 10 years or more to go on your mortgage, it could be smarter to keep making the minimum payments to retain the tax advantages. As an alternative, consider the advantages of refinancing the remaining balance. At the reduced principal amount and with mortgage interest rates near historical lows, you may be able to reduce your monthly payments such that you can save nearly as much as you would if your mortgage were paid off.
Smart debt management is often overlooked as a way to improve your finances, yet it can be as powerful as smart investment management.
Please call if you’d like to discuss this in more detail.
Copyright © Integrated Concepts 2013. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.