The Great Recession has drilled home a lesson many people seemed to have forgotten: debt can be dangerous to your financial health. For 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 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 considerations unique to each individual, such as your age, how much you’ve already saved, what rate of interest you’re paying, and more. A review of investment planning basics is a good place to start. Following is an outline of how income (above and beyond your day-to-day expenses) should be allocated:
First Priority: Insurance
One of the best routes to financial ruin is not having adequate insurance. So your first priority should be to have the right insurance policies in accurate amounts to 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 attempting 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 minimum payments until you’re properly insured and 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 in connection with a job change.
Make 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 debts, 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 may be impossible 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 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 them 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.
Reesa Manning is Vice President and Senior Financial Advisor at Integrated Wealth Management, specializing in retirement and income planning. For more information, call Reesa at (760)834-7200, or [email protected].
The above list is being provided for informational purposes only and should not be considered investment advice. The information is as of the date of this release, subject to change without notice and no reliance should be placed on such information when making any investment decisions.
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