You may feel like you’re getting conflicting messages about debt and savings. On the one hand, you know it’s not good to carry too much debt. It’s expensive, can lower your credit score, and creates some risk. At the same time, you’re advised to have savings to help weather the unexpected. And, you’re warned about your retirement investments falling short and leaving you in a bad situation as you grow older. But, your budget will only stretch so far. There’s no one-size-fits-all answer. The right choice depends on your circumstances and your personal financial goals. This overview will help you make the right decision for your situation.
You may feel like you’re getting conflicting messages about debt and savings. On the one hand, you know it’s not good to carry too much debt. It’s expensive, can lower your credit score, and creates some risk. At the same time, you’re advised to have savings to help weather the unexpected. And, you’re warned about your retirement investments falling short and leaving you in a bad situation as you grow older. But, your budget will only stretch so far.
There’s no one-size-fits-all answer. The right choice depends on your circumstances and your personal financial goals. This overview will help you make the right decision for your situation.
Establish An Emergency Fund
Before you think about either paying off debt or making long-term investments, protect yourself with emergency savings. This should be your top priority. Most people can’t absorb an expense like a significant car repair, let alone weeks without work. Your emergency fund can provide the buffer you’ll need to keep the bills paid and food on the table if something goes wrong.
How much you’ll need to save depends on your situation. Your first step should be to add up how much it costs you to live each month. Start with essentials such as:
Rent or mortgage
Health insurance and any regular medical expenses
Car payment and insurance or other transportation costs
Also factor in minimum payments on credit cards, personal loans, or any other ongoing obligations. While making these payments isn’t essential to survival, making sure they’re covered will help keep your finances stable. Missing payments during a short-term crisis can lower your credit score, trigger a higher interest rate, or mean losing a credit card account.
Once you know your total monthly expenses, multiply. At a minimum, you’ll want to set aside enough to pay your expenses for two months. Many personal finance experts recommend saving enough to live on for six months.
It will take some time to build your emergency fund, but it’s worth the investment. It won’t do you any good to be debt-free if you’re unable to pay your rent in a crunch. Many people think having available credit on a credit card is as good as an emergency fund, but that’s not an approach that’s guaranteed. Most credit card issuers reserve the right to terminate your account at any time. During the pandemic, tens of millions of credit card accounts were closed. Other users saw their credit limits shrink, even though their accounts were in good standing. With your own emergency fund, you’ll always know exactly how much reserve you have available.
Of course, that doesn’t mean you can neglect debt payments. Missed credit card payments and late payments on other accounts can be expensive. And, if an account goes delinquent and a credit card issuer or other creditor or debt collector sues you, they may be able to take your savings to cover the debt.
Pros And Cons Of Investing
Investing wisely can make you a lot of money. Occasionally, getting lucky with an investment can do the same. Unfortunately, the opposite is also true. Poor choices, economic shifts, and even bad luck can cause you to lose a lot of money. In the Great Recession of 2007-2008, the stock market dropped by nearly 50%.
How To Invest
Purchasing individual stocks can be a risky business. Even professionals sometimes lose big this way. Many hobby investors play the markets without generating any real profits. The safer way to invest is to set up a retirement account such as a Traditional IRA or a Roth IRA. You can get information about setting up an IRA through your bank or a financial advisor.
Some of the benefits this type of investing offers include:
Professional management of your investments
A mix of investments that can typically be tailored to your risk tolerance
The ability to invest some funds pre-tax
Protection of your funds in bankruptcy and some state-level protection from creditors
Similarly, if your employer offers a 401(k) plan, you should take advantage of it - especially if your employer offers matching contributions. That means that when you route a percentage of your paycheck into your 410(k) account, your employer matches that contribution up to a certain percentage. Matching contributions aren’t required, but most employers that offer 401(k) plans do match at least some contributions. That means extra money is deposited into your retirement account every time you make a contribution.
These contributions are also pre-tax, up to a limit. That means you won’t pay income tax on the part of your paycheck that you divert into your retirement account. And, federal law protects employer 401(k) accounts from creditors.
Making smart investments while you’re young can make a world of difference in your finances later in life. That’s because compound interest across many years can dramatically increase your investment. Imagine, for example, that you put $50,000 into a 401(k) and never touch it again until you are ready to retire at age 65. To keep the math simple, let’s say you get an average rate of return of 5%.
If you open that account when you’re 45 years old, you’ll have just over $132,000 when you retire. On the other hand, if you deposit that $50,000 when you’re 25 years old, the power of compound interest means that you’ll retire with more than $350,000. The more you contribute early on, the greater the impact of compound interest will be over time.
If you have an employer-based retirement plan and leave your job, make sure you roll it over into another retirement account. You can continue to make contributions to the new account and keep building your investment. If you don’t roll over the distribution, you could pay a hefty tax.
Non-Retirement Investment Options
Retirement investments offer a lot of advantages, from untaxed contributions to possible employer matching to varying degrees of protection from creditors. But, a retirement account may not work as your only investment account.
There are many reasons you may want to diversify investments, including contribution caps on some retirement accounts. For most people, the most significant reason to diversify is the lack of access to retirement account funds. IRAs and 401(k)s are intended to provide for your retirement. That’s why they get such favorable tax treatment.
But, these benefits come with limitations. The exact rules differ depending on the type of account, but you may not be able to withdraw funds before you reach the age of 59 ½. If you do take money out of your retirement account prematurely, you may have to pay a tax penalty. So, if you’re saving up for a pre-retirement goal, like buying a house or sending your child to college, you’ll want a different type of investment.
You can learn more about the options from your banker or a financial advisor. One common, easily accessible type of investment is a certificate of deposit (CD), which you can purchase from your bank. CDs are typically a safe investment and one you can make with a relatively small amount of money to start. But, it’s important to understand the terms of any investment you’re considering. CDs often offer low interest rates and may tie up your money for years. If you need your money back sooner, the penalty for early withdrawal can eat up any interest you might have earned.
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Pros And Cons Of Paying Off Debt Faster
Many of the upsides to paying off debt faster are obvious. For instance, you’ll save money because you aren’t being charged interest every month. There’s a box on your credit card statement that shows how much you’ll pay in total if you make minimum monthly payments and how much you’ll pay if you pay off your credit card debt in three years. Depending on how much debt you’re carrying and what your interest rate is, that difference may be thousands of dollars.
Paying down debt can raise your credit score, too. That’s because one of the factors credit reporting agencies use in calculating your score is “credit utilization.” This term refers to the percentage of your available credit that you’re using. Keeping your credit card balances below 30% of your credit limit can have a big impact on your scores.
You’ll also gain peace of mind. If you’ve ever had to try to decide which bills to pay and which to delay or watched late fees add up when you were already broke, you know how important that is. You’ll also have fewer bills to cover if you lose your job, get sick, or for some other reason have to dip into your emergency fund.
When To Pay Down Debt
After you’ve established your emergency fund, it’s time to make a bigger investment in paying down or paying off your debt. It’s important to always make your payments on time. But, save the larger payments for after your emergency savings account is well established.
When you are ready to start paying off debt, be strategic. For instance, some debt is more expensive than others. Paying off high-interest credit cards and other high-interest debt first will save you more in the long run. Different types of debt also impact your credit differently. Carrying high balances on credit cards can hurt your credit even if you always make your payments on time. But, other types of debt, like mortgage loans, generally have lower interest rates and don’t have the same effect on credit.
You should also be sure to explore other options before paying off debt. For example, if you have large medical bills that you’re struggling to pay, you may have other options. You may be able to negotiate for a lower lump-sum payment, or the provider may have an assistance program that can help you eliminate or reduce your bill.
Similarly, many student loan borrowers have options for cancelation or forgiveness. Some federal student loan cancelation or forgiveness programs are based on the type of work you do. You may also be able to take advantage of loan forgiveness if your school went out of business or in some way misled you into enrolling. Always make sure that you fully understand your options before making a decision about which debts to pay off and when.
Figuring Out Your Financial Goals
Before you make any significant financial decisions, take stock. To make the best decisions to advance your personal financial goals, you’ll have to know what those goals are. Are you working toward saving for retirement? Do you have more immediate goals like traveling or buying a house? Are you expecting changes ahead, like an increase in expenses or a drop in income while you take a few years off to stay home with children?
Your goals and priorities should be driving your financial decisions. They’ll help you determine whether paying off debt or investing is a more immediate priority. They’ll also help you choose between directing all or most of your investments into a retirement account or diversifying to stay flexible.
You may want to consider working with a professional financial advisor. Of course, you’ll have to pay for their services. But, their job is to make the relationship pay off for you, even after those fees. You can start with your bank, where you may be able to get some basic financial advice for free. If you need more extensive advice, they may be able to provide a referral. But, that’s not the only way to go.
Shop around to find a provider with whom you’re comfortable. Trust is essential to this type of relationship. Don’t be afraid to ask for testimonials from past or current clients. Ask friends and family for recommendations and research advisors online. Before you get started, make sure you understand exactly what services they offer and what you’ll be charged.
There are upsides to both investing and paying off debt. Ultimately, you’ll want to do both. Deciding where to focus right now is a process that should be driven by the details of your situation and your goals. Start with the security of extra cash in an emergency fund, and then assess how investing or paying off debt will serve your short-term and long-term goals. It may be beneficial to work with an experienced financial advisor to determine the best way to achieve your goals.