I was recently coaching someone who spent quite a bit of time excitedly talking about their savings and investment strategy. As we talked further, I came to understand that they have several pieces of debt, including car loans, student loans, and unpaid credit cards. Some of which they’ve had outstanding for many years. So, should they keep putting excess money into savings, or instead pay off that non-mortgage debt? What is the right answer?
Here’s the input I gave them…
#1 Do you have an emergency savings fund? If an appliance or your car breaks down, how will you pay for it? Having an emergency savings fund avoids you going further into debt to fix what breaks.
How much is enough? My rule of thumb is a baseline of $500 and then add another $500 for each house or car you own. So, a couple with a house and two cars should have $2,000 in a bank account or money market savings account. This is money you can get to by the next day to quickly pay for any emergency.
#2 Are you taking advantage of your employer matching into your 401K or IRA? Most employers will match contributions you make into your retirement account up to a maximum level. This is FREE money! Make sure you are contributing up to the maximum allowed to take full advantage of your employer’s match. You won’t find a better investment return than this!
If you are self-employed or your employer does not offer a match, then should you be contributing to retirement while also having debt? That will depend in part on how much debt you have to tackle and more importantly what the interest rate is that you are getting charged on the debt. A rule of thumb could be that if the rate you are being charged is greater than 10% (like most credit cards) then pay this debt completely off before contributing non-matched money into retirement accounts. If the highest rate of your debt is under 10% then maybe do a little of both.
#3 Debt time! Okay, so now that you’re prepared for any immediate emergencies and you’re getting your free money from your employer for the future, it’s time to tackle that debt! For some advice on how to go about choosing which debt to pay off first, see my article titled “Help! How do I Get Out of Debt?”
In short, the first step is to list out all your non-mortgage debt including the total amount owed, minimum payments required and their frequency, and the interest rate you’re getting charged. Then prioritize your debt using my previous article. While paying just the minimum required on all the other debt, toss as much as you can toward the debt you prioritized first. Once this debt is paid off take all the money you were applying to it and toss it at your second priority debt. Continue this until you are debt free!
#4 Get back to saving. But first celebrate! It’s a wonderful feeling to know that you have cash available to handle an emergency, are getting free money invested from your employer, and are debt free. Once you’ve swallowed that last bite from your celebratory dessert, take the money you were applying to your last debt payment and start putting it away into additional savings.
At this point I would prioritize building up your non-retirement savings beyond just the emergency fund. How much? I’d suggest 3-6 months-worth of expenses. This will come in handy should you unfortunately lose your job and be temporarily without an income.
Once you’ve done this, put those additional payments toward more retirement savings above and beyond your employer match, begin contributing toward some higher education goals, or increase your level of giving to some crazy fun levels!
In summary, paying down your debt is a guaranteed return on investment. If you decide to start investing while you’re in debt, make sure your return will be higher than the interest rates you’re currently paying on your debt.