Saving

Save first, then pay down debt? Or go the other way? Here's how to prioritize financial goals

Deciding how to use your money to achieve your goals can be difficult. This guide will help to educate you about how to invest, save for retirement, and pay off debt.

Twenty/20

With so many money goals to focus on, it can be difficult to figure out where to start. Should you prioritize setting yourself up for a comfortable retirement or building up emergency savings? Save for the future or pay off debt now? And which kinds of debt should you try to pay off first, anyway? 

The first thing you need to figure out is how much money you're working with. The popular 50-30-20 framework advises allocating 20% of your salary to financial goals. But even once you have a budget in place, you might still be unsure of which of those goals to prioritize.

Luckily, experts say, there's a formula that works for many if not most people. This step-by-step process can help you go in order, attacking the highest priorities first and building on your victories.

Step 1: Pay off high-interest debt while building an emergency fund

While there is no rule as to what is considered high-interest debt, if the interest rate is above 8%, you probably want to put it in this category. This debt is most commonly in the form of credit cards, which currently have an average APR of about 15%.

If you have high-interest debt, you might be inclined to put all the extra money towards that balance. But according to some experts, that could be a mistake.

"Before you can pay down debt, you have to have a strategy to prevent it from getting worse," said Mark La Spisa, a certified financial planner and president of Vermillion Financial Advisors in South Barrington, Illinois. La Spisa advocates for splitting your funds between paying down high-interest debt and building up a cash reserve. This way, when an emergency comes up, you'll have the cash to pay for it and won't fall back on old habits by using a credit card.

The economic fallout from the coronavirus pandemic has shown many people the importance of having an emergency fund. Fifty-eight percent of Americans said the crisis made them realize they need to build up their savings, according to a recent CouponCabin/Harris Poll survey.

Before you can pay down debt, you have to have a strategy to prevent it from getting worse.
Mark La Spisa
Certified financial planner

For a single person, La Spisa advises saving six months of expenses, while a married couple should have three months saved if both people are working. Until you reach that goal, consider splitting your money 50/50 between paying down your high-interest debt and building up your savings.

"One thing I've learned over the years is the best way to pay down your debt is to start saving," certified financial planner Pamela Capalad wrote for Grow earlier this year. "What I see happening over and over again is that the people who are constantly paying off credit card debt never seem able to get rid of it. Even the most well-intentioned debt advice often doesn't take into account the reality that life happens."

Step 2: Get your 401(k) match

A 401(k) retirement account, if you have access to one through work, can be an easy way to save for the future. The amount you contribute isn't taxed until you take it out of the account, likely in retirement, and it comes out of your paycheck before you see it, so you won't need discipline to succeed.

Additionally, many companies offer a 401(k) match, meaning they will also contribute what you put into your account up to a certain percentage of your salary. If your job offers this benefit, you should make sure you're contributing enough money to get the full match. If you're not doing so, you're missing out on extra money from your employer.

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"First and foremost for everybody is, don't ever leave free money on the table," says Carolyn McClanahan, a certified financial planner and the director of financial planning for Life Planning Partners in Jacksonville, Florida. She advises making getting your full 401(k) match a priority, along with building up emergency savings and paying off high-interest debt.

But about a third of workers don't have access to a 401(k) or other workplace plan. If you you're among them, an equivalent step here would be to start funding a traditional or Roth IRA.

It may be difficult to prioritize saving for retirement if you're young, especially since it offers no immediate gratification. But it's important to not put it off too long. Thanks to compound interest, the earlier you get started with saving, the better prepared you'll be for retirement.

Step 3: Work on mid-interest debt while focusing on big goals 

After you've paid off high-interest debt, shored up your emergency savings, and boosted your 401(k), the next step is addressing other debt and savings. These categories will depend on your individual goals.

If you have debt with an interest rate of roughly 5%-8%, you could consider making additional payments to pay it off more quickly. Student and auto loans might fall into this category. You can use our loan calculator to see how much money you can save by making additional payments.

Alongside paying down mid-interest debt, now is the point when you might start saving for big-ticket items like a down payment on a home, a new car, or a vacation. If you have children, consider starting an investment account, like a 529 plan, on their behalf. If you can afford it, investing just $1 per day from birth can lead to more than $13,000 by the time your child turns 18.

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While you may want to make your kids a higher priority, it's important to make sure your own finances are in order beforehand. "Put the financial oxygen mask on your face first before the kids," financial expert Suze Orman told Grow last year.

This is also when you might consider putting aside extra money for retirement. That doesn't have to be in your 401(k). Experts recommend investing in a Roth IRA if you're young and in a lower tax bracket. That's because while you'll have to pay taxes on the money you invest, you won't have to when you withdraw money in retirement. This means your money grows tax-free, which will save you in the long run. You can use our retirement calculator to help you make a plan. 

Step 4: Address low-interest debt and make other investments

Once you have the rest of your financial plan in place and are on track to meeting all of your goals, you might start looking to make other investments in vehicles like bonds, individual stocks, or ETFs.

This point is also where experts advise you start considering making additional payments toward low-interest debt, like a mortgage. While you may be tempted to prioritize paying off your home early, mortgage rates tend to be so low that you're likely to see better returns on your money elsewhere.

In most cases, saving for retirement should be a higher priority than paying off your mortgage early. "Most mortgage interest is going to be really low, and if you don't [max out your] 401(k), you can never go back and do that," McClanahan said.

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But don't just look at the numbers. It's OK to let your emotions help guide your decision-making. If being debt-free will help you feel more financially secure, then it could be the right move for you. "My number one overriding decision would not be the math," McClanahan says. "It's going to be what makes you feel better."

Be aware that if you pay off mortgage or other debt early, you will need to have the discipline to make sure the extra money in your budget from not having debt payments goes toward improving your finances and not just your standard of living. Discipline is also important when it comes to making sure you're actually saving or investing money if you're not putting it all toward debt. This could be difficult for many people, especially those who are prone to spending instead of saving.

"If you have this extra money and you want to invest it instead of putting it toward your debt, make sure you actually invest it and you're not using it to go out to eat an extra time or two per month," La Spisa says.

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