Pay Off Debt or Save? Your 5-Step Guide for Making Smart Money Decisions
Not sure whether to save, pay off debt, or invest for retirement? Use this 5-step guide to make smart money decisions. It will help you leverage your financial resources, reduce stress, and build wealth as quickly as possible.
Laura Adams, MBA
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Pay Off Debt or Save? Your 5-Step Guide for Making Smart Money Decisions
Making decisions about money can be difficult. Most people have several financial goals—but knowing which ones should come first or where to start can be challenging.
We all have limited financial resources to manage. If you don’t know what your priorities should be, it’s easy to feel stuck and never make any progress.
Here are some recent questions I received from Money Girl readers and podcast listeners:
Michele M. asks: “I’m wondering if I should use my savings to pay off my credit cards and then build my savings back up again?
Naomi S. wonders: “I’m trying to get out of credit card debt, take control of my financial life, and set up a good financial future for my children. Do you have any tips on where to start so I can have less financial stress?”
James B. asks: “With so many ways to spend and invest money, I’m not sure that I’m focusing on the right things. What should my financial goals be, exactly?”
These are questions you may have asked also. In this episode, I’ll answer them by giving you a step-by-step guide for making smart money decisions.
5-Step Guide for Making Smart Money Decisions
Whenever you have a money question or dilemma, come back to this guide for a clear path forward. It can be the ticket for leveraging your financial resources, reducing stress, and building wealth as quickly as possible.
Step #1: Build a cash reserve.
Oftentimes I get money questions about paying off different types of debt, such as credit cards, student loans, and mortgages. My first response is to ask if you have a cash reserve, also known as an emergency fund.
Your number one financial priority before doing anything else should be to accumulate an emergency fund. Having a cash cushion to fall back on can be the difference between surviving a financial emergency—such as losing your job or having an unexpected medical bill—or getting buried under it.
Devastating events are tough enough to handle without also being stressed about money. When you don’t have a financial cushion to soften the blow of a large expense or a loss of income, you could end up going into debt.
How much emergency savings you should have is different for everyone. If you work in an unstable industry or are the sole breadwinner for a large family, you probably need a bigger financial cushion than a single person with no dependents and plenty of job opportunities.
Ideally, you should accumulate at least three to six months’ worth of your living expenses. Another good rule of thumb is to accumulate at least 10% of your annual gross income. For instance, if you earn $50,000, make a goal to accumulate and maintain a $5,000 emergency fund.
If you’re starting with zero savings, you could begin with a small goal, such as saving 1% or 2% of your income each year. Or you could start with a small target like $500 or $1,000 and increase it each year until you have a healthy amount of emergency money.
If you’re trying to accomplish other financial goals before accumulating a cash reserve, you’re putting the cart before the horse.
If you’re trying to accomplish other financial goals before accumulating a cash reserve, you’re putting the cart before the horse. Take the time to evaluate how much emergency money you have, how much you need, and create a plan to bridge the gap.
Also, I don’t recommend investing your emergency money or considering your retirement fund your cash reserve. Your emergency fund should be in a safe, high-yield, FDIC-insured savings account. Don’t worry if your cash reserves earn little or no interest in the bank. They’re not supposed to.
The purpose of emergency savings is to be accessible and liquid in the short term. If you invested it, the value could shrink to nothing the moment you desperately need it.
Being financially responsible means that you’re prepared for a day when bad luck may strike. Think of an emergency fund as an investment in yourself that ensures future financial safety and happiness.
If you’re struggling to build a cash reserve, automate the process by having a portion of your paycheck direct deposited into a savings account or transferring funds from your checking to savings.
Let’s return to Michele’s question about using her savings to pay off my credit cards and then building it back up again. You should always keep an ample emergency fund because you never know when you’ll need it. If you have more than enough savings, then you need to use it for the following steps…
Step #2: Fill your insurance gaps.
In addition to having an emergency fund, an important part of taking control of your finances is being adequately insured. Many people get into debt in the first place because they don’t have enough of the right kinds of insurance—or they don’t have any insurance at all.
As you earn more and your net worth increases, you’ll have more income and assets to protect from unexpected events. Without enough insurance, a catastrophic event could wipe out everything you’ve worked so hard to earn. Make sure you have enough coverage to protect yourself and those you love from something unexpected jeopardizing your financial security and happiness.
Drivers and homeowners with a mortgage must have auto and home insurance. Ask yourself if your current coverage would give you enough protection based on the assets you own and your net worth. I have an inexpensive umbrella liability policy that offers additional protection for any type of lawsuit.
But there are other types of coverage that can be affordable and give you financial protection. For instance, if you rent and don’t have renters insurance, you need to get it today. At an average cost of $188 per year, it’s a bargain for the protection you get!
Health insurance is a critical coverage because any kind of medical issue or accident could leave you with a massive bill. Even a quick trip to the emergency room or a short hospital stay could cost thousands of dollars.
The Affordable Care Act, known as Obamacare, makes it mandatory to have health insurance, even though the penalty is no longer enforced. No matter the politics behind healthcare, going without a policy is a risk you should never take.
If you believe that you can’t afford a health policy, shop for coverage on the federal or state marketplace, which offers coverage at a reduced price based on your income and family size.
Disability insurance is another important, yet often-overlooked, coverage that every earner should have. It provides a percentage of replacement income, such as 60% or 70%, if you’re unable to work due to a disability, illness, or accident.
Remember that if you’re sick or injured and can’t work, health insurance only pays a portion of your medical bills—not everyday living expenses, such as housing or food. Disability benefits allow you to pay any bills or debts until you can get back to work.
There are short-term disability policies that begin in as little as a couple of weeks for situations such as back injury, digestive problems, or pregnancy. Long-term policies typically begin coverage after six months for issues including cancer, cardiovascular problems, and joint disorders.
If you don’t have a disability policy through work (or you do but it’s not sufficient), purchase a policy and have enough emergency money set aside to tide you over until coverage begins.
Life insurance is critical when you have loved ones who would be hurt financially if you died. If you’re in relatively good health, a term life insurance policy for $500,000 might only cost a couple hundred dollars per year.
Step #3: Pay off any dangerous debts.
After accumulating some amount of emergency money and having the right types of insurance, your next financial priority should be getting rid of what I call dangerous debts. These might be tax liens, overdue child support, or accounts in collection. If you have any of these types of debt, you need to get caught up as quickly as possible.
Dangerous debts also include high-interest credit accounts—such as payday loans, credit cards, and car loans—with rates in the double digits. These accounts can destroy your financial health because they drain your resources and keep you from using your money to save or invest instead.
In general, it’s best to tackle your highest-rate debt first because it’s costing you the most in interest. Don’t worry yet about paying off low-interest debts, like mortgages or student loans, ahead of schedule because they’re relatively inexpensive. In addition, they come with built-in tax deductions, which further reduces their cost on an after-tax basis.
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Step #4: Fund your retirement.
After you’ve prepared for the unexpected with savings and insurance and dealt with any dangerous debts, it’s time to turn your attention to retirement. As I previously mentioned, this is a higher priority than paying off any low-rate debt, such as mortgages and student loans, ahead of schedule.
After you stop working you could, and hopefully will, live for decades. Whether you’ll live in poverty or have financial freedom in the future is completely up to you. Social Security benefits for the average retiree are only around $1,000 per month. That’s nice to have but isn’t enough to be comfortable.
The earlier you begin saving, the better. Not only does starting early give you more time to contribute money, but it leverages the power of compound growth. Compounding is when your earnings earn their own earnings! Your account balance can easily mushroom as the growth you receive provides even higher returns.
Consider this: If you invest $500 a month over 20 years for a 10% average return, you’d have about $380,000. If you started five years earlier and invested that same amount for the same return over 25 years, you’d have over $665,000.
But if you invested for 30 years, you’d end up with an impressive nest egg that’s over $1.1 million! Did you get that? Simply starting to invest 5 years earlier can give you an additional $435,000, even though you only put in $500 per month. Procrastinating even 10 years could make the difference between scraping by or have a comfortable lifestyle down the road.
A good rule of thumb is to never invest less than 10% to 15% of your gross income.
A good rule of thumb is to never invest less than 10% to 15% of your gross income. For instance, if you earn a $50,000 salary, be sure to invest from $5,000 to $7,500 per year. As I mentioned, if you do that consistently over several decades, you can easily retire with a million dollars.
If you have a retirement plan at work, such as a 401k, 403b, or 457, that’s the first place your savings should go. For 2019, the contribution limit is going up slightly from $18,500 to $19,000. And if you’re age 50 or older the limit increases from $24,500 to $25,000.
But what if you don’t have a job with a retirement plan? In that case, you can use a traditional IRA, a Roth IRA, or a special account if you’re self-employed, that also come with nice tax advantages.
The maximum amount you can contribute to an IRA isn’t as high as a workplace plan, but it’s likely to increase in future years. For 2019, you can contribute up to $6,000 or $7,000 if you’re age 50 or older.
Once you’re consistently saving 10% to 15% of your income for retirement, then it’s time to consider paying off your less expensive, low-rate debt ahead of schedule.
For a summary of different retirement accounts and their rules, download the free, one-page Retirement Account Comparison Chart PDF.
Step #5: Fund your goals.
The final step in making smart money decisions is to consider your other goals. Maybe you’ve got your heart set on buying a home, sending kids to college, starting a business, or paying off low-interest debts early.
Expenses you plan to make in a few years, such as buying a car or taking a vacation, should be saved, not invested. You’re better off protecting this money from market volatility and potential loss by keeping it in a bank savings account.
For dreams that you want to achieve beyond five years, use a taxable brokerage account for higher rates of return. Regular investment accounts don’t come with any tax advantages, but unlike a retirement account, you can take withdrawals at any time without penalty.
Making smart money decisions comes down to preparing for the unexpected by having financial safety nets. Then you’re in a great position to dig out of any dangerous debts, invest for the future, and save for any other financial dreams you may have.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.