Pay down debt! Max out your 401(k)! Add funds to your children’s college savings plans! Buy insurance! Save for retirement! Build an emergency cash reserve! Pay off your mortgage aggressively! Pay it off even more aggressively! Do more investing!
With so many options, rules and recommendations on what to do with your paycheck, it’s hard to know where does that next dollar go? Do you pick one bucket and fill that before looking at any others, or do you slowly chip away at each one? The answer is of course, complex… but read on.
The basic idea is that with each dollar you bring in, give it a job. This is the fundamental premise from YNAB (You Need a Budget), and we think they are spot on. Yes, it can feel awfully overwhelming when you consider all the places you can put your hard earned income. However, if you consider the potential growth of each of these buckets it becomes clearer what kind of plan you need to put in place. And that growth is measurable in both directions. This growth increases your future bottom line with potential returns like investments, and decreases your bottom line with interest charges like debt. If you can determine a potential growth rate from each of these, then you can compare them rather easily.
Consider this: credit card debt typically carries a higher interest rate than some student debt or home mortgages. Paying off the debt with the higher rate helps you pay less interest over your lifetime. But what about aggressively paying down a 4 percent mortgage compared to investing in your 401(k)? A bit less “apples to apples” but still measurable. According to Vanguard, a balanced portfolio generated an average 7-8 percent between 1926 and 2016. These returns are a bit higher than we expect going forward, but it gives you a comparable measure to consider. You can avoid paying an additional 4 percent per year as mortgage interest to your bank, or you can potentially earn 7 percent per year in the markets. (We say potentially because the returns of the markets are of course not guaranteed and can be volatile in any given year).
Don't forget about your 401(k) and its accompanying employer match if you have one. The match is free money! Your employer contributes this money to your 401(k) for your retirement benefit and as long as you invest enough in your 401(k) to receive the match, this additional money is considered part of your overall salary package. If you are not investing enough in your 401(k), then you're leaving this (free!) money on the table. So take it! And not to mention, a 401(k) grows tax deferred, yet another substantial benefit.
The bottom line is that if you evaluate each bucket of money based on its current rate and growth potential and keep in mind any perks like employer match, tax deductions, or an emotional reward like paying off debt, you can make a plan, which can be the most important step you take.
1. If you haven’t pulled together a net worth statement yet, that’s a great first step to see what you have and where everything is. We think the most efficient way to do this is through a financial integrator app like Mint or Personal Capital. You can also do it the old school way through excel. A visual snapshot of your cash flow, savings and investments will help you with the rest of this process.
2. If we had to pick a default plan, we’d recommend tackling things in the below order. Keep in mind, that you may have personal or non-financial reasons to deviate from this plan and by all means, do what works for you.
Pay down expensive debt such as high interest credit card or personal debt. Moving forward, pay off your full credit card balance each month, no excuses! If you don’t earn it, you shouldn't spend it.
Build an emergency cash reserve.
And then, consider adding a portion to each of these monthly:
If you have student debt, have a plan on how to pay if off and by when.
Save for retirement by maxing out your employer retirement funds to at least get the “free” employer match, and if possible, put the maximum amount allowable by the IRS into your account each year. Consider allocating funds to other tax deferred accounts like IRAs if you're eligible.
Plan for College Savings Know how much your kids will need for college and then decide if and how much you want to contribute to their education. If you do want to contribute, come up with a plan to allocate funds to college savings every month. Keep in mind that dollars you allocate to college savings typically occur at the expense of saving for retirement. We’re fans of the “put your own airplane mask on first” when considering these two options and recommend having a plan for retirement savings before over-funding college savings.
While considering the above, next evaluate paying down your mortgage more aggressively than your standard monthly payment. Look at your current (and perhaps floating) interest rate, what you pay each month, what the payment terms are and if you have any prepayment penalties. Compare your interest rate to current mortgage rates, and what you could make if you invested excess cash in the market. Typically, this decision ends up being a emotional one, not a financial one. Most people simply want to pay off their mortgage so they can be debt free, even if they think they can make more by leaving that capital in the investment markets. We’re a fan of debt free and the markets… This decision is a personal one.
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