So you have a few dollars to save, payoff debts, or invest for the future. What do you do with the money, so you can reach your goals in the quickest and easiest way possible – and not waste time or money on poor decisions?
Step One: Your Emergency Fund
You have received an inheritance of $50,000. What do you do with the money? Yes, you could buy that big screen TV and sound system, and take a major vacation – but what if you wanted to make huge progress on your goals, and not let the money waste away, bit by bit?
You have $500 left after your monthly bills and other fixed expenses are paid, and you set aside money for gas, food, clothing, and other necessary expenses. You could spend this money on little luxuries, pay extra on your mortgage, or save for retirement. How do you make the decision?
The first priority should be setting aside money in your Emergency Fund. Yes, even before you pay off your credit card debt (unless you are in default or delinquent on your bills – then first pay them enough to bring them up to date).
Regardless of how much credit card debt you have, the first step in creating a prosperous future is to change your habits. When the unexpected bill comes (and it always does), you should have money in your Emergency Fund to pay that bill, to avoid racking up additional credit card debt. If you have spent every extra dollar attempting to pay off your debt & have no money set aside, when something unexpected happens, you will rack up even more debt and be right back where you started.
Your Emergency Fund should contain three to six months of your actual bottom-line living expenses. Or more … I have some clients with up to one year of cash set aside; typically, they are generally risk adverse, are self-employed, or have a fluctuating income stream. Your amount is not three to six months of your salary – it is the bills and necessarily expenses you would have if you were unable to earn income. These funds should be maintained in a cash account, typically a savings or money market account. The Weinstein family Emergency Fund is in an ING Direct Orange Savings Account.
A home equity line of credit (HELOC) does not count. Yes, you could use a home equity line, or take out a loan on your house, if you were unable to earn income or had emergency expenses. But, it would just rack up your monthly expenses and debt even further. And, since interest rates have risen, even the tax deduction does not compensate for the high expense of using the HELOC.
Once you have a well-established habit of saving money each month, and have your Emergency Fund set aside, we can move to the next step – prioritizing debt and your life goals.
Action Step One:
Open up a dedicated savings or money market Emergency Fund account. Set aside a fixed amount of money each month – whether it is $50, $500, or $5,000 – until your fund is at three to six months of your living expenses.
Step Two: Pay Off “Bad” Debt
You’ve set up your Emergency Fund, and created a wonderful habit of saving $50, $500, or $5000 each month. We don’t want to let that habit disappear … so where do we put your money next?
Step 2 is to pay off any “bad” debt. What that means really depends upon the person, and your tolerance for debt. Some people are not particularly bothered by debt, so their only “bad” debt are those with high interest rates, or minimal tax advantages (non-mortgage and non-student loan debts).
There are two situations where I may ignore the interest rate, and recommend the client pay off the debt ASAP.
(1) Loans from family or friends. These loans, while low interest, may be eating away at the relationship, without you even knowing it. They may reduce the relationship to a formal, strained, money-based transaction, instead of a loving, friendly, supportive bond. You may know the debt is a problem, or ask other relatives to see if the debt is a problem in culture of the family – if so, pay it off quick.
(2) Debt that is keeping your up at night, or making you feel unsuccessful. Debt may be the new “American way” – but it is not right for everyone, or even most people. Monthly payments, or even the idea that you could be repossessed or foreclosed upon, may be eating you up at night. You may feel venerable, or like you have never achieved any of your goals until that debt is paid off.
If this is you, then your debts may become a high priority, even over other goals, like college funding or purchasing a new home. Whether your debt should be paid off as a high priority, depends not just upon the interest rate, but upon the mental and emotional interest rate you are burdened with each month you are making loan payments.
Action Step Two:
Take a personal inventory of your debts, and how much they are costing you in mental and emotional energy. Do they bother you? How much? If so, regardless of how low the interest rate is, paying them off should be a high priority. Start today – pay an extra $10, $100, or $1000 on the principal each month. Even better, set up automatic bill payments in your online bank account bill-pay system to make automatic regular extra payments each month or quarter.
Step Three: Goals Funding – Base Level
Now you have set up your Emergency Fund, and paid off your “Bad” Debt, including a loan from a family member, a high-rate credit card, and an old debt from college that was really bothering you.
You have a bunch of goals – retirement, paying off your mortgage, buying your next house, launching a new business, and sending the kids to college.
Which comes first? Retirement? The kids? Paying off your debts? How do you decide?
Step 3 of Where to Put Your Next $1 is to fund your goals, in order of priority, at the base levels – the amount of money you need to satisfy the minimum requirement of your goal.
For example, how much money do you need to pay your bills in retirement – not live an extravagant lifestyle, or play golf every day for 20 years, or travel the world – but how much to keep out of a cardboard box and live comfortably?
How much money do you need to save to send the kids to State College, as opposed to Ivy League? How much would it cost for the house you need, as opposed to the house you want?
Then fund the minimum, base level of those goals in order of priority. This may mean you start by contributing to your retirement plan or IRA, then contribute to a 529 Plan for the kid’s college education, then set aside money in a CD to start a business in 3 years, and then, finally, invest to raise funds for a bigger house.
How do you decide the order of priority? First, determine if there is another way to pay for the goal, besides your own savings – if so, then it is probably a lower priority than goals for which you have no other alternative. For instance, there are loans easily available for college education, but not for retirement (with the exception of a reverse mortgage). Also, you could obtain investors or take out a loan to fund a new business, and pay them off with the new income stream.
Second, evaluate if you are giving up “free money” by not utilizing pre-tax or matching savings or retirement plans. If you can save pre-tax, the federal government is contributing to your goal (since you don’t have to pay those taxes), and if you don’t take advantage of this each year, you are leaving money sitting on the table. Similarly, if you are lucky to be employed by a company who matches a 401(k) plan, you may want to contribute at least the match, to “let” your employer help fund your retirement.
Action Step Three:
Make a List of Your Goals, in order of priority. Look at your #1 Goal – is it really your most important, or is it just first in order of time? Any special types of accounts or matching available for this goal? How much will your goal cost? What’s the base level for that goal?
Set aside money each month to fund the base level of your #1 Goal – use your automatic savings or investment plan help you execute this week’s Action Step.
Step Four: Above and Beyond …
You’ve maxed out your Emergency Fund, paid off your “bad” debts, and funded the minimum levels of your most important life goals. Great job! What’s next?
Step 4 is to fully fund your goals, in order of priority. For example …
* Max out your Roth IRA, if you are eligible.
* Max out your 401(k) and IRAs (yes, you can do both, the IRA just might not be deductible).
* Purchase ESPP stock (and don’t forget to regularly sell and diversify).
* Contribute to a 529 Plan and/or taxable investment account for college education.
* Invest in taxable or tax-advantage accounts for miscellaneous future goals, or additional retirement funds.
* Buy investment real estate and/or rental property.
* Pay off your mortgage.
* Purchase CDs or Bonds for specific, time dated goals.
* Leave money sitting in your Health Savings Account, invested and tax-deferred, until you can roll it over to an IRA in your retirement.
Wow, do you still have money sitting on the table? Wonderful! If your goals are already funded, then don’t forget to enjoy your money now. Take a first-class vacation, hire a errand service for a few hours each week, buy a new sound system, or make a significant donation to your favorite charity. Balance saving for your future goals with living life now.
Action Step Four:
Choose your highest priority goal from Step 3. Have you fully funded this goal, to achieve your ultimate dream? Evaluate whether you have funded the minimal level of your other goals. If you have, then choose an action step from the list above … and enjoy your prosperity!