Lower Debt, Raise Savings

Investing

You have paid all your bills this month and you have some extra cash left over. Great! Now, what to do with it? Many people debate on what is the best approach between paying off debt and saving. Well, one answer does not fit everyone since each person’s areas of focus are different. You need to analyze your own situation to develop a customized plan,

Start by first knowing what is good debt and bad debt. Good debts are obligations that have a low interest rate and can potentially be tax deductible. For example, student loan debt or a mortgage loan are considered good debt, as you can deduct the interest you pay on your income tax return. Most good debts are for items that are essential for everyday living. Bad debts are classified as high interest obligations that can become extremely expensive over time and costly to your financial well-being. A few examples are credit cards, which commonly have interest rates that can sky rocket, or car loans, as your car depreciates continuously from the moment you drive it away from the lot.

To decide whether to allocate extra funds either towards debt or savings, consider the rates of return. For instance, you have a credit card with a balance of $15,000 and an interest rate of 22%. You are essentially getting a 22% return by eliminating those interest payments. This means to make the decision to save instead of paying off the credit card, you would need to earn at least 22% on an after tax rate basis to make saving a better choice.Now, a different scenario would be if you were to have a mortgage with a 2.5% interest rate. In this situation, you need to evaluate the return on your savings versus the interest rate on your mortgage. More than likely the return on your savings will be higher than the 2.5% mortgage rate. In that case, it would then be better to put the extra money in savings rather than paying down the mortgage.

When it comes to repaying debt, always pay at least the minimum payment amounts, though preferably more to help pay it off quicker as well as to decrease the amount of interest you pay. In addition, any extra funds that can go towards debt, consider first paying the bad debt with the highest interest rate.

Saving money needs to become a habit! The next question that might arise is, where do you save first? 401k, savings account, 529 plans, etc. Here is a suggested priority list for your savings:

1) Participate in your employer’s retirement plan. – It is highly recommended to contribute at least as much as the employer will match. An employer’s match is like free money… who isn’t willing to receive that!

2) Create an emergency fund to cover at least 4-6 months of non-discretionary living expenses. These fund will pay for any urgent cash requirements or a few months of bills if your income is decreased or ends for a period of time. (Always remember to replenish it!)

3) Contribute to an individual retirement account (IRA). – If you are in a lower income tax bracket, consider contributing to a Roth IRA (contributions are with after tax dollars – withdrawals later in life are tax-exempt). If you are in a higher income tax bracket, consider contributing to a qualified retirement plan such as a Traditional IRA (you may deduct the amount of your contribution on your tax return within certain AGI limitations – withdrawals later in life are taxed).

4) Save for your children’s education. – There are various options to save for education, e.g., a Cloverdale or 529 account.

5) Save for a home, home improvements, vacations, or other items on your wish list. – These are recommended once you are saving for retirement and have eliminated any bad debt.

6) SAVE, SAVE, SAVE!

For short term savings, like your emergency fund, you should keep these funds in an account that you can easily access. For long term savings, keep these funds invested.

If this feels overwhelming, don’t let it be. There is not one right answer for everyone. First, start by analyzing and prioritizing debt obligations to decide which obligations to pay more than the minimum amount (think bad debt first!). Then, figure out how much is remaining after all non-discretionary living expenses are paid, this is the amount you have for savings. And yes, you are allowed to have some play money… life is too short to not enjoy it!

Please feel free to contact WealthPoint Advisors to discuss any questions you may have. We are always here to help!

About the Author: Brent Walker

Brent Walker, CFP®, President is head of business operations for WealthPoint Advisors, LLC. His primary responsibilities are business strategy decisions, client communication, investment advice and management, and business development.