Should you pay off your credit card debt first, and then build an emergency fund? Should you save for retirement while you still have school loans? Which credit card should you pay off first?
I agree with trying to start investing as early as you can but what if you have debt? Shouldn’t you pay that off first?
My first reaction was to look through the archives here to find articles that cover this topic. I found several–
- Should You Sell Investments to Pay Off Credit Card Debt?
- Should you invest in a 401(k), a Roth IRA, or pay off credit card debt?
- Should You Stop Saving for Retirement to Pay Off Debt?
- Save or Repay Debt–That is the Question
One thing that I found interesting is how my approach to this topic has changed over the five years I’ve blogged here at the Dough Roller. Today, my starting point would be to prioritize savings and debt repayment. Let me explain.
Recently I wrote about where you should put your retirement savings. Based on a forum posting over at the Bogleheads, the priority looks something like this:
1. 401k/403b up to the company match
2. Max out Roth IRA
3. Max out 401k/403b
4. Taxable Investing
So let’s add some debt into this picture. Let’s assume the following debts:
1. Fixed rate mortgage at 5%
2. Student loans at 3.4%
3. Car Loan at 7.5%
4. Credit card debt at 18%
Now the picture is not so easy. Still, I think we can come up with a general framework on how to approach this, recognizing that every situation can be different and require a different approach. So where do we begin?
Lower Every Interest Rate You Can
Step one with debt is to get the lowest interest rate you possible can. Can you refinance your mortgage? Even at the 5% in our example, a refi down to 4% may be doable, given the low mortgage rates today.
Can you refinance your car loan? It’s actually much easier than you might think. Most auto refinances can be done online. Finally, can you transfer your balances to a 0% credit card? Credit card rates tend to be the highest as compared to other forms of debt, so getting your interest to zero can save a lot of money.
Where do you start?
Let’s assume that you can’t get your interest rates any lower. Where do you start? If I were in this situation, my first step would be to invest in a 401(k) up to my company’s match. Why? The company match is free money. Even with credit card debt I’d take advantage of my employer’s contribution to my retirement. Some may disagree with me on this one, but it’s just too hard for me to turn away free money.
Once I’ve done that, or if my employer doesn’t match 401(k) contributions, I’d turn my attention to a small emergency fund. For me, I’d start by saving enough money to cover my expenses for one month. I just can’t stand the thought of living paycheck-to-paycheck.
Once I had a small emergency fund stashed in a savings account, I’d tackle my high interest credit card debt. At 18%, the cost is too high to ignore. And I’d do everything in my power to pay of the cards as quickly as possible. (If you’re struggling with high rate cards, check out our series on how to get out of credit card debt.)
Once you get rid of your high rate debt, the choices become a bit more difficult. Some would say pay off all of your non-mortgage debt. But at reasonably low rates, I prefer a more balanced approach.
I would take any extra cash (over and above the minimum payments I had to make on my debt) and put it in equal parts toward retirement savings, debt, and my emergency fund. For the debt, I’d tackle the car loan first because it has a higher rate than the school loans. The school loans would come second. And I wouldn’t begin paying more on my mortgage until I was maxing out my retirement savings and a 6-month emergency fund.
The problem I have with trying to pay off all your debt first is that so many people never succeed. The pay down their debt for a period of time, but then something comes along that causes them to go into more debt.
So that’s how I’d approach Deacon’s question. How do you handle debt and investing?