Many consumers must decide whether it’s better to pay off debt, such as student loans, to save money or to invest it. This is rarely an easy choice.
Budgeting decisions are among the most important issues for many households. They determine a household’s long-term financial health. But by zeroing in on a few key points, you can determine what’s best for you and create a sound strategy. Consider the steps below.
Debt and income
First, take stock of your debt, pinpointing what you owe to each lender. That includes the principal and monthly payments and the interest rates. Learn if there are any prepayment penalties. Next, consider your income so you understand what you’re taking home each month, after taxes are withheld or after you’ve accounted for estimated taxes.
Last, consider your budget and spending. Where is your money going each month and year? By understanding these variables, you’ll be ready to personalize a plan, including whether to pay off debts or save, or pay off debt or invest.
How much is your debt?
Consider how much debt you have and the interest rate. If you have high interest rate credit card debt or high interest rate student loan debt, for example, it makes sense to pay that off before saving or investing the bulk of your extra funds. Why? Those interest rates are likely much higher than you would get by investing the money. Making a plan to pay off that high debt as quickly as possible gives you more financial freedom.
If your debt has a low interest rate, for example a car loan, government student loans or a mortgage, it may make sense to continue making those regular payments each month and budgeting for them. Also, some interest, like a mortgage, may be tax deductible, so there are other advantages to paying back that debt more slowly. The interest rate you may receive from investing in a mutual fund or stock might be higher than the interest rates you’re paying on these types of debts, so you’ll come out ahead in the long run.
It’s good to have some money in the bank as an emergency savings account, though the amount varies depending on the person’s situation. If you have no savings, then a sudden car repair bill or medical bill may cause you to put the charge on your credit card, which could result in a high interest payment. Having a few thousand dollars in an easy-access savings account for these types of emergencies might help you sleep better at night.
Your company might offer the opportunity to save for retirement. Funds that come directly from your paycheck can be invested using automatic direct deposit each pay period. These investments can earn compound interest that benefits you in your golden years.
There are several advantages to directing a portion of your money to retirement investing. You may be able to choose a plan using pretax money, meaning that you pay less tax on your income. You’ll still owe the taxes later, when you withdraw the money, but presumably you’ll be in better financial shape at that point.
Another advantage to retirement investing through work is that some companies offer a matching plan. They will match a percentage of your salary or a percentage of your investment. That’s free money for you, which you keep if you stay at the company for the prescribed amount of time and invest enough to get the match. Making retirement investing an automatic payment from your salary is a good way to get into a healthy saving habit and to let the long-term accumulated interest and potential company match work for you.
Looking to the future
If a lot of your debt is consumer debt, meaning things you bought for your lifestyle, consider scaling back now so you don’t create more debt in the future. That might mean eating out less, buying fewer electronics or making impulse purchases etc. so you can stabilize your finances and save for the future.
Once your higher debt is paid back, don’t slide into the same habits. Set aside money from each paycheck to invest for your future goals, whether that’s a rainy-day savings account, retirement account or other type of savings.
Get personalized financial advice by talking to a financial advisor. An advisor can help you understand your specific situation, and can help develop a plan for meeting your financial goals.