Now that Christmas is over and we’re approaching the New Year, you may start thinking about New Year’s resolutions and many of those probably involve financial goals. But we all have a limited amount of cash flow to work with. Which of those goals should you prioritize first?
In my last post, I reviewed some protection goals to start with. In this post, we’ll take a look at the next steps of paying down debt and saving for education and retirement. Let’s say you have a credit card balance of $5k at 14% interest, a $300k mortgage at 4%, not enough saved for retirement or college, and you can save about $2k next year. Where should you put that money?
The obvious answer might be to pay down the credit card debt first since the 14% interest rate is higher than the mortgage rate and more than you’re likely to earn by investing the money for retirement or education. But what if I told you that you would get a full match from your employer on that $2k in your 401(k)? Let’s look at the numbers. Using our Debt Blaster calculator, we can see that putting $2k extra on your credit card debt would save you $7,679 in interest over the almost 19 years it would have otherwise taken to pay off that debt. Contributing that same $2k to your 401(k) and earning about 6% per year, it would grow to about $12k over that same time period. (Without the match, that $2k would only grow to about $6k.)
You can do the math for your own situation (the interest rate on your debt, how long it would take to pay off, your employer’s retirement plan match, and the expected rate of return on your investments), but a good rule of thumb is to first max the match on your employer’s retirement plan. After all, it’s hard to beat a 50% or 100% return on your money even if it’s only the first year. After that, pay down any high interest debt and by “high-interest,” I mean anything higher than what you can expect to earn by investing the money instead (8% if you’re aggressive, 7% if you’re moderate, and 6% if you’re conservative).
Once you’ve paid off your high interest debt, it may be tempting to start saving for college or paying down the mortgage, but you’re probably better off using a retirement calculator to make sure you’re on track for retirement first. That’s because there’s always financial aid for college and mortgage interest is usually relatively low and tax-deductible. In fact, there’s a case for never paying your mortgage off.
Keep in mind that if your retirement investments do better than expected, you can always use some of that money to help your children pay down their loans. (If they perform worse than expected, you’ll be glad you don’t have even less in your retirement accounts.) It’s like the “oxygen mask rule” in airplanes. Make sure your own oxygen mask is on before helping your children with theirs.
By the way, being on track for retirement is about more than building up a nest egg. It’s also about making sure those savings are protected, particularly from the costs of long term care. Once you have more than a couple hundred thousand dollars of assets, you may want to think about purchasing long term care insurance before you become too old and/or sick to qualify for affordable premiums.
So here is a summary of some guidelines to prioritizing your financial goals for next year:
1) Make sure you have adequate emergency savings and health, life, disability, and property and casualty insurance coverage.
2) Max your employer’s match.
3) Pay off high interest debt.
4) Save enough to retire.
5) Purchase long term care insurance.
6) Save for education.
7) Pay off low interest debt. (maybe)
Now, if only accomplishing them were that easy…