What Comes First: Saving, Investing, or Paying off Debt?

June 06, 2013

One of the most common questions we get is whether to prioritize paying down debt, building up savings, or investing for retirement. Ideally, of course, we would do all three but most of us have limited dollars with which to work with. So what should take priority? It’s a topic that has generated some disagreement among some well-known financial gurus. Here are some guidelines to follow:

1)      Do you have an emergency fund?

If not, building this up should be your first priority but how much is enough? Experts suggest having anywhere from at least $1k to 3-12 months of necessary expenses. By “necessary expenses,” I mean things like your rent or mortgage payment, basic utility bills, loan payments, insurance, and food. These are the absolute necessities you would spend money on even if you were to lose your job. How much you need partly depends on how secure you feel your job is and what other resources you might have available to you.

Some examples of an emergency fund would be a savings account or  money market fund and possibly investment accounts and a retirement plan that you can borrow from. The latter two are only reliable if they’re at least twice what you need since their value can fall considerably, especially in tough economic times when you might need them the most. Also keep in mind that you can only borrow up to half the value of your retirement account so you actually need 4 times as much in there. Available credit on credit cards and home equity lines of credit can be considered supplemental but shouldn’t be relied on since they can be cancelled at any time.

One interesting place to put those emergency savings is a Roth IRA. That’s because whatever you contribute to a Roth IRA can be withdrawn tax and penalty-free at any time and for any reason. (If you withdraw any earnings before age 59 ½ and having the account open for at least 5 years, they could be subject to taxes plus a 10% penalty.) The advantage is that whatever you don’t withdraw can grow to be tax-free for retirement. This way, you’re killing two birds with one stone. Just be sure to keep the Roth IRA somewhere safe and accessible like a money market fund until you’ve accumulated sufficient emergency savings somewhere else. At that point, you can invest the Roth IRA in something more aggressive for retirement.

2)      Do you get a match in your employer’s retirement plan?

If so, this should be your next priority. Otherwise, you’re leaving free money on the table. Where else can you get such a high, guaranteed return on your savings?

3)      Do you have any high-interest debt?

By “high interest,” I mean more than what you can expect to earn by investing instead. That partly depends on your risk tolerance. If you’re more aggressive, you might expect to earn a 7 or 8% average annualized return on your investments. If you’re conservative, it might be closer to 4 or 5% and 6% if you’re in the middle. In any case, credit card rates are typically much higher than any of these so pay them off before investing, starting with the highest interest balances.

4)      Do you want to buy a home?

Once you’ve paid off your high-interest debt, you might want to start saving for a home purchase since you might need to put down 20% of the home value to avoid PMI. Buying a home can also be part of your retirement plan since you’re removing most of your housing expenses once the home is paid off and the equity can even be used to supplement your retirement savings in a variety of ways. The sooner you buy the home, the sooner you can start building that equity. Just be sure it’s a home you’ll keep for at least 3-5 years.

5)      Are you on track for retirement?

Use a calculator like this to see if you are and if not, how much more you need to save. This should take priority over saving for your children’s college expenses since they don’t give financial aid for retirement. Try to first max out tax-advantaged accounts like your employer’s retirement plan,  IRAs, and even an HSA (which can be used penalty-free for any purpose after age 65).

6)      Do you have any children or grandchildren you’d like to help with education expenses?

This should be the last priority. It’s not that education isn’t important but that low-interest loans are generally available to help them fund it. If you do have extra money for education, consider tax-sheltered accounts like 529 plans and Coverdell Education Savings Accounts. You state may also provide a state tax deduction for contributing to your state’s 529 plan.

7)      Where else can you invest?

Once you’ve maxed out all the tax-sheltered accounts, it still is generally beneficial to invest in taxable accounts if they can be expected to earn more after-tax than what any remaining debts are costing you in interest. Some investments that make the most sense in taxable accounts include tax-free municipal bonds, tax-deferred savings bonds, and stock since you only owe the capital gains rate on capital gains and qualified dividends as long as you hold a stock for at least 12 months. Foreign stocks are also eligible for the foreign tax credit when held in a taxable account. (While municipal bonds and savings bonds pay very little interest, holding them allows you to invest for more aggressively in other parts of your portfolio.)

In the case of your mortgage and possibly student loans, be sure to factor in tax deductions on the interest when you’re trying to figure out how much they’re costing you. But even without the tax break, the rates tend to be pretty low. In fact, mortgage rates are so low, especially after-tax, that you might never want to pay it off at all.