One of the questions I get most often from friends and family is about priorities; which loans to focus on paying off first? What to do if you find a little a little extra money? Perhaps this tax season you are expecting a check from Uncle Sam and are wondering what to do with it. Maybe your car is finally paid off and you’ll have a few hundred bucks a month to allocate. Maybe you just want to be sure your doing the right thing for your family’s future.
This blog focuses on Financial Priorities. I will explain the types of accounts mentioned (IRA, 401K, 529) in separate blogs. Here are some general guidelines that can assist you in determining where that money will serve you best;
Pay the bills first. If you have any outstanding bills, this is a great time to catch up. Never save, invest or blow money frivolously instead of paying the bills. Doing so will destroy your credit score in a hurry, especially once you hit the 90 days delinquent mark. You can destroy your credit score (also known as a FICO score) in a matter of months but rebuilding it takes years. Your credit score may seem inconsequential now but long term it is a big, big deal. It will determine how much it costs for you to borrow money. It can raise the interest rate on any line of credit you are after; a mortgage, car loan even credit cards.
Second, build an emergency fund. I recommend having a minimum of three months worth of your bills covered in your emergency fund. Six months is preferred. This means that if your mortgage, car payment, insurance, utilities, gym membership, Netflix, etc totals $2,500 a month you should have a minimum of $7,500 in a savings account ($15,000 is preferred). If you or your spouse lose your job or got into an accident, you need to be able to cover your expenses. This is especially relevant if you have a job with uneven income distribution like if you work on commission or if work is seasonal.
Second, build an emergency fund. I recommend having a minimum of three months worth of your bills covered in your emergency fund. Six months is preferred. This means that if your mortgage, car payment, insurance, utilities, gym membership, Netflix, etc totals $2,500 a month you should have a minimum of $7,500 in a savings account ($15,000 is preferred). If you or your spouse lose your job or got into an accident, you need to be able to cover your expenses. This is especially relevant if you have a job with uneven income distribution like if you work on commission or if work is seasonal.
When you are totaling your monthly expenses be sure to include money for gas, groceries and a little extra for your discretionary expenses (gym membership, cable service etc) as well. It is always better to over-estimate your expenses than to under-estimate.
Third, erase debt. Once you have your financial safety net in place it is time to start trimming debt. If you happen to have some credit cards or other debt with high interest rates (think 10% or higher) this may be worth looking into sooner, say, once you have 3 months worth of emergency savings. Make sure you prioritize which debt you pay down first starting with the one with the highest interest rate and working your way down. This likely means starting with your credit cards and any unsecured loans you may have. Mortgages, car loans and college loans in recent years have had very low interest rates so you can get away with paying the minimum until those high interest loans are gone.
Third, erase debt. Once you have your financial safety net in place it is time to start trimming debt. If you happen to have some credit cards or other debt with high interest rates (think 10% or higher) this may be worth looking into sooner, say, once you have 3 months worth of emergency savings. Make sure you prioritize which debt you pay down first starting with the one with the highest interest rate and working your way down. This likely means starting with your credit cards and any unsecured loans you may have. Mortgages, car loans and college loans in recent years have had very low interest rates so you can get away with paying the minimum until those high interest loans are gone.
Fourth, Retirement contribution. As I discussed in my previous blog the sooner you start saving, the better. If you’re lucky enough to land a job with a company that has a 401k or similar retirement account, be sure to contribute. This account allows you to defer taxes and many employers provide some sort of matching, meaning they will match every dollar that you save, often up to as much as 3 or 4 percent of your total salary. Once you start your 401k contributions, if you've got cash left over or if no 401k is available to you, start a ROTH IRA.
Fifth, a college fund for the kiddies. Why is this so low on the list? Simple. There is a lot of money out there for college these days. There are scholarships, grants, loans and work study programs all that can help pay for some or all of your child’s college expenses. If you don’t manage to save enough to send your child to college chances are they will be eligible for one or more of these programs.
For retirement, there is one failing system out there to help you should you not have enough to live on: Social Security. You need to be sure that you have taken care of retirement before setting up a college savings plan for your child. It sounds harsh but your retirement is going to be longer and far more expensive and you will have very little assistance from Uncle Sam or anyone else save your family and no one wants to burden their family in retirement.
One of the newer tools available and gaining in popularity is the 529 account, named after the section of tax code that regulates these accounts. In many ways they are similar to IRAs but the money can only be pulled out without penalty if it goes to some form of college expense. This includes things like tuition, books, a dorm room (or other living quarters), a computer and school supplies. Each state has two or three of these accounts available and they all have different fees and benefits associated with them. That is why I intend to devote an entire blog to them in the near future.
I hope you found this helpful. I will follow up with a blog on the Traditional and ROTH IRA and the 529 account in the near future. Check back next week and I am sure I will have something up. In the meantime, if you have questions feel free to ask them via the comments.
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