You worked hard, finished school, and managed to get a job in a very tough job market. For the first time in your life, you are making a real living and you want to get your financial life off to a healthy start. The question that always comes to mind is: “Should I focus on saving or paying off my debts?”
On one hand putting money into savings is an investment in your future. The earlier you start saving, the more money you will have later, right? But then, paying off your debts would mean more money in your monthly budget and less money being wasted in interest payments. What should you do?
Create a budget.
Seriously. Before you can even start to consider the question of paying off debt vs. saving, you need to have a clear picture of your financial situation. You don’t have to get fancy. Simply write down and add up all of your monthly expenses and payments as well as your monthly income from all sources. Then compare the two numbers.
If you have more money coming in than you have going out, you are in good shape and can save and pay off your debts. If you have more money going out than you have coming in, you will have to make some drastic changes to make your budget balance. This will mean cutting back on your expenses or finding a way to make more money.
Establish your emergency savings fund.
Start off by creating a separate account for your emergency savings fund. The purpose of the fund is to give you the cash you will need when life happens and you find yourself in the hospital for three days or you have to repair your car. The account needs to be separate from your normal checking account so that you are not tempted to dip into it for non-emergency spending. The account also needs to be liquid so that you can get to the money quickly when you really need it. If you use an account that pays some interest on the balance, you are catching on quick.
How much do you need to place in your emergency fund? Your goal should be to have 3 to 6 months of expenses saved in your emergency account. However, you can start smaller as long as you keep saving until you reach your goal. For instance you might want to start with a smaller milestone like $1,000. As a bare minimum, you will want to be able to pay any deductibles you have on your car, home, or health insurance policies. I chose $1,000 because that amount will cover a lot of car repairs and will cover most deductibles.
To make saving easier, automate the process. Have your employer deduct a little from every paycheck and send it directly to your emergency savings account. After you’ve reached your first milestone, you can keep saving enough to make comfortable progress towards your larger goal of 3 to 6 months of expenses but leave enough money free in your budget for the next two steps.
Establish your 401k.
If your employer offers a 401k program with a company match, be sure to contribute enough from your pay to get the maximum employer match that is offered to you. If you don’t max out your employer’s match, you are just throwing free money away. Your 401k is for your long term retirement savings. As we stated in the beginning, the earlier you start saving for retirement, the more time compound interest has to work its magic and the more money you will have at retirement.
Pay off your debt.
You reached your first emergency savings milestone and you are contributing enough money to your 401k to max out your employer’s match. Now is the time to start knocking out your debts. If you are like 70% of college graduates, you have school loans that are probably a big drain on your monthly budget. However, you need to use any extra income you have in your budget to pay off your high interest debts first. This means credit cards, car loans, high interest private school loans, etc. Paying off higher interest debt means you are reducing the amount of interest you will pay on those debts and you will save more money in the long run.
What about your low interest federal student loans? Keep making the minimum payments on time. By paying the minimum amount on time every month, you will improve your credit score. Never miss making at least the minimum payment on any debt or your credit score will be affected and you will be charged late payments and eventually higher interest rates on your debts. That’s wasted money.
What is the next step?
Now it’s been five years since you graduated. You received a promotion and a few raises since you first entered the workforce. Your emergency fund is growing nicely as well as your 401k. You’ve paid off your high interest debts and are still paying on your low interest student loans. Now what do you do? Should you focus on paying off your low interest federal loans completely or should you dedicate your extra cash to your 401k, IRAs or other investments?
You should consider investing. Chances are that you will receive a much larger return on investing your money than you will get by paying your low interest school loans off early. You will need to look at your student loan interest rates and compare them to the returns you can get from investing the money. If you are only paying 4% on your student loans and can get 8% by investing more in your 401k, IRAs, and other investments, investing could be the better way to go. If you would just feel better knowing that your student loans are behind you, then you should consider your feelings as well. Make the decision that is right for your circumstances and for your personal goals.
What if your financial picture is not so pretty?
It happens. Sometimes life can hit you really hard or your job doesn’t pay as much as you had hoped. What should you do if you are struggling to make the minimum payments on your debts and you feel like you’ve lost control of your finances?
Get help! The worst action you could possibly take is to ignore the situation. By doing nothing, your financial picture will not magically improve on its own. Instead, your personal finances will continue to go downhill even more.
Turn to a non-profit financial counseling organization like Apprisen. Apprisen offers free student loan and personal finance counseling that can help you get your finances back on track…and keep them there. Call 800.355.2227 or visit Apprisen online to find out more.