How to Lower Debt While Building Savings
When you’re carrying household debt, it can be hard to decide which to do first: pay off what you owe, or save and invest what you have.
For many, the challenge has grown more daunting. According to a recent survey by the personal finance website NerdWallet, the average credit card debt per American household has increased by more than 10% over the past four years to $16,061. Meanwhile, credit.com reports that the average Class of 2016 graduate had $37,172 in student loans.
When we asked members of the American Funds “Voice of the Investor” panel about their financial priorities for 2017, we heard a common refrain. Many said they wanted to pay down debt even as they pledged to save more for future goals, including funding their children’s education and building a retirement nest egg.
“When you’re in your 20s, 30s and 40s, you’re trying to manage student loans and credit card bills,” says Jamie Hopkins, co-director of the New York Life Center for Retirement Income at the American College of Financial Services. “The question becomes, how do you split limited resources?”
Paying down debt and boosting savings requires diligence, discipline and tough decisions. The upcoming America Saves Week (americasaves.org) may be an ideal time to tackle the challenge. Here are some steps to get you started.
Do a gut check
Understanding your emotional response to debt is an important first step. Are you the kind of person who is uncomfortable with any kind of debt at all? Are you willing to live with some low-cost debt in order to put more of your dollars toward saving and investing?
“There is no one-size-fits-all philosophy,” Hopkins states. “You have to do some financial soul-searching.”
Secure your safety net
First, you should have some money that’s readily available in the event you’re faced with a challenge like a sudden illness or job loss. A good rule of thumb is to establish an emergency fund that would cover at least three months’ worth of living expenses. One of the easiest ways to do so is by setting up automatic withdrawals from your paycheck. Even if you start with a small sum, say $100 a month, it’s worth getting into the habit of “paying yourself first.”
Contribute to your workplace retirement account
People often debate whether they should put money into their 401(k) before paying down debt. If your employer offers a match, consider contributing at least enough to your 401(k) to qualify for the matching funds. You never want to pass up “free money.”
Divide and conquer
Make a comprehensive list of your debt — credit cards, student loans, auto loans, mortgage and other obligations — starting with the one that carries the highest interest rate. Credit card debt likely will be at or near the top of the list.
If the interest rate on a particular debt is higher than the rate of return you might earn by investing, it often makes more sense to chip away at that debt. It could be argued that paying off your high-interest debt is its own form of investing.
If you erase a credit card balance that has an interest rate of say 20%, think of it as a 20% return on your investment. It may make doing so a little less painful.
“It’s better to pay off a credit card with a 22% interest rate than to put money into an investment that will only make 3% to 5%,” says Deena Katz, an associate professor of personal financial planning at Texas Tech University and co-chairman of Evensky & Katz/ Foldes Financial Wealth Management.
The decision can become more complicated with student loans. If you have private student loans you might be better off paying them as soon as possible. The interest rate on some fixed-rate private student loans is higher than 12%. Variable rates are lower, but they are also less predictable.
However, if you have a federal student loan with a low interest rate, prepayments might not be the best choice. The current interest rate for federal direct loans for undergrads is 3.76%. Your rate might be higher or lower depending on when you borrowed the money.
There’s another factor to consider when deciding whether or not to prepay student loans: Qualified taxpayers can deduct up to $2,500 in student loan interest from their income.
Step up your retirement savings
If you’re already contributing up to the level of your employer’s match, considering going a step further. You can set aside up to $18,000 of your salary in your 401(k) in 2017, and if you are 50 or older you can make an additional catch-up contribution of $6,000. Financial planners generally recommend saving 10% to 15% of your pre-tax income annually for retirement.
If you don’t have access to an employer-sponsored retirement plan, you could set up an individual retirement account (IRA), which also offers tax advantages. You can contribute up to $5,500 in 2017 ($6,500 for those 50 and older).
Thanks to the power of compounding, even modest contributions to a retirement account can make a difference over time. In addition, qualified retirement plans offer attractive tax advantages.
Build up your investment portfolio
As you pay off your debts, you will have more money available to save and invest.
Assets you might need in the near term should be put into more conservative savings vehicles, such as money market accounts. If you’re not planning to touch the money for at least five years, your investment mix can be more aggressive.
Adds Katz, “You’ll want exposure to large-cap U.S. equities and other asset classes, such as small-cap and international. Different markets move differently at different times, so you want to make sure you are diversified.”
A financial advisor can help you craft a financial plan and investment strategy.
Make it stick
Now that you’re lowering your debt and building your savings, you want to remain focused on living within your means. Before you make an impulse purchase, ask yourself if it’s really worth adding to your debt. Rather than pursuing instant gratification, consider buying a bit more peace of mind.