The age old question of how to allocate available income is best resolved by either paying off pre-existing consumer (credit card, car loans, etc.) debt, and/or investing for the future. Presumably, when we speak of investing the most popular way to accomplish this is through stocks and bonds. But how much to throw at debt, and how much to invest is often under debate. Are there fixed percentages that financially responsible individuals use (e.g., 85:15%, 60:40%, etc.)? Can we just add an extra $100 on top of our minimum monthly payments and live with that? Does investing in asset classes that average a certain percentage of return justify putting our dollars there [e.g., if I can confidently assume a 9% rate of return year-over-year (YOY) but my car loan interest rate is only 6%, I should choose funding that particular asset class]?
All of these questions will be explored, and more, in this article. But first, it’s worthwhile mentioning that no two snowflakes are identical. And thus, not everyone will have the same savings strategy. Although the strategies contained herein may be effective for some, and not others, the basic idea(s) are almost universal. So take what you can from me, and absolutely feel free to tweak according to personal preferences.
Now, let’s go tackle some debt.
Or do we squirrel away a few extra acorns this month instead? I mean the time component of investing is really how to capitalize on long-term gains right? Compounding interest and such? Maybe it’s best to actually get some money in the stock market now, so that it can start actually growing.
Well, my response is… yes, and yes. Tackling debt while wading into the investing waters is the reality that many, if not most, individuals face in today’s game. To speak candidly, this skill is almost essential for young people ages 18 – 35. Because, as I’ve indeed learned myself, there’s no magic wand to wave that makes debt magically disappear.
Fortunately, there’s hope. The first step to solving a problem is acknowledging it’s existence! You don’t have to know what the end-point is exactly, to get started down the path. Okay, so with that, we know that debt should be eliminated. And a portion of income should be saved for investing in assets.
Fixed Percentages Strategy
Determining how much to allocate towards debt begins with a budget. So I’m assuming that you know how much is leftover roughly each month to play with. Say there’s $312.5 leftover from each monthly cycle to use towards building wealth, which represents 15% of your monthly income. This means your annual income is roughly 25k/year. Are you going to be using your savings in the same way as somebody making 85k/year, or more?
Yes and no. The person making 85k+ per year might have 100k in student loan debt; whereas the individual making 25k annually could be debt-free. Therefore, the proportion of leftover income that should be used for investing will vary between these two individuals. Ideally, having 15% of your income to use is a great target to shoot for initially. And this figure can further be broken down to 15:85% of paying-off debt vs. investing. For example, let’s say your annual income (after taxes) is 50k/year. That means each month you should have $625 extra to save (i.e., 15%). 15% of that amount = $93.75, which is used to invest; whereas the remaining $531.25 is used to pay down debt. If that’s too aggressive, tweak it to 24:76% of an investing:debt pay-off ratio; which results in a cool $150 to use towards investments monthly.
This example assumes that you actually have a sizable amount of outstanding debt to pay-off; however, if you only need $150/ month to put towards (we’ll say) credit card balances, then the remaining $531.25 can be used to invest (following the previous figures). In this scenario, the individual is implementing a 76:24% ratio of investing:debt pay-off from their 15% monthly remaining income. Cool.
Match Employer Contributions
Either the 24:76% or 76:24% ratios would steadily build up a nest egg for the 50k/year earner (with the later obviously resulting in a higher rate of growth), while quickly reduce outstanding debt; however, they don’t account for any employer matches into retirement accounts. For example, my wife has a 403(b) plan that her employer (the Board of Education) offers with a 3% match. Since this is free money, the maximum amount should be contributed to this account monthly to earn the match. Then everything else goes towards outstanding debt.
Along these lines, many individuals (myself included) are considered self-employed, and don’t have employer contribution perks. It’s for people like me that the percentage strategy might be the most useful. Setting up automatic deposit/withdrawals monthly can further simplify the savings process. So you know, I’m currently using a 60:40% percentage of investing to debt-payoff ratio, as I’ve completely paid off any old outstanding debt. Therefore, ~40% of my 15%+ extra monthly income (my “Me money”) is put towards any new consumer debt – to bring all credit card balances to zero.
Extra $x On Top of Minimum Payments
If calculating percentages isn’t your thing, another strategy that many individuals use is the “extra money on top” technique. Growing up, my mother always said that making just the bare minimum payments towards my credit cards is Not Good. High-interest rates will kill any progress you make towards reducing the overall principal. Therefore, it’s necessary to pay much more than just minimum payments.
When implementing this strategy, adjusting monthly automatic payments is often a helpful way to streamline paying bills. So you’d just have to login to your online banking portal, and adjust the monthly automatic payment by increasing by $x; where x could be equal to $100 or more. Initially this may seem like a big drain on your checking account; however, after a few recurring withdraws, it becomes a lot less painful. When a few months have passed in this way, you may even go back into your account and bump up the amount. That way your outstanding debt will be reduced that much quicker. Then, whatever extra money is leftover at the end of the month gets allocated towards investments.
Emergency Fund Funding
Depending on how much outstanding debt you have left; funding an emergency fund may be a smart idea, to prevent unforeseen incidents having to be paid for with plastic. According to Dave Ramsey, in Total Money Makeover, you’ll want to have an emergency fund of at least $1k. And apply the debt snowball (paying off lowest balances first, then applying that monthly payment towards the next highest credit card account balance, and so on) while stashing away that 1k.
Therefore, before taking to investment waters it might be wisest to create an emergency fund first. Then take to implementing one or more of the strategies discussed here. Ideally, Mr. Ramsey advocates, we should have approximately 3-6 months worth of expenses saved up as an emergency fund. This may be a bit daunting initially, and tweaking your savings rate to accommodate either the “fixed percentages” or “adding $x on top” strategies is amicable.
Comparison of Returns Game
Finally, depending of the type of debt that you’re dealing with (e.g., student loan, car loan, credit card, mortgage, etc.) there’s a great amount of variability in the interest rate that’s attached. For example, credit cards typically carry a very high interest rate (i.e., 14-22%) unless you’re still within the initial promotional Annual Percentage Rate (APR) period. Compared to student or car loans, which may have an APR of 6-10%, the rate of return from investments may be equivalent or greater to interest amounts. Because some people see that investing in the stock market now (the S&P 500 has returned an average of 9-12% for the past decade) is more profitable than reducing outstanding debt balances, they’ll channel a larger percentage of available income towards their investments. And leave the (relatively) low-interest rate loan to be repaid via automatically-recurring monthly payments.
Personally, that’s a great strategy to implement because time literally is money; however, would only be logically effective if you’re purely carrying a low-interest rate loan. Having student loans and credit card debt, for example, may occasion a more focused pay-off strategy (e.g., either of the two strategies aforementioned, or a combination of the two). Really any way to get those credit card balances eliminated, as soon as possible. Because it’s then that your income will be more readily available for creative investment implementations.
Investing Made Easy
Does funneling money into the stock market sound intimidating? Well, it’s a lot simpler than you may think. There’s a plethora of robo-advisors out there now that are super cheap (like pennies a month) to use. And your cash is completely liquid, which means you can access it at any time (although you probably shouldn’t). Just to give you an idea of what a robo-advisor looks like, I personally have been using Wise Banyan for almost a year now. So far, so good. Just search for them in the app store. Or you can get up an running with a free $20 through the link above. Getting a Rainy Day fund set-up is quick and simple, and you’ll be invested in the S&P 500 by allocating cash towards that account.
In conclusion, there’s more than one way to skin a cat. I have years of experience for dealing with debt, and much of my knowledge is derived from that. Although you won’t find a deep dive into the annals of financial literature here, you might just stumble over something that resonates. Similarly, developing a system that works best for you, the individual reader, is key in sticking to it.
And getting out of debt, and into investing, is just using the wide-angle scope of a financial plan.
I recommend the following process for most people:
- Pay-off any outstanding debt using the techniques discussed above.
- Fund an emergency fund so that you don’t have to ever rely on a credit card for unforeseen expenses.
- Setup an investment account through a robo-advisor of your choice.
There’s ways to accomplish multiple financial goals simultaneously, the discussion of which was the purpose of this article. A lot of personal finance experts recommend focusing on paying off debt completely first, because it feels liberating. And that feeling often engenders more confidence (and more cash-flow) towards related future objectives.
Featured image courtesy of Jeff Maion, “Country Road” retrieved from www.maion.com