What to Do: Pay Off Debt or Savings for a Rainy Day?
The new class of college graduates means millions of young people are entering the labor market for the first time. But there is still a lot to learn between setting up an emergency fund, paying off your student loan debt and making your first investment. So what do you prioritize? This is what we are doing this week.
Every Monday, we address one of your pressing personal finance questions by seeking advice from several financial experts. If you have a general question or money issue, or just want to talk about something PeFi-related, leave it in the comments or email me at [email protected].
This week, the question comes from Aaron:
Recently I just started my first job and now I have a lot more money than I’m used to. Family and friends showered me with financial advice that told me to either focus on paying off debt or create a savings fund for a rainy day (I literally didn’t have a savings account last month, so make progress!) Or start investing.
I currently prioritize saving for a rainy day fund, then pay off my debt, and then start investing. Though I feel like the last two can be done in parallel and don’t have to be mutually exclusive. How would you rate this order of priority? All the articles I might have missed, what’s a touch on this?
This is what individual experts usually say about a problem that affects each person differently: if you need personalized advice, you should see a financial planner.
Debt repayment priority
Congratulations on your new concert! From what you said, you definitely have the right priorities. The order in which you solve them depends largely on your individual situation.
First things first: you want to make at least the minimum monthly payments on your debt. I’m going to assume that this is a student loan debt and you don’t want to keep up with it and watch interest and late fees accumulate.
It will also improve your overall financial picture. “When you start paying off your student loans … your credit score will start to improve as well. This means you can start getting better credit card deals and start saving money on future loans, housing or car payments in the future, ”says Jill Gonzalez, an analyst at WalletHub .
And if it’s not student loan debt, but rather credit card debt, that’s even more important. “If your credit card interest rate is 15 percent [or higher], channel as much of your cash flow as possible to pay it back immediately ,” said Greg McBride, chief financial analyst at Bankrate . “It’s a risk-free 15 percent return.”
Think about what kind of debt repayment plan you need. When it comes to student loans, experts love income-based repayment plans (assuming you have federal loans). For other types of debt, there is the snowball method, the stack method , and more .
Make a comprehensive plan
However, don’t focus on debt at the expense of the rest of your financial life. “The big picture is that you can do all of these things at the same time, essentially prioritizing 1a, 1b and 1c,” McBride says.
How to do it? Your standard personal finance rules apply. Set up a direct transfer from your paycheck to a dedicated savings account to create an emergency cushion for yourself. In fact, as long as you are comfortable with paying off the debt – again, doing at least monthly – I would focus on your emergency fund.
“Our research and experience has shown that people are most worried about unpredictable things like unplanned financial and medical expenses,” says Chantelle Bonneau , wealth advisor for Northwestern Mutual. Knowing that you have a margin of safety – ideally three to six months of living expenses – will help you calm down and help you achieve your other financial goals.
This is especially important in the first year or so in the workplace. You want to get a financial boost.
“Your top priority should be saving 10 percent, ideally 15 percent of your income, and being able to pay off the debt at a relatively low interest rate over time,” McBride says. “Time is your main ally in saving and accumulating wealth.”
Simultaneously enroll in your 401 (k) workplace or other retirement plan as soon as you qualify and start saving for retirement directly through payroll deduction, at least until it matches your employer. This is part of your compensation and you want to receive it. You can usually also tune your auto-escalation premiums, which means they will increase by a percentage point (or as you define yourself) each year, which is a smart way to save money.
If you are not already eligible for the pooled contributions, open a Roth IRA instead. Roth IRAs are retirement accounts where you deposit money from which you have paid taxes. You invest like a 401 (k) (although usually with better options if it’s not your employer) and the money grows tax-free. This is a great option for younger workers (and heck, older workers too ), you will likely be taxed at a lower rate now than in the future.
They also act as emergency contingency funds because you can withdraw your contributions at any time without penalty (however, you cannot withdraw profits at any time). So if you are not already an employer qualifier, consider opening Roth in places like Vanguard or Fidelity.
And remember: you won’t be able to put things in order overnight. It will take you a while to set up an emergency fund and you should plan to invest for the rest of your life . Your debt won’t go away either tomorrow, and you’re likely to face several setbacks along the way. It can be frustrating at first, but starting now will only be good for you in the future. Good luck!