In the course of your life, you’re going to have to many different things you want to accomplish with your money. That’s just the nature of life; we all have more than one goal we want to accomplish at a time, and given the reality of a capitalist system, most of those goals are going to involve earning, saving, and investing our money in order to reach them. The question we have to face, then, is how do we prioritize our goals in order to accomplish everything we want to accomplish, given our financial and other limits?
Let’s use my finances as an example (only fitting, since it is my blog). After I take care of my general monthly expenses (rent, utilities, etc.), I have some money left over, which I apply to one of my larger, unable to be fulfilled in a single month goals. Currently, I have four them: Paying off my Mastercard debt, paying off my American Express debt, paying off my student loans, and investing for the future (both in retirement accounts until I’ve maxed out my contributions, and then in non-retirement accounts).
How do I decide which goal to put my money towards first? Well, my first consideration is
As I’ve discussed before, one of your first considerations when deciding which financial goal to pursue is the associated interest rate (because compound interest can be both a friend, and an enemy). High interest rates will either cost you a great deal of money (for your debts) or earn you a great deal of money (for your investments). In either case, finding the financial goal with the highest associated interest rate will enable you to maximize the effectiveness of the money you put towards the goal.
In my case, the choice for highest interest goal is pretty easy; my Mastercard has an associated interest rate of 29.99% (plus the prime rate, I believe, which is currently zero). (In case you’re wondering why my interest rate is so high, it’s because (a) it’s a department store credit card, (b) I got it back when I was in high school, and (c) I’ve never tried to have the interest rate lowered, although that’s something I’m adding to my To-Do list.) None of my other financial priorities has an interest rate anywhere near that amount. For every hundred dollars I put towards paying down this debt, I can save more than $30 over the next year, to say nothing of years down the line.
On the other side of the equation, my lowest priority goal is also pretty easy to determine. My student loans have a fixed interest rate of 2.85%; that’s less than half of the rate for any of my other goals. Because of that, I only pay the minimum amount I have to towards paying off my student loans; by putting my money into goals with higher interest rates, I’ll have more money to pay off my student loans when I finally get around to it years from now.
The last two goals are a bit harder. My American Express has an interest rate of 7.99%, while my investments, assuming they perform as they have in the past (a big assumption, particularly given the way the economy has performed these past few years) should average around 10%, give or take a few percentage points. Just on the basis of percentages, the ideal solution would seem to be to max out my investments, while paying the minimum (or a bit more) on the Amex. But that plan ignores the difference between
Fixed and Variable Returns
Again, I’ve discussed this before, but it bears repeating: it’s usually better to put your money towards slightly lower fixed returns than somewhat higher variable ones, particularly in the short term. In one, three, or even five years from now, the volatility of investments in something like the stock market will likely make fixed returns look more attractive. For this reason, I’m planning to put more of my money towards paying down my Amex, and only investing a fairly small portion of my ‘extra’ money until all my credit card debt is gone.
But What About An Emergency Fund?
I’ll be the first to admit, I don’t have much of an emergency fund at the moment. When you have debt with nearly 30% interest, or even 8% interest, it doesn’t make much logical sense to save money at 2% interest (and given the current interest rate climate, that’s if you’re lucky). On the other hand, having some money available that can be quickly accessed in case of an emergency is usually a plus. In my case, it’s especially important; one of the realities of being a graduate student is that when summer comes, my major source of income, my stipends from grad school, will decrease significantly, while my free time to get another job will be largely nonexistent (thanks to the research I need to do in order to graduate). Having enough savings to cover a month or two of expenses will be necessary.
In my attempt to play Solomon, the best course of action seems to be putting money towards an emergency fund at the same time I’m working to pay off the Amex. I’ll have at least one credit card paid off, and if my financial calculations are complete, that should allow me to build up a pretty solid emergency fund by the start of the summer.
Overall then, my plan looks like this:
-Start by paying down my Mastercard tab as quickly as possible (I’m still in the grace period for my most recent expenses, but that won’t last)
-When the Mastercard tab is gone, begin splitting money between American Express and saving for an emergency fund (with perhaps one hundred or so a month being put towards investing)
-Once the emergency fund is sufficient, get even more aggressive on paying down the American Express (and bump up the investment amount)
-After the American Express tab is paid off, start going whole hog into investing (assuming I haven’t exhausted the emergency fund and need to refill it, then split the money between emergency fund and investing), and
-Pay only the minimum necessary on the student loan for as long as possible; at less than three percent interest, it’s cheap money.