Last time, we funded our 401(k)s up to the maximum match our employer will give us (yay for free money!) and built a small emergency fund covering about one month of expenses. Now that all of that is done, it’s time to begin the real fun: paying down debt and ensuring a good retirement!
Step 5: Pay Down High Interest Debt
Here’s the biggie; most people who are having money trouble get stuck on this step, cutting down their high interest debt. You might be wondering, what exactly constitutes high interest debt? Personally, I would consider any debt with an interest rate above six percent to be high interest. That’s about the amount you can earn from a good bond mutual fund, a fairly conservative investment. Thus, if given the choice between paying off debt at five percent or investing the money, I would opt for the investment option. (You could raise the limit to eight percent if you are willing to pay a little more interest on the higher interest rate debt; just be sure not to hold debt at rates any higher than that.)
Once we know what high-interest debt is, the question becomes, how do we best pay if off? The simple version is, you pay the minimums on all your debt (which you should already be doing as part of your regular expenses, anyway) and put all the money you can spare toward paying down the highest interest rate debt. When that debt is gone, you start putting all the money that wnet toward paying down that debt into paying off the second highest rate debt, then the third, and so on until all the high interest debt is gone. (I ran some numbers a few weeks ago to prove that this is the most efficient method.)
That’s it; no special formulas, no secret codes, no cheats or ways to skip ahead. You just need discipline to stick to your repayment plan, control to avoid building up more debt, and patience to see it through to all the high interest debt is gone.
As for the low interest debt, the debt below six percent, the best plan is just to keep paying the minimums and enjoy having relatively low interest debt. Consider your interest payments as rent on money you can put toward investments that will return more than six percent. If you invest properly, as in our next step, you’ll end up better off financially by investing than focusing purely on debt repayment.
Step 6: Bulk Up Your Emergency Fund
Once the high interest debt is out of the way, you can go back to our emergency fund and work on bulking it up some more. One month of expenses is decent start, but it won’t cover you in a serious emergency. Before you start to pump up your retirement savings, you need to make sure that your won’t have to tap your 401(k) or IRA if there is something major and long-term, like losing your job.
A good goal for our expanded emergency fund should be six to eight months. There are plenty of options for where you can hold your money in order to keep it safe but available. Our standard suggestions of money market funds and high interest online savings accounts both work quite well. You could also consider a CD ladder in order to get a little more interest from your emergency savings. The important thing is to just build up your savings; now that you aren’t making the minimum payments on your debts, it should be easier to find money to put towards your emergency fund.
Alright, these steps took some pretty serious effort. If you completed them, enjoy your accomplishment; it gets easier from here. No, really, it does.