One of the most common questions I and other personal finance experts get is whether to pay down debt or save for the future. This question can come in many forms, from the new graduate just starting out who has student loans to deal with but wants to open his or her first IRA to parents just a few years from retirement who are juggling credit cards and a mortgage.
Although the decision seems tricky at first, it's really a combination of math and psychology that is not too difficult to figure out if you are careful to prioritize. Once you've paid for food and shelter, here's where your money should go, in the following order.
2. Emergency saving. After you have paid down your monthly debt obligations, it's time to start an emergency fund. A good rule of thumb is that you should always keep eight months' expenses in a savings account or a money market account. The emergency fund needs to be liquid, although that means it is not going to earn much (if any) interest in today's climate. The money needs to be there to hedge against the medical issue, car repair, unemployment or other unexpected event that could put you quickly behind the financial eight ball. As a freelancer, I keep back about 30 percent of each check for taxes as well as saving. Once you have your emergency savings squirreled away, though, you don't have to keep adding to this account. Any extra dollar to spare should go toward:
3. High-interest debt. What gets a better return than any investment you could name? Money that goes to pay down high-interest debt -- anything above a 7 percent interest rate. For this reason, it's not a good idea to remain in a long-term payment plan, such as income-based repayment for student loans, or to make only the minimum payments on a credit card, past the point where you've built up an emergency fund. As soon as you can afford to, do more. Pay it off as fast as you can and shut it down.
4. Retirement saving. It's only when you have zeroed out your high-interest debt that it's time to save for retirement. We should all be putting 10 percent to 15 percent of each paycheck into a 401(k) or IRA. This is long-term investing, with a long-term projected return of 6 to 8 percent, assuming mostly stocks held over 10 years.
5. Low-interest debt. This includes loans such as a 30-year mortgage, which until recently were averaging around 4 percent or better. It also includes federal student loans, currently at 3.4 percent. It's fine to pay these debts down over a matter of years while also saving for retirement at the same time.
In theory, the math is simple here. Debt with an interest rate higher than the projected long-term return on the stock market--estimated at around 7 percent -- should be paid off before you save for retirement. Debt with an interest rate lower than that should be paid off at the same time as you're saving for retirement.
However, there is one more wrinkle to consider, and that's psychology. Research shows that inertia is a huge factor in determining whether people will save adequately for their futures. Thinking actively about how to manage your money takes a lot of energy and effort, which is sporadically applied for most of us. For that reason, even if you have high-interest debt to pay off, I would advocate opening up a retirement account, making allocation decisions, and setting up an automatic monthly transfer from your paycheck of a token amount, say $10 a month. That way, once the debt is paid off you will only have to increase the amount, rather than go through the whole decision-making process again.
(Anya Kamenetz' latest book is "DIY U: Edupunks, Edupreneurs, and the Coming Transformation of Higher Education." She welcomes your questions at email@example.com)