Setting priorities for your savings and financial plan

So you decided you need a financial plan that’s great. You started reading my blog and other articles and realize there are lots of great savings and investment options and so many things to save for you don’t know where to start. You can’t possibly do them all!

First off congratulate yourself for realizing you need a plan and then take a deep breath. If you are committed to saving at least 20% of your salary there is not a wrong answer so you have won the biggest part of the battle. Some choices may be better than others but the most important thing is deciding to pay yourself first. While everyone’s situation is different I will try to give you some guiding principles to get you started on how to divvy up those dollars you are saving. While the guiding principles apply to anyone the details of this post will be geared toward young professionals and recent graduates just starting out.

The guiding principles for your savings dollars should be

1.      Maximize your rate of return

2.      Distinguish between short term saving and long term investing

3.      Try to take advantage of tax free or tax deferred accounts every year

4.      When making decisions decide how it affects you in both the short and long term with emphasis on the long term.

Many college graduates have student loans to pay off, and maybe even some credit cards balances or a car loan. Minimum required payments on any of your debts should fall into their own separate “need” category and should not be counted against your saving goal which is also a need. See my post on knowing the difference between needs and wants. Making additional payments or paying down the principal of any debt can be counted towards your saving goal.

Many people that do not have a plan think that it is best “to pay off your loans and fast as you can and put every spare penny towards doing that.” These same people think it is wise to pay off their mortgage as soon as they can. While I am a big proponent of paying off your debts and limiting the money you spend on wants until your debts are paid off, some debt is better than other debt and some savings and investing is better than paying off your debt. Again paying off your debt is a form of savings so you are better off doing that then spending the money, but you are not always better off doing that than investing. You need to look at the rate of return.

For starters you should always make at least all the minimum required payments on all of your debt obligations, because failure to do so results in penalties, bad credit and even higher interest rates. Again consider that a need, not part of your savings. After that look at guiding principal number one to determine if you should make more than you minimum payments.  Maximize your rate of return. Think of the interest you are paying on any debt as your rate of return. If you want to get really fancy you can even look at it as a tax free rate of return because unlike interest you receive from a savings account, interest you don’t pay because you reduced your loan balance is not taxable. So let’s look at some options that you can apply your savings to. I will list them in the order of which you will most likely want to prioritize them.

1.      401K with employer match

2.      High interest credit card or other debt (interest rate above 7%)

3.      Roth IRA

4.      Short term Savings (emergency fund, saving for house down payment)

5.      401K without employer match

The first thing you need to do is make sure you are taking full advantage of the employer match. Failing to do so is the number one mistake Americans make in their financial planning. Most employers match at least 50% of a certain percent of your salary that you contribute to your 401K. That is an immediate 50% guaranteed rate of return (subject to a vesting period if you are a new employee). Not taking full advantage of this is like giving money away. I cannot imagine a higher guaranteed rate of return. If you have any loans that are charging you above that rate they likely came from a loan shark who will break your legs if you don’t pay. So if you have any of those loans, by all means pay them off first!

The second thing you need to do is pay off your high rates loans, starting with the loan with highest rate. Other than making minimum payments, don’t spread this around. Pay off the highest rate loan first. When that is done move on to the next. Close out the balances one at a time.  Again look back to principal number one. Highest interest rate equals highest rate of return. Getting rid of high interest payments is the equivalent of investing the money at a guaranteed tax free rate of return.

Once you pay off the balance on a credit card make sure you keep it paid off by paying the full balance each month. If you owe just one dollar at the end of the cycle everything you buy with that credit card is charged interest from the date of purchase. If the balance is paid off at the end of the month you are charged no interest on any future purchases as long as you pay off the full balance each month.

You have to look at your student loans to see if any of them are “high interest rates”. It depends on the type of the loan and the lender, but any of them that are charging more than 7% interest you want to put in line to pay down ASAP after any other high interest debt. Any that are subsidized or otherwise below that rate you don’t need to pay down as quickly and you can consider other saving and investment options that may be in your best long term interest.

The third and fourth priority can be talked about together because they are close and one may be better for you than the other depending on your personal circumstances. While I think it is important everyone have an emergency fund it is something you should grow over time and not establish immediately while forsaking all other investment opportunities. Same with saving for a house. While I believe home ownership is a laudable goal, from an investment perspective don’t assume it is a good investment. From an investment perspective it usually is not a good investment unless you plan to own the home for at least five years. Also if you cannot put at least 20% down, while you may still be able to qualify and purchase a home, from an investment perspective this is a more expensive way to do it. Finally are you getting a home because of a want or a need? For single individuals the cost of buying an individual home is probably more of a want than a need unless you are committed to lining up and living with a roommate or two. Whatever your reason for buying a home, if that is your goal you should start saving for it and that will be part of your short term savings. In addition to whatever you plan to put as a down payment on a home you should plan on having at least another $5,000 in cash for all the unexpected things associated with buying and owning that first home. Your short term savings for a home can be comingled with your emergency fund until you buy the house or have an emergency. How much cash you need and how quickly you will need to get there will depend on when you want to buy a house and, how secure you feel in your current job. Depending how much you already have saved it is easy math to figure out  how much more cash you need to save each month to reach your goal in the time frame in which you want to reach it. See, How much cash do I need and where should I keep it for more guidance.

The Roth IRA is one of my top picks for investing long term. See my post about the tax free advantages of a Roth IRA. The problem is that you have a limited amount you can contribute each year and the sooner you get money in the better. So while you need to put money aside for short term savings, whatever amount you don’t put into your Roth every year, short of the maximum amount allowed, is an opportunity lost to generate tax free income that you will never get back.

Finally if you still have money to invest after maximizing one through four go back and contribute to your 401K because of the tax advantages.

For elastration purposes I will give you a quick example. You need to look at your own situation and modify accordingly. Remember 20% is the minimum I recommend you save but if you can save more it certainly gives you more ways to take advantage of all these wonderful saving and investing options you have. The example is annual, divide by 12 to get monthly. You can plug in your salary and follow the calculation’s to give you your own starting point.

Let’s take a person that just graduated with no money in the bank, no high interest loans, that landed a new job making $50,000 a year with a company that matches 50% of the first 6% of their 401K contributions.

Their savings goal would be a minimum of $10,000 (0.20x$50,000)

1.      First they should contribute $3,000 towards their 401K to get the match (0.06x$50,000)

2.      They have no high interest debt, but if they did that would be next priority until paid off

3.      They would contribute $5,500 to their Roth

4.      They would contribute $1,500 to their short term savings. (Could increase this and reduce (3) if job unsecure or want to buy house soon. Once short term savings goal is met they can go back and contribute to their Roth if they have not already maxed it out and then to their 401K non-matched.

Some of you make more than $50,000 and obviously all of you can save more than 20% (which while young and without children is the thing to do) so if either of those apply it will allow you to boost your short term savings or pay off your high interest loans even faster.