Everyone wants to be both debt-free and financially secure, but how do you prioritize the two? Is it best to hold-off with aggressive saving until you are debt-free? Or is having a savings cushion more important than getting rid of debt? It’s critical to pay down your debt, but it’s critical to create a plan that will build your bank accounts as well. To be smart about accomplishing both goals, you need to carefully prioritize your saving and debt-reduction efforts. Unless you have a very good reason not to, I recommend that you adhere to the following priority sequence:
1. Stop using credit cards and pay only the minimum payments until step four is reached.
2. Aggressively save for an emergency fund starting with at least one month’s expenses. This will create a cash cushion for emergencies rather than needing to pull out the credit card.
3. If an employer will match contributions to the company 401(k) plan, save the amount necessary to get the full matching dollars.
4. Allocate 50% of savings to an emergency fund, and 50% to debt reduction until four to six months’ of living expenses are covered in the emergency fund; four months for a two-income family, six months for one income.
5. Now focus on eliminating all debt except for home and car loans.
6. Build up annual savings until the maximum tax-deferred savings allowed by IRS guidelines is reached. Once you reach this point and are saving as much as you can pre-tax, throw a party and reward yourself with something very special. You’ve earned it!
7. Pay off any car loans, then start saving $250 a month in a new car fund.
8. Increase saving to at least 15% of pre-tax income. Save for home ownership If not currently in a home. Homeowners should also accelerate mortgage payments and continue until it is paid off. Also, during times when fixed-interest rates such as CDs have fallen below 3.5%, be aware that making extra mortgage payments provide a better after-tax return on your money.
9. Families with children might want to start a specific education fund based on the child’s abilities, needs and desires. (Please read “Paying for an Education” in chapter eight of Money Smart to see if this is something you should do.)
Small monthly changes can have a huge impact on savings and debt reduction, especially when you follow the right sequence. Be smart in setting your priorities and your Spending and Saving Plan will put you on the path to financial freedom in no time