I have friends who are in debt. Either with cars, school loans, and credit cards. They often come to me asking what they should do first, invest in their retirement (401k or Roth IRA) or put all their money towards paying off their debt?Lets say they're our age, around 23-26. I have the hardest time answering this question. I would definitely tell them to pay off their credit cards first because they usually have the highest interest rates 15-25%.
What would suggest Mr. Financial Penguin?
Everyone is different. First of all we have to remember that everyone is different and there is usually not going to be a clear cut solution for every person. Most of this stems from the way people view money. Some people are scared that they will run out of it so they fear their money. Some people just want everything so they throw money left and right. All of these unique personality traits must be taken into account in order to bring that person back on track
Starting young allows you to make mistakes. This does not mean I recommend you take obscene risks or that is not a bad thing to make mistakes. Mistakes always hurt, but not as much as when you’re older. Hopefully we’re also learning from our mistakes so we won’t ever repeat them. That itself could make certain mistakes the best thing that ever happened to us.
Debt is a fact of life and there is GOOD debt and BAD debt. Good debt includes things like mortgages and student loans. Bad debt includes all the fun kinds of debt like car loans or credit card debt. Your goal should be to pay off your BAD debt as quickly as possible and keep to a solid schedule to pay off your good debt.
Rates Rates Rates You are absolutely right in looking at the rates in order to help your friends set their priorities. What is the point of putting all your money into savings to make 8% while you still have a debt at 15% to 25%? Let’s be careful now. When just comparing rates make sure you consider tax implications to certain kinds of savings and certain kinds of debts.
Step 1: GET RID OF CREDIT CARD DEBT If your friends still have okay credit to their name encourage them to move their balance into a lower rate card. There are cards potentially available where you can even defer interest payments for a year when you transfer an existing balance to the new card. However, read all the fine print since some of these cards make you pay back all the previous year’s debt if certain conditions are not met. You also want to make SURE your friend gets rid of his/her old card after the balance transfer. That zero balance card may be an incentive to go out and get the newest gadget he/she desires. Also note “defaults to other creditors” in the fine print. This means that if you miss a payment on another debt, your rate on this card can rise. Avoid “two-cycle billing” (Discover and WaMu) or “anytime any reason” (AmEx, BofA, Chase, WaMu) fine print which can cause your rate to rise. Shop around at www.cardratings.com or look into credit unions for cards with fewer and lower fees and rates.
Step 2: Look at that car That car may be your baby, but it might also be sucking you dry. Make sure that your auto loan fits in your priorities. “Trading down” might be the quickest way to get you back on track.
Step 3: Pay Yourself First! That’s the age old adage that never goes out of style. PAY YOURSELF FIRST. Most people must pay rent, need to pay the bills, have to buy food and then save what’s left. The problem with this method is that there is usually nothing left. If you’re like me (and most other people) you can always find more money to spend. With this method, you don’t really even need to make a budget, although that is recommended. Just decide to save so much from every paycheck and you spend the rest as you see fit. Now when you have to decide to fix food yourself or go out, you know you’re not dipping into your long term savings for a convenient splurge now. The best case is if your company lets you direct deposit into multiple accounts to have a certain amount of money go directly into another account that you touch only in emergencies or to move money into long term savings (like IRAs or CDs).
Example Case Study
- John is 24 and is making $40,000 a year.
- John just graduated college and has $20,000 in school debts at 5%.
- John lives in an apartment with 3 people and pays $550 a month plus utilities
- John now has bad credit and about $15,000 in debt with him on two cards at 20%
- John also bought a Subaru WRX which cost him $40,000 with a 5 year loan at 8%.
- John’s company has a 401(k) that matches 50% of his contributions up to 5% of his pay, but he doesn’t contribute.
Well, here we have a HUGE problem. Assuming you have no taxes at all to pay, $30,000 gives you $3333 a month. Unfortunately we come to the striking realization that he NEEDS to dump that car. If he wants nice cars for the REST of his life, he’s going to have to drive something more sensible now. Something that doesn’t look half bad, with some power, and at this point used will do the trick. Look for something around $12-15 thousand if looks are still important. Of course the less he spends, the better off he will be in the short term. Dumping that $40,000 loan for a $15,000 loan lowers monthly payments from $810 to $305
Now here’s the situation. He’s making $40,000 but he pays $420 to federal withholding, $210 to social security, $50 to Medicare, $110 to California withholding and probably $60 to medical. That means a take home pay of $2553 a month.
Assuming all the regular tax stuff (standard deduction, 1 personal exemption etc.) he will owe $4550 in federal taxes which allows him a $490 refund at tax time.
Now we pay off his college in 15 years for $160 a month. His credit cards in 2 years for $765 a month. His $15,000 car now only costs him $305 a month. He has $550 for rent and about $50 for utilities split between people. That leaves him with $727 for food, gas and personal things. That’s still relatively meager living but you can easily do it if you keep your spending in check and avoid eating out.
A 12% credit card will lower his credit card payments from $765 to $705 a month which helps. That could almost pay for auto insurance for the year!
The problem with this method is that he still isn’t saving. If you assume a 8% return on investment, $1000 invested from 25 to 55 becomes $10,062. However $1000 invested from 35 to 55 is only $4660. THAT’S LESS THAN HALF!! That is the time-power of money. So now we NEED to find a way for John to also save WHILE pay off his debt.
John isn’t contributing to his 401(k) which is a BIG problem because he is losing out on FREE MONEY! 5% of his pay will be $2000 or $170 a month. But remember his company will match his contributions. He’ll get $1000 a year for free! Because the contributions are before-tax they lower his taxable income which drops his federal taxes $435 per year. And now he has retirement income since his $2000 annual contribution along with an 8% growth gives him $246,000 by age 55. $2000 per year is for 30 years is only $60,000. You made FOUR times your money. AND I FORGOT HIS FREE $1000 company match. Now you put in $60,000 in 30 years but because of your company’s matching John is going to have $370,000 at age 55.
Where is he going to get this additional $170 a month? We’re going to extend his credit card payments from 2 years to 2.5 years. That means he pays $640 instead of $765 a month for $125 savings. His bigger income tax refund will make up the rest of the $45 needed. That’s almost like getting a whole lot of something for nothing. He ends up paying an additional $850 in interest payments, but that allows him to make many more contributions to his 401(k).
In 2.5 years, John no longer has his credit card debt and if he’s good instead of spending his extra $640 a month on personal things, he’s going to take that money and put it into a savings account toward a down payment on a house, condo, townhouse. Rent is throwing money away. Once you have your down payment, your house mortgage interest is TAX DEDUCTABLE. This is that good debt.
Why didn’t I recommend to put his money towards paying off his student loans? Because you need a sizeable down payment to buy a house. The student loan will always be there and if you pay it off sooner, the money you save in interest is not even going to come close to the freedom and pride of homeownership and the savings in tax deductions.
Hope that helps some. Questions? Comments? This can be refined much much more, but those are the basics!