It’s a question that almost everyone faces quickly after they start taking their finances seriously. Once they’ve taken that first step and started spending less than they earn, they have a surplus at the end of the month to apply to their financial progress — but what exactly is the best thing to do with it?
Should people focus on applying their money to their debts first? Not only does eliminating debt mean fewer monthly bills, it also means that your money isn’t draining away from you in the form of interest payments.
Should people put money to their savings first? There are a ton of financial goals that most people have: building an emergency fund, saving for retirement, saving for a down payment, saving for their next car, saving for a child’s college education and more. Do any of these goals take priority over reducing debt?
These are difficult questions, and the answer isn’t the same for every single person. Here are seven strategies you can use to find the right balance for you.
7 steps to balance your finances between savings and debt repayment
Get all of your bills up to date
The first thing you should do with any financial surplus you have is to get all of your bills up to date because the constant cycle of late fees and the damage done to your credit by not being up to date is financially paralyzing.
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Along with getting up to date on your bills, you should also aim to escape any routine checking account overdrafting you might be doing, as well as escaping any payday loan cycles. Those should be your first financial priorities.
Spend less than you earn consistently
You should live well below your financial means. This means consistently spending less than you earn. If you have a habit of ordering take out instead of cooking, aim to eliminate take out spending.
This needs to be the new normal, not just something you’ve adopted to get your head back above water, or else you’ll wind up right back in the same debt-riddled situation shortly. If this isn’t a foundational move, deciding whether to pay off debt or to save is a rather meaningless move, since that money will just evaporate soon anyway.
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Take out some older bank and credit card statements, go through each expense, and ask yourself which ones were really meaningful and worthwhile. Everything that wasn’t meaningful and worthwhile should represent spending you can easily cut from your life without reducing your quality of life. You should especially focus on cutting routine spending that isn’t bringing you any lasting value — either eliminate it entirely or reduce it to a less expensive form.
Establish a small emergency fund
The first move you should make once you’ve stabilized your bills and have adopted sustainable spending habits is to build a small emergency fund. This should not be a credit card, but rather cash socked away in a savings account for life emergencies like a job loss, an unexpected car repair or a trip to urgent care.
I recommend focusing on building your savings account up to $1,000 as fast as you can. Then, once that’s in place, set up an automatic weekly transfer of $10, $20 or $50 depending on what you can afford from your checking into your savings account, so that the emergency fund continues to slowly build over time. Automating it means you no longer have to consciously decide each week to replenish or build your emergency fund.
Tackle your high-interest debts
Your next move is to start tackling your high-interest debts. The interest that you pay on high-interest debts is costing you far more than you’ll get back from savings or investing. I consider any debt with an interest rate above 8% to be a high-interest debt.
Make a list of those debts, then try to reduce the interest rate on each of them. Use zero percent balance transfer offers on credit cards. Look into refinancing or loan consolidation. Simply call your lender and talk to them about getting a lower rate.
Then, order that list of debts by the new interest rate, with the highest at the top. If you have a debt that’s got a short term introductory rate, use the long-term rate when ordering them — consider the lower introductory rate a nice bonus, not the real rate. Then, make minimum payments on all the debts along with the biggest possible extra payment you can on the debt at the top of the list. When it’s gone, cross it off and keep going with extra payments on whichever debt happens to be on top. Your goal is to clear out that list of everything with an interest rate over 8%.
Start saving for retirement
Once all of your high-interest debts are paid off, focus on saving for retirement. This is the most important financial goal for most people. It addresses a core life need that all of us have, plus there are many tools available that amplify your retirement savings by offering tax benefits.
If your workplace offers any form of contribution matching, you should contribute to retirement to get every drop of that matching as your top priority. Once you’ve locked in all the matching funds, figure out if you’re eligible for a Roth IRA and, if you are eligible, open one up and start contributing to that.
How much should you contribute? If you’re under 40, 10% of your pre-tax income is a great target. If you’re over 40, particularly if you haven’t contributed much in the past, aim for 15% or even more if you can, as you have ground to make up.
Evaluate other life goals to save for
If you already have retirement savings in hand and have paid off all of your high-interest debts, you have many options available. Your best move is to sit down and give some serious thought to your major life goals in the coming years. These will vary greatly from person to person.
Do you want to buy a home? Do you want to move to a different or nicer home? Do you have any major expenses coming in the next few years, like a vehicle replacement? Do you want to open your own business? This is the point where you start assessing your long-term goals and figure out what you need to do to make them happen.
For short-term goals, the best approach is to save in a savings account, as you do not want volatility in your savings and you also want the funds to be easily available. For long-term goals, some short-term volatility is fine, as is tying the money up for a while — consider things like stocks or real estate.
Tackle your low-interest debts
You may also simply have a goal of debt freedom, and that’s a powerful goal as well. It minimizes your monthly bills and gives you a great deal of personal freedom while still making great financial sense.
If this is your long-term goal, make a list of your remaining debts by interest rate, as described earlier, and focus on making large extra payments on the debt with the highest interest rate. The larger your extra payments, the faster you get rid of the debts.
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