Now that you’ve cut expenses, it’s time to kick these steps into high gear. This step is going to cover two different phases. I’m covering two at a time because your situation is unique, and you’ll have to make your own decision on how to proceed. I mention a lot on the site that there is no one size fits all solution to finances and its true! How you go about it is completely up to you, I’ll just try to explain the benefit to each and let you decide. Let’s look at what makes more sense for you: to build an emergency fund or pay off loans.
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What Debts Should I Include
First of all, you don’t need to include all your debt in this step. If you have low-interest debt, such as most mortgages, you can leave that out for now (I’ll explain why in the next step: investing). Focus on anything that you’re paying higher than 5%. The main culprits here are usually credit cards, but you might have car loans and even student loans at higher rates. Keep in mind a lot of these loans are also variable rate, meaning that when the fed raises the prime rate, your interest rate goes up with it. What this means is that in the current environment, you might want to consider including these before the rates get too high.
Emergency Funds First
Emergency funds can prepare you for any unseen circumstance. From disasters to job loss, to even an unexpected sickness, these funds can help you stay afloat and not get into unnecessary debt. Once you build this fund up, you are no longer part of the 78% of Americans that live paycheck to paycheck, now you have some breathing room in case something comes up.
Obviously, the advantage here is protection. You never know when you’ll need some extra money. The consensus on emergency funds is to have 3-6 months worth of paychecks in a savings account for a rainy day. Depending on job security, you can start with 3 months and work your way towards 6 months at a slower pace.
The idea behind it, which got even more popular in the Great Recession, is that if you lose your job, and it takes you some time to find a new one, you can still pay your bills normally for 3 to 6 months. Although jobs are a little bit easier to find now than they were during the 2008 recession, it’s still a good habit to have.
Credit Cards First
Let’s be honest; even if you have perfect credit, there is no savings account that will pay you what you pay in interest. You lose money daily with a credit card (remember interest is charged daily, it just posts once a month). The longer you put off paying your credit cards, the more you’ll pay overall.
Not only that but once you finish paying the card off, you’ll have more money to save, invest, or do whatever you want to do with! If this is a line item on your budget, wouldn’t it be amazing to remove it completely and be able to use that money towards something else?
The Bad Part of Each
Like I mentioned, debt builds up interest daily. Building your emergency fund first means you will pay more in the long run.
On the other hand, paying off your credit cards first might leave you vulnerable. Even if your job is secure, you can’t predict car trouble, or an appliance breaking in your home.
By The Numbers
If you are looking at it strictly mathematical-wise, paying off your high-interest debt is the better option. You’ll save money in the long run which means you’ll be able to save more in the long run.
But remember that math doesn’t protect you if you need money. There’s no point in paying off debt to just get back into more debt because of an unforeseen circumstance.
The Dave Ramsey Approach
Dave Ramsey tackles this problem by breaking them up into his baby steps. While I don’t necessarily agree with all of his approaches, I think they might work out for others so I’m open to the ideas.
Ramsey suggests saving $1000 for emergencies, then focusing on high-interest debt, and then back to building up your emergency fund. Keep in mind you don’t need to leave it at $1000. For some, it might be too little, for others too much. As with all the financial gurus out there, its good to take their ideas, and twist them so they can make sense in your life. You can read more in his book:
Splitting Your Goals
If that approach doesn’t work for you, consider splitting your goals. If you don’t want to send all your extra money to just one goal, divide them how you see fit. Keep in mind that this means more interest paid over the long run, but if it works out in your situation, go for it! You can try the approach that works best for you.
Debt Snowball: Pay off the smallest loans first, to create momentum and excitement by seeing yourself eliminate debt.
Debt Avalanche: Pay off the highest interest loans first to save money in the long run.
Pick whichever excites you more and go for it! There’s is no wrong way to this!
At the end of the day, you have to decide for yourself what makes the most sense. You know your situation more than anyone else could. No matter which you decide to go with, always remember that you are headed in the right direction. You’ll hear different advice from different people, and that’s okay!
We are all on the road to financial freedom, we all don’t have to take the same path.
What method do you recommend for anybody starting out? Post it in the comments below!
Check out all the Basic Steps here!