In the life of most working individuals, there’s a turning point, where you move from living paycheck to paycheck to finding a bit of extra money left in your account at the end of each month. What you do with those extra dollars can make or break your future. Recently, a client of ours asked us to help steer his son in the right direction. He had some credit card debt and a home mortgage. In addition, he was dreaming of starting his own business. How should he be allocating those extra dollars at month-end? Here’s an amended version of what we told him, edited for confidentiality and length:
Step 1: If you are still using your credit cards for every day purchases, stop.
Only use cash or a debit card until after you are able to clear away all of your non-mortgage debt. After you’ve cleared your debt, only use your credit card if you can pay it off in the current month.
Step 2: Establish a savings account to use as an emergency reserve.
I suggest setting $2,000 into this account as soon as you can. This will give you the ability to have a place to go to if you have an emergency without having to use a credit card.
Step 3: After you’ve established your initial emergency reserve start applying your excess cash to paying off your credit card debt first.
Make minimum payments on most of your cards and pay 100% of your excess cash flow to the highest interest rate card first. Once that card is paid off move onto the second highest rate card and so on. You’ll be surprised how your payments will quickly snowball as you begin dropping off minimum payments on the cards as you get them paid.
Step 4: After you’ve gotten all your cards paid, finish off your emergency fund.
I would recommend you build this account to cover 6 months of your living expenses. I want to stress how important it is to focus on getting the credit cards paid off before building a big emergency reserve. Let me give you an example: Let’s say you have $10,000 in cash that you can either save or apply towards credit card debt. At today’s current interest rates of under 1% you would earn $100 in interest from a savings account. If you were to use that $10,000 to pay down credit card at 20% interest you would save $2,000. In my example, saving the money before paying your credit cards would be making you go backwards by $1,900.
Step 5: You mentioned wanting to save for your new business. Once your debt is paid off and you’ve fully established an emergency fund the next thing I would suggest is you start allocating money for this goal.
As a business owner I can tell you that income can fluctuate immensely from paycheck to paycheck, especially in the start-up phase. Not having the drag of all of that other debt will greatly increase the chances that your business will have the chance to succeed. For these same reasons I would like to see your emergency fund fully funded first.
Step 6: Maximize retirement savings.
I suggest you continue to contribute to your retirement plans even as you’re focused on paying off your debt, but while the debt is still in place, only contribute to your retirement plans to the extent you get an employer matching contribution. After the first 5 steps are complete start maximizing your retirement savings contributions.
Steps 7 and beyond:
These first 6 steps will take a while and should set you on a good financial path. With little to no debt you should find your cash flow will continue to increase as you move through your career. As your circumstances change and should you start a family, you will want to begin thinking about college education funding, adding investment accounts that are not just your employer sponsored retirement plan, etc.
Whatever you decide to do, we strongly encourage you to begin. Remember every journey begins with a first step.