“If I only have about 15 percent of expendable income to use as savings or to pay debt, how much should be used for debt and how much for savings?” — from Melissa in Annapolis.
In religious studies, I remember well the story of King Solomon and his suggestion to the two women fighting over a baby to split the baby so each could have half. Of course, we all know that he was testing each of them. The real mother sacrificed her “half” to save her baby’s life — thereby revealing the true mother.
Sometimes, when there is just not enough money to go around, you feel like King Solomon yourself. You have to set priorities to fund whichever is most important, but there are a few rules of thumb that may assist you in making a challenging decision like this easier.
I’m going to assume your debt is on some sort of payment plan and/or you are paying as agreed — so, no past due debt. If you do have debt which is past due, then pay that first and foremost so you are not behind on payments.
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First, savings is important as an emergency fund, so you must be sure to have enough money saved for these unexpected expenses. Depending on how conservative you may be, you will want to be sure to have between three and 12 months expenses set aside in a savings account.
These funds can be especially handy if you find that you are out of work or unable to work for an extended period of time. You can keep this in a standard interest-bearing savings account so it is readily available.
Once you have enough money saved for your emergency fund, if you have a retirement plan at work that matches your contributions, you should save here next. Some plans will match dollar-for-dollar to a limit, so if your plan matches the first 4 percent that you contribute, then you should at least contribute 4 percent. By contributing less, you are failing to take advantage of “free money” from your employer. Once you can afford to contribute more, you can increase your deferral. If your employer does not match, then you may want to pay-down part of your debt before contributing to your retirement plan.
To pay debt, there is a pecking order from which to attack. You will want to pay your highest interest loans first. Some revolving debt or credit cards charge more than 20 percent interest, so the penalty for holding a balance can be very expensive — eliminating this debt is like saving 20 percent annually since you are eliminating that cost.
As a general rule, you would pay excess toward your mortgage last, as the interest may be tax deductible. Of course, as with anything pertaining to taxes, you will want to seek advice from your tax adviser.
If you have a question that you would like answered in an upcoming column, please send an e-mail to [email protected]. Sean O’Neill, CFP(R) is a financial adviser with RBC Wealth Management in Annapolis, Maryland, and these comments are his opinions and not necessarily those of RBC Wealth Management. For more information, visit www.seanoneillrbc.com. RBC Wealth Management, a division of RBC Capital Markets LLC. Member NYSE/FINRA/SIPC.
