January 05, 2021
Set Priorities and Optimize Debt to Balance Out Uncertainty
To look back on 2020 and say it was a challenging year would be an understatement. Uncertainty was a theme, stimulus debates took center stage, and millions of Americans scrambled to revisit their budgets.
But there is a sense of optimism that often comes with turning the page into a new year. And January is an excellent time to take a deeper dive into your financial picture, deconstruct where your money is actually going, and build a plan to balance out the uncertainty.
Let’s begin by acknowledging there are almost always competing goals involved, both short term and long term, that can understandably take your thought process in different directions. Meeting these goals may involve decisions about whether to prioritize building a sufficient emergency fund, saving for retirement, or paying off debt, such as a mortgage or student loans.
As you weigh your priorities heading into the rest of 2021, consider the following to help with the balancing act.
Would you be in an acceptable position if you had to leave your job today and a stable income disappeared?
You’ve likely heard it before, but it bears repeating. The typical emergency fund should be a minimum of three to six months of expenses that you can access immediately through a savings account, money market account, or higher-yielding cash management account. However, some may prefer to have 12 months of expenses or more quickly accessible in case of a true emergency. A primary driver for you should be what helps you sleep at night. For purposes of budgeting, once a decision has been made, it helps to automate the savings directly from your paycheck.
Retirement Savings and 401(k) Match
Are you leaving anything on the table?
The baseline when contributing to your retirement plan should be at least to defer up to your company match. Everyone likes free money, right? Once you get there and have extra cash flow, prioritize contributing up to the maximum amount you can defer each year. However, extending too far now by maxing out your 401(k) could work to your detriment if you have high-interest-bearing debt that needs attention first.
Student Loan Debt
What is your interest rate?
This is where expected return and guaranteed interest cost factor into your decision. In general, whether it makes more sense to invest your next available dollar or use it to pay off debt will depend on the interest rate of the debt versus the expected return of the investment. When you invest in a brokerage or retirement account, you can assume an expected positive return over time for putting your money at risk. It doesn’t always pan out this way, but historically it has been the case. When paying off a debt, like student loans, you are guaranteed to “lose” a certain amount from interest costs. So, if the interest rate on a debt is higher than the return you expect from an investment, then pay down the debt first. If the return you expect from the investment is higher than the interest rate on the debt, then invest instead. Because of this, and because student loan interest is typically high in terms of long-term debt, it’s important to prioritize paying off student loans when you have extra cash flow.
Should you pay off your mortgage early?
With interest rates historically low, many homeowners have wondered about the merit of paying off their mortgage early. Pros may include the elimination of, most likely, the largest monthly expense in your budget, the chance to avoid unnecessary interest costs, and simply obtaining certain peace of mind that’s hard to find these days. Cons, on the other hand, may include compromising progress toward other goals, like saving for retirement, that need to be prioritized in long-term planning.
The reality is that the answer probably isn’t as cut-and-dry, and it likely involves meeting in the middle. If minimizing debt is important for you, and assuming no prepayment penalties, you can significantly save on interest and shorten the life of your loan by paying extra every month toward your principal. An alternative could be to refinance and shorten the life of your loan (e.g., moving from a 30-year term to a 15-year term) if your cash flow is sufficient. Being too aggressive can make the balancing act more difficult, so that may be something you want to avoid.
Preparing for a rainy day, saving and investing for retirement, and optimizing your debt are all important facets of your overall financial life plan. So capitalize on any momentum that comes with the beginning of a new year to identify the priorities that matter most to you – and how they’ll fit into your budget going forward.
The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Individuals should seek advice from a qualified professional based on their individual circumstances. Information contained herein may be based upon third-party information and may become outdated or otherwise superseded at any time without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®.
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About the Author
Tom serves as an associate wealth advisor for Buckingham Strategic Wealth. He works as a team alongside wealth advisors to ensure that clients have a tax-efficient, evidence-based strategy to help them make progress toward their most important financial goals.