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Plan Well, Retire Well

Saving and investing your money

Wednesday, February 2, 2011

What to do first? Pay down debt, build emergency fund, or save for retirement?

Posted by Karen Chan - Karen Chan Budgeting Credit and Debt Organizing Finances

We all want to "do the right thing" with our finances, but sometimes it's hard to know what the right thing is. A question recently came to me about a person who has large student loans and credit card debt. She is working in a low wage job, not yet able to find a position in her field. She's living with a friend and has kept current on all her debt payments. She even manages to have just a little extra each month (amazing). Her question is, what's the best thing to do with that money? Put it toward student loans? Pay extra on her credit cards? Start an emergency fund? Or start an IRA and put it toward retirement savings?

Student Loans

Student loans are one of those special debts that never go away, even if you file bankruptcy. There are certain circumstances where some of the debt might be forgiven, but by and large, you're going to pay those loans no matter how long it takes you. So wouldn't it make sense to use any extra money to pay down those obligations? Maybe. But one rule of thumb when deciding which debt to pay down first is, Attack the debt with the highest interest rate first. Her student loans probably have lower interest rates than credit cards. Plus, she may be able to get a tax deduction for student loan interest. So student loans may not be the best use of extra dollars.

Credit Card Debt

Paying off credit card debt is a very good thing to do, especially if you have a high interest rate. But today, there's the possibility of unintended consequences. In the old days (pre-2008), credit limits only went in one direction: UP! Therefore, when you paid down your balance, you had more available credit. If your credit line was your emergency fund, paying down the balance gave you more available credit to tap.

In 2008 and 2009, that changed. Judging by the number of complaints I've read and heard, lots of people saw their credit limits cut. Some said that the reductions in credit limit seemed to be their "reward" for paying down the balance. So, yes, they had less debt after paying extra on the credit card, and they reduced the amount of interest they were paying. But the reduction in their credit limit meant that they had less available credit to draw on in an emergency. Therefore, a person had to choose between paying down debt and building an emergency fund.

It's hard to say how likely credit cards are to reduce credit limits today. I found some recent complaints online, but I did not find any authoritative source talking about current trends or statistics on this. Since cutting credit limits has been a recent pattern and this person's financial situation sounds precarious, caution may be in order.

Emergency Fund

I would vote for building a small emergency fund first, rather than putting every available dollar toward the credit card balance. She might split her extra dollars between the two goals. It's a trade-off between paying more in interest now and the security of having some liquid (accessible) funds. Once she has at least a small emergency fund, any extra cash could go entirely toward paying down the credit card debt.

There are several acceptable options for where to keep an emergency fund. I discussed these in a June 2008 post.

Retirement Savings

The standard recommendation is to pay down debt - especially high interest debt - before putting money away for retirement. That assumes that the person will actually pay down the debt, and not just charge up the credit cards again. I once encouraged a friend to sign up for his retirement plan at work even though he had credit card debt. I knew him pretty well, and I did not believe that he would ever pay off the credit card. As a result, he might never save any money toward retirement if we followed the standard advice.

Fifteen years later, he still had credit card debt. But he also had a substantial amount in his retirement account.

If this woman is disciplined and serious about paying down her debt, the standard advice might work for her. Once her credit card debt is paid off, she can decide whether to devote that amount each month toward student loan debt or to retirement savings. Things that could tip the balance would include the interest rate on the student loans, whether her employer offers matching on her retirement contributions, whether she has any income tax liability and, if so, whether she qualifies for the Saver's Credit. If she owes no tax for the year, she gets no benefit from the Saver's Credit or from contributing to a traditional (tax-deferred) retirement account.

She might consider a Roth IRA. Her contributions are are not deductible, but qualified earnings will be distributed tax-free. She could actually take out her contributions at any time without tax or penalty, allowing the account to function as a last-ditch emergency fund.

Using her extra dollars for any of these choices will be a good thing. By evaluating her choices, she may be able to get a little more bang for her buck.

What would you do? Click on my name below, and send me your thoughts. We'll feature your ideas and comments in a future blog post.

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