Get on the Right Path
There are a lot of different philosophies on managing finances. In the end, it all comes down to risk tolerance and goals. If you are drowning in debt, then you need to prioritize paying off what you can before they tackle other things. If you want to become wealthy, then you are going to have to save more than the average person.
Regardless of where you are now, there are some steps to take to get on the right path:
- Figure out your budget.
Before you can get to work, you need to know what materials you’re working with. This step can be eye opening, scary, exciting, or expected depending on how closely you currently follow your bank accounts.
List all of your income. For most of us, this will just be what we make at our jobs. If you get paid for something else, list it if it’s dependable. If you can’t count on getting the money, then pretend you don’t get it at all.
List your expenses. Go through your credit card statements, bank statements, bills, receipts, and checkbook to list every expense for the past 3 months. Then add up all of the expenses and divide by three to average it out. Now compare that to your income.
Now the important step! After you’ve figured out where your money is going, find what you can cut. Do you need Netflix and Hulu every month or can you alternate them? Can you eat more meals at home? Do you buy things you don’t really need? It might be a bit painful, but most of us have things we can cut out of our spending.
- Save for emergencies.
With the money you are saving by cutting out spending, you can now save up that money to keep you from relying on your credit card. Most advice suggests this amount should be $1000. However, if you don’t have anything that could cost $1000 to fix then you might need less. Conversely, if you have an old house or car that could rack up a $1000 bill easily then you might need more.
The idea here is to save up enough money to keep you from getting into further financial trouble. For you, that could be $500 or $5,000. Be realistic, but don’t go below $500.
- Get free money.
Now that your budget is tightened and you are prepared for an emergency, you can make sure you aren’t leaving any money on the table. If your job offers a retirement matching program, then you should contribute what is needed to get that match.
This percent can range greatly depending on who you work for, so if you don’t know you can ask your HR or similar department. If your employer will match up to 5% of your salary you put into a 401k, then you should cut your expenses until you can put in 5%.
The best thing about this is that you save on taxes too! The US median income for 2018 was $61,937. If you are single and make the median salary, then you would save over $600 in taxes by contributing 5% of your salary to your 401k. On top of that, your employer would be putting over $3,000 into your retirement account for you!
- Pay off the worst debt.
The worst debt to have is high interest debt, which is anything with an interest rate over 4-5%. This is typically a credit card or student loans. If you can transfer the credit card debt to a 0% introductory card or refinance your student loans, then it may help you get rid of the debt. The main part of this step is simply paying it off.
Take any extra money that you have and pay it towards this debt. This step often takes the longest, and is the least fun. Money that you wish could be spent on fun things is going towards paying back what you’ve already spent. This will require a lot of mental fortitude, patience, and support. Hang in there. There are two essential methods to this, and which you choose will depend on what kind of person you are.
Method 1 is to pay off the highest interest debt first. You pay the minimum payment on all of your debts, and then determine which has the highest interest rate. So if you have a loan with 7% interest and one with 12% interest, then you pay off the 12% interest debt first. It doesn’t matter how much you owe; you keep paying it until it is gone. After that is paid off, you add what you were paying on that debt to the payment for the 7% interest rate debt. This method is most efficient because you pay less interest overall by getting rid of the highest interest rate debt first.
Method 2 is to pay off the lowest balance debt first. You pay the minimum payment on all of your debts, and then determine which has the lowest balance. So if your 7% debt was for $1,000 and your 12% debt was for $2,200, then you would pay off the $1,000 debt first. After that is paid off, you add what you were paying toward that debt to the payment for the 12% interest rate debt. This method is psychologically more satisfying than method 1 for many people because you usually pay off the individual loans more quickly, though you don’t become debt free more quickly.
Choosing one of these two methods provides a structure to your debt repayment, as well as gives more immediate goals to focus on.
- Start saving.
Now that you’ve paid off the worst of your debt, you can start saving. At this point you can contribute to an IRA, attempt to max out your 401k (or 403b, etc) contributions, or save for things that will keep you from taking on debt. This could be school tuition, or a fund to replace your furnace that might not last for a few more years.
- Strive toward other goals.
Finally, you should put money toward other goals you have. Do you need a down payment for a house? Want to start a business? Need to replace your car? This is the time you should save for those things. You can also start a college savings account, such as a 529.