You probably would like to be conscientious and responsible about prioritizing your finances. I mean, who wouldn’t want to do a good job of prioritizing their finances? The problem is that while this might sounds good theoretically, it but can get very confusing when you try to put it into practice. You’ll want to build an emergency fund, a retirement savings fund and pay off your debts but determining this using with some kind of consistent method can lead to paralysis by analysis. The tripwire here is prioritization. It’s critical that you allocate your money correctly but this raises the question of how can you determine how much money you should allocate for any one of them?
Here are some tips to eliminate the problem and get your finances on the right path.
Step 1: Create a mini-emergency fund
The first step in prioritizing your finances should be to create a mini-emergency fund. If you don’t have some money put aside to cover an emergency and you run into trouble you’ll probably have to borrow money, which means just creating more debt. So how much would be a mini-emergency fund? Try of about $1000. That way you’ll be able to cover small emergencies like an automobile repair or a quick visit to the ER.
Whenever you deplete that fund stop doing anything else until it’s back to that $1,000. Once you achieve the nirvana of having no debt you can then go to work on creating a bigger emergency fund, which most financial experts should be enough to cover between 3 to 6 months of your living expenses.
Step 2: Refinance your debts
In prioritizing your finances the next step should be to find ways to cut your debt before you go to work on paying it off. For example, if you have credit card debts with high interest you might be able to do a transfer their balances to one of those 0% interest balance transfer cards. If you have other types of debt you might be able to get a debt consolidation loan with a better interest rate. If you do get one of these loans, it’s important to make sure it doesn’t have longer terms. This is because the longer the terms, the more you’ll end up paying an interest. Also, be sure to continue making your same payments as this will shorten the amount of time you it will take to pay off your debt and without requiring you to make any big changes in your lifestyle.
Step 3: Focus on saving
There are people who say you should focus all your attention on paying off your debts before saving any money for retirement. However, while doing this you should try to put 10% to 15% of your take home pay towards retirement. The reason for this is because retirement saving is for the long term and its most important component is time. The sooner you start and the more years you have to save money; the more money you’ll have. It’s really just that simple. This is why if you put just a small amount for 40 years it’s actually much better than saving a lot of money every year for just 20 years.
Here’s an example of this. If you are 28 years old and save $5000 a year in an account with an average 8% return you should be able to retire with $1,295,000 at age 68. However, if you waited until you’re 40 you would need to save $13,583 a year at the same 8% return to have $1,295,000 at retirement.
Step 4: Make a debt repayment plan
Now that you’re saving for your retirement you need to make a plan for paying off your debt so that you will have more money available for your retirement savings. You could do this one of two ways — increase your earnings or reduce your spending.
You could up your earnings by getting a raise, getting a different job or by getting part-time work. If you were to get a part time job at $10 an hour and work just 20 hours a week, which should be pretty easy to do, you’d have about $800 a month before taxes or around $2400 a month. Put that money against your debts and you should be able to become debt free fairly quickly.
If you choose the other alternative, to decrease your living expenses, you will need to develop a budget and then find those categories where you can make cuts. For example, do you go to a lot of movies with friends or is there a health club membership you don’t use? Could you find a better cell phone plan or auto insurance with a lower premium? If so, this is money you could apply towards repaying your debt.
There are two ways to pay off debts. They are the avalanche method and the snowball method. The avalanche method means ordering your debts from the one with the highest interest rate down to the one with the lowest and then focusing all your efforts on paying off that first debt as this will save you the most money. The snowball method means ordering your debts from the one with the lowest balance down the one with the highest and then focusing your energies on paying off the one with the lowest balance first as this should give you momentum to begin paying off the debt with the second lowest balance and so on. If you’d like more information on the snowball method here’s a brief video featuring Dave Ramsey, the person who created it.
Now, work on beefing up your emergency fund
When you have repaid debts you should be able put that money towards beefing up your emergency fund. At this point you’ll be saving for your future and yourself and not just paying off old debts.