A Nice Problem: Save More or Pay Off Loan?
Dear Debt Adviser, In your opinion, is it better to put any extra money toward paying off loans? Or is it preferable to put excess income toward long-term savings? My family's household budget is solely based on my spouse's income. Thus, I have my take-home salary of approximately $35,000 a year to put toward strengthening our personal finances.
At the moment, the only debt we have is one small student loan, a car loan at 2.47% interest and a mortgage with a rate of 4.6%. If I focused on paying off the loans, all three could be retired within eight years. That would save us well over $200,000 in interest over the long term. But that means minimal money would be put toward savings. Should I focus on paying off the debt or pumping money into savings? -- Emily
Dear Emily, As they say, if you don't know where you are going, any road will take you there. Just knowing your income, overall expenses and your debt load gives you an excellent start. But what is missing from this equation is the rest of your life. What are your short-, medium- and long-term goals? Are they included in your budget? Maybe they are fully funded, but I suspect they are a future expense that you plan to address later.
I suggest you take an hour or two and develop some shared goals with your spouse that will guide and galvanize your lives for years to come. Your finances are the fuel that will help you realize your goals. These goals, in conjunction with your income, expenses and debt repayment, will give you a dynamic picture of how to best handle your resources.
Goal-setting isn't hard. Visualize what you want your future to look like; this vision will drive your financial goals -- the immediate and longer-term varieties. Examples of short-term goals, or those less than five years away, would be a vacation, down payment on a new vehicle or upgrading your kitchen appliances. Long-term goals, or those more than 10 years off, might include retirement, education funding or a vacation home.
Once you map out your goals, determine how to allocate your income to reach them. There are two things to keep in mind. One, your goals need to be flexible enough so they can be revised as circumstances change. Two, your plan should include building an emergency fund that could cover your expenses for at least six, and preferably 12, months. This cushion will give you financial protection from an uncertain job market and economy.
Deciding how best to manage extra money is a nice problem to have. After developing a strategy for financing life goals and an emergency fund, I suggest you then pay down your debts. Of your debts, I'd retire the car loan first, the student loan second and the mortgage last, provided its a fixed-rate loan. The reason to address the home last is the tax advantage of mortgage interest.
Because you and your spouse have managed your income and expenses so well, you might not need any assistance with the planning. However, if you would like or need the benefit of a professional financial planner, I recommend you meet with one. Ask friends and family for recommendations, or visit the Financial Planning Association website.