*Each month I contribute a personal finance column to The Rich Life, an online community devoted to the practice of living a rich life with less stuff. Here my February contribution. Find the rest of my series as well as contributions by other women on http://www.therchlfe.com.
Hi Rich Lifers! And happy February to you! First, I want to say that I am super inspired by every single one of you who have come out of the woodwork to report that you’ve started to budget. Whether you’re using Mint, Quicken, the budget we provided here on The Rich Life, or another tool, you’re taking the steps to take control of your finances, and I love it!
So! Now that you understand the time value of money, and now you’ve made sure to set aside some cash for the future, it’s time to figure out what to do with that cash: It’s time to talk about allocating your savings.
When I say allocating your savings, I’m talking about big picture. How much should you be saving for retirement, given your short-term savings needs? And what about paying down debt?
We have a lot of choices with our money, but the rule we should live by is this: Earn the maximum return possible on every dollar you save. In other words, at the end of the year, you want to ensure that your money was in no better a place than where you chose to put it.
When determining how to allocate your money to earn the maximum return, it’s your job to split your savings among the following choices:
– pay off debt (high interest or low interest)
– save for short-term needs (e.g. emergency fund)
– save for mid-term needs (e.g. down payment on a house)
– save for long-term needs (e.g. retirement)
I wish there were a formula I could give you to determine this for you, but there’s not. Factors like how old you are, how much cash you’ve built up and the stability of your income will all determine what your best allocation scheme is, and most likely it will involve contributing to more than one – if not all – of these accounts.
Here are three rules of thumb to guide you in these decisions.
Rule of thumb #1: Pay off high interest debt first. I’m talking credit cards and in some cases (mine!) student loans. Your goal is to earn the maximum return on your cash, and while counter-intuitive, sometimes that requires using that cash to pay off debt. Consider this example:
Marie has $10,000 of savings to allocate, and she has $10,000 in credit card debt at an 18 percent interest rate. She’s trying to save for retirement, and she wants to know how she should allocate her $10k – should she pay off her debt or invest in the stock market? Let’s look at the following scenarios:
- Scenario A: Marie makes the minimum payments of $25/month on her credit card, and allocates the rest of her money ($9,700) to the stock market at a 10% annual return. Here is a breakdown of Marie’s return for the year, under this scenario:
In this scenario, despite investing almost $10,000 in the stock market and making 10 percent on those gains, Marie lost money, as the interest her credit card charged her was more than her stock market gains.
- Scenario B: Marie decides to split her savings evenly between her credit card and her stock market investment, allocating $5,000 to her credit card payment and another $5,000 to her retirement fund. Here is a breakdown of Marie’s return for the year, under this scenario:
In this scenario, Marie earned $500 from saving on her credit card interest, combined with her stock returns. However, keeping a $5,000 balance on her credit card still cost Marie $900.
- Scenario C: Marie allocates all $10,000 to her credit card payment. Here is a breakdown of Marie’s return for the year, under this scenario:
I hope you can see where this is going. In this final scenario, Marie was able to earn $1,800 by saving on the interest her credit card would have charged her, had she not paid off that $10,000 balance. Scenario C was the best place for Marie’s money.
*Note: If you’re asking yourself, “But what if the stock market had a blow-out year, and would have earned Marie a better-than 18 percent return?” then you’d be right to think that Marie’s money would have been better off in the stock market. However, when making that decision, keep in mind the risk involved. In this case, Marie knew her credit card company would charge her 18 percent interest, but she didn’t knowhow the market would fare. Since a better-than-18 percent gain in the stock market was possible but unlikely, the rule of thumb still stands that it’s best to pay high interest debt off before investing in the market.
Rule of thumb #2: Save cash for an emergency. If you needed $2,000 in a pinch, would you be able to scrounge it up? Many financial advisors say that you should save between three and nine months’ living expenses in cash, just in case the worse happens.
Yes, that’s a lot of cash. It is also the kind of investment that earns close to 0 percent return, as these kinds of savings typically sit in low-yield but easily accessible savings accounts. Determining how much to contribute to this type of account is important, but it’s also a personal decision based on your circumstances. If you have a stable job and no dependents, contributing as little as 1 percent of your income per month to your emergency fund might be fine. Don’t trust your employment situation quite as much? A larger contribution until you reach your goal is a good idea.
Rule of thumb #3: Split the rest of your savings between mid-term needs (like saving for a down-payment on a house) and retirement savings. Again, there is no set percentage here, but make sure you take care of both these needs. An expensive house isn’t worth buying if it means you’re eating ramen when you’re 80, but retiring when you don’t have a paid-off house (that has appreciated in value over the last 30 years!) may not be ideal for you either. Take care of yourself.
I hope you’re able to make some really clear decisions about where to put your savings this year. Until then, stay tuned for next month’s installment, when we get into the nitty-gritty of investment types. Hurrah!