Unsure how to prioritize your excess cash flow? Here’s a 3-step process to create a plan.
Think about your assets as having a return—either positive or negative. Money you contribute to investment and retirement accounts will grow over time and have a “positive” return. Debt, like credit cards and auto loans, demand interest payments, and have a “negative” return.
With that in mind, consider this 3-step process to prioritizing your cash flow:
First, allocate cash flow among the three pillars—Credit Cards, Cash, and Retirement/Health Savings Accounts.
Retirement and Health Savings Accounts—Employers often offer a match of up to 50% to 100% on a portion of your contributions. That means that for every $100 you put in, they’ll add $50 to $100. That’s a great return in addition to growth of investments over time. Do not leave this matching money on the table!
Credit Cards typically have high interest rates of 10%-24%. That means if you have a $100 balance, you’re paying $24 annually in interest. Pay off credit card debt as soon as possible.
Cash—Cash earns little to no interest, but a cash reserve allows you to cover emergencies or take advantage of an unexpected opportunity without tapping your credit card or retirement accounts. Keep 6 to 12 months of cash in savings for these occasions depending on if you are in a two-income family or a one-income family. Read more about the importance of cash in “Cash is More than Defense.”
Once you’ve balanced the three pillars, think about building an investment portfolio and paying down other debt.
An investment portfolio provides funds for goals between 5 years and retirement. Unlike cash, these assets will grow over time, and unlike retirement accounts, you can access these funds as you need them. Sell assets from these accounts 3 to 5 years before you need them to avoid having to time a bad market.
Finally, work your other debt into the cash flow plan.
Student loans are very individual. If you’re on a debt forgiveness plan or income-based plan, then you might not accelerate the payoff of these loans. The federal government is considering some level of forgiveness as well. However, if you have extra dollars, you could pay off private loans more aggressively, as they are not likely to be part of a federal forgiveness plan.
Auto loan—cars lose value over time, so make sure your loan balance is less than the value of your car. You don’t want to be stuck with a large repayment balance if you need to replace your car.
Mortgage—Typically, a mortgage is the last debt to be paid down since it has a low interest rate locked in for a long period. However, if your interest rate is variable or higher than the interest rates on the other loans, you might prioritize this over the others. Alternatively, if the interest rate is higher than going mortgage rates, you could refinance to a lower rate and continue making regular monthly payments.
Keeping in mind the above, when determining the priority between student loans, auto loan, and your mortgage, consider the interest rate of each, and pay off debt from highest to lowest interest rate.
Building this full framework into your financial plan will take time. To learn how to track your progress, read this article on creating a personal balance sheet to track your progress. Take it step by step and watch your future grow!