It’s a new year — a perfect opportunity to think about financial planning. After all, no matter what your salary or career stage, financial stability is key to meeting your goals. But when is the right time to seek expert advice? When you want to buy a house? As soon as you start a family? Once you get closer to retiring? According to experts, the answer is now.
The Federal Reserve Bank of New York’s latest Report on Household Debt and Credit states total U.S. household debt was nearly $4 trillion in the third quarter of 2019. While most of this debt is for mortgages, student loans account for $1.5 trillion and credit cards for nearly $9 billion. And when it comes to debts that are more than 90 days delinquent, student loans and credit card debt are at the top.
Those who may be feeling the weight of student loans and credit card debt are not alone — but what to do? The best approach is to incorporate debt pay down strategies alongside saving and investing strategies. Finding a balance between both can have one of the greatest impacts in your long-term planning success.
Begin by shifting your mindset around student debt, says certified financial planner Ben Smith, founder of Cove Financial Planning in Whitefish Bay, Wis. “I always reiterate to clients that student debt is not necessarily a bad thing, and it certainly should not stop you from seeking out help from a financial planner,” says Smith, adding that in many cases, incurring college debt to eventually secure a high income and fulfilling career is often worth the investment from both a numerical and emotional standpoint.
On the other hand, 83 percent of Americans between the ages of 30 and 49 have a credit card, and the average U.S. household has more than $5,500 in credit card debt. Further, credit card rates have increased by more than 3.38 percent — resulting in higher month-to-month costs for consumers, according to the Federal Reserve of St. Louis.
So, let’s get to the obvious question: Is it more important to save money or pay off debt as quickly as possible? Answer: Both. Two key factors to consider when building your strategy are cash reserves and loan interest.
Cash reserves means readily accessible money, such as funds in a checking or savings account. Adequate cash reserves are important because if you incur an unexpected expense and cannot cover it, you may need to take on additional debt, according to Smith, who adds that the new debt often is in the form of credit cards at a higher interest rate than student loans. “It may end up putting you in a worse financial position than if you were to bolster your cash reserve up front,” he says.
Although the target is different for everyone, Smith recommends maintaining cash reserves equal to 3 to 6 months of your living expenses. So, if your rent or mortgage, utilities, groceries, clothing, car expenses, etc., and minimum debt payments equate to $3,000 per month, you should maintain a cash reserve between $9,000 and $18,000.
“If you are single, or if you and your partner work in the same industry, or if you and your partner have very different income levels, you may want to stick to the higher end of the range,” says Smith. “If you and your partner both earn a similar income in different industries, it might make sense to target the lower end of the range.”
What to Look for When Seeking a Financial Planner
Fee-only: This means the planner is only compensated by clients for objective advice. They do not sell products and do not make a commission or kickback on any of your decisions.
Fiduciary: Look for a planner who signs a “fiduciary oath” to adhere to the highest possible standard of care and agree to always put their clients’ interest first above and beyond their own interest and the interest of their business.
CFP®: The Certified Financial Planner is the gold standard in financial planning credentials and education. This designation requires considerable education and career experience, along with passing a comprehensive examination covering all aspects of financial planning.
After you have accumulated adequate cash reserves, it is time to tackle debt reduction and investment. Despite the common misconception that you can’t allocate money to your future until you pay off debt, no financial plan is one-size-fits-all. And interest is a very important factor in determining how much to pay toward loans versus saving for your future, says Smith.
A balanced, diversified investment portfolio typically yields 5 percent to 7 percent annually. This may fluctuate year to year, but 5 percent to 7 percent is a well-established annual return pattern. Now, look at the interest rate on your student loans. If your interest rate is less than 5 percent, it may be best to invest most of your excess cash flow (what you have left after living expenses) each month while making the minimum payments on your student loans. This is because you are likely to achieve a greater return by putting cash into an investment account rather than the interest rate on your loans. By comparison, if the interest rate on your student loans are more than 6 percent, you’re likely to pay more in student loan interest than you are to gain from an investment portfolio. In this case, you may benefit from paying off the student loans.
Credit cards are a different story. As of summer 2019, the average U.S. credit card rate was 16.91 percent — much higher than the 5 percent to 7 percent annual return on an investment portfolio. Furthermore, some credit card companies levy rates up to 30 percent if a payment is missed, making the interest on credit card debt up to six times higher than the return on most investment portfolios.
“If your credit card company charges an interest rate in the double-digits, then it’s important to aggressively pay down your credit card balances as soon as possible,” says Smith. But contrary to popular belief, the best strategy is not necessarily to start with the card with the smallest balance. “There’s an emotional aspect to carrying debt,” says Smith, “and I understand the [feeling of] urgency to pay off relatively small balances — less than $5,000 — as soon as possible.” Instead, focus on paying off those with the highest interest rates first, then move on to the next highest interest rate, and so on. “This strategy is known as ‘snowballing’ and can help you pay down debt more efficiently,” Smith says.
What if, after living expenses and minimum payments on your loans or credit cards, you have no leftover income to build up cash reserves, much less invest or make more than minimal payments on debt? All is not lost.
“If you have student loan debt with high interest rates or from several different lenders, or if your credit card balances exceed $20,000, it may be in your best interest to explore debt consolidation options,” says Smith, adding that they tend to benefit people with reasonable credit scores and incomes. “This strategy could not only simplify your payments, but also may help lower your average interest rate to make paydown more manageable.”
For more information, see Smith’s post “What is a Fiduciary, and Why are They Like Dietitians?” on the coveplanning.com blog.
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Follow and tweet Ben on Twitter at @BenSmithPlanner.