A lot of folks ask a lot of questions in /r/personalfinance on a daily basis about “I inherited $X…”, “We have saved $X…”, “What should I do with $X amount from my tax refund…”. All these boil down to the same question: “What should I do with $X” or, more basically, “How should I handle my money?”
And the #1 answer is: read the Prime Directive. The sidebar contains a bunch of valuable links, but probably none as important and oft-referenced as the Prime Directive, a wiki which tells you in step-by-step format (and even has infographic here and a simpler version here!) exactly what to do with any amount of money you may have.
Some dispute its effectiveness and why some shouldn’t follow it (emotion, risk tolerance, increased cash flow, etc.), but the fact of the matter is that following the prime directive in the order listed will generally yield you the most bang for your buck (read: the least amount in your money paid to other parties / the most amount of your money kept, and the best strategy for earning more money with that money).
While the wiki does a great job of explaining exactly what to do and in which order to do it, there are also some pretty valid reasons as to WHY you should do it in the order listed (some of which are explained in the wiki and some of which aren’t). I’d like to take a second and elaborate on the ones that make the most sense to me (and hopefully others) below.
Note: this is by no means an exhaustive list nor a 100% correct one, but just my thoughts on the matter, and I’ll edit it with additional info as/if other comments come in.
Question: “Why should I…”
Step 0: Budget and reduce expenses, set realistic goals
Answer: to know how best to spend your money, you need to know where your money is going in the first place. Budgeting allows you to see where you’re spending your money and allows you to see where you can cut back and reallocate funds towards the higher steps listed here for the most efficient use of the funds you have.
Step 1: Build an emergency fund
Answer: to ensure real emergencies don't become financial emergencies. If something unexpected comes your way (job loss, home/car maintenance, unexpected travel, medical emergencies, etc.), you don’t have to worry about what credit-affecting monthly minimum you'll have to forego. You’ll have the financial security of knowing that you have quick access to funds that will allow you to at least pay for your minimum necessities: utilities, rent/mortgage payment, car payment, monthly minimum credit card payments, etc.
Step 2: (Take advantage of) employer-sponsored matching funds
Answer: it’s free money. If you’re lucky enough that your company offers you a retirement savings plan and even more lucky enough that they also match it, you should take full advantage of that match. But, getting to the heart of it, the number one question I see is folks questioning “Why should I this before paying down my debt?” Short answer, again: it’s free money. Long answer: whatever the match rate your employer is offering you is a guaranteed return on investment (ROI), and one that’s likely a far better ROI than paying off that 5% car loan, or a 4% mortgage, or even paying down that 15% credit card balance you’re holding. (Note: by paying off a debt amount at X%, that's a guaranteed return on investment of X% on that same amount, so it can be compared to the ROI you would receive elsewhere in other investments.)
For example, as my employer does, if your employer matches 25% of your contributions up to $4000 and you contribute that max of $4000 each year, your employer is simply handing you another $1000 in free money every year. That’s a guaranteed 25% ROI (not to mention the gains that money will have in the market over time), versus with the ROIs just mentioned.
Hell, even if you don't invest a penny of it and/or it's a matching HSA contribution or something similar, it's still likely a higher ROI than if you were using that money to pay down debt that's at a lower interest rate than the match rate.
Step 3: Pay down high-interest debts
Answer: because of the stock market. This is the step that probably makes the least sense to folks and leaves them asking “Why just my high-interest debts?” The long answer: the benefit of paying off low-interest debts (commonly referred to as anything with <=4% interest rate, though I’d personally suggest and use a figure closer to 5-6%) is generally probably not going to outperform the ROI you would get if you put that money in to the stock market which has a historical average return of ~7%. So, essentially, the money saved by paying off that 3% loan when you could have invested that money at (at least) 7% (and thus yielded a 4% net gain, or 7% - 3%) isn’t the most beneficial choice financially.
However, queue the often-stated disclaimer of “Past performance is no indication of future results.” and to quote the Prime Directive specifically: “While this has been true in the past, keep in mind that paying down a loan is a guaranteed return at the loan's interest rate. Stock performance is anything but guaranteed.” Basically, that means to invest at your own risk: a 7%+ return is no guarantee, which leads some to have some doubts and modify this step to pay off ALL debts prior to investing further, which generally isn't the most financially beneficial thing to do.
Step 4: Contribute to an IRA
Step 5: Save more for retirement
Step 6: Save for other goals
Answer: again, because of the stock market. Same as above, the money invested is likely still going to yield a higher ROI than using that same money to pay down low-interest debts. There are far more details as to how and in what exact order you should perform steps 4 and 5 (generally, max out tax-advantaged account before taxable accounts) that I won’t go into here but feel free to read more about it here.
Beyond that (and sort of mixed in with the previous two steps), it’s generally debatable and discretionary as how you should spend: sock it away in an HSA if you have health problems or a growing family, a 529 if you have children that will go to college, pay off the low-interest debt if you have a low risk-tolerance, contribute to taxable investment accounts, sock it away in a high-yield savings account, etc.
Submitted April 26, 2018 at 11:24AM by aRVAthrowaway https://ift.tt/2vYhE0z
