When I was up to my earlobes in debt in my early twenties, I knew I needed to change my money reality. I started reading personal finance books by David Bach, Suze Orman, Robert Kiyosaki and more and was well aware that living below your means and having a healthy savings cushion were smart, but I wasn’t following any of the expert advice.
At the time, I felt my income didn’t support both paying off my debt and socking away some cash in savings. The following question plagued me and I’ve come to find out it plagues many others who are in the digging out phase of wealth creation: Should I prioritize paying off my debt first or putting money into savings?
I’ll tell you what I did in a moment, but first, there are a number of questions you need to answer before you can know which direction to put your money:
- What is your debt snapshot? What type(s) of debt do you have, how much do you owe, to whom, by when, and what are your interest rates? Vagueness and avoidance are incredibly common when it comes to our financial lives. Answering the questions above in writing will give you so much clarity. After the initial shock of knowing the whole truth wears off, there’s actually a profound sense of calm and power that emerges. Once you know where you are now, you can chart your course to your desired location.
- What is your savings snapshot? How much cash do you currently have in your bank account? Do you have any money in reserve anywhere? If so, write down where it is, how much, and what (if any) are the interest rates. (For the sake of this exercise include all accounts like 401(k)s, IRAs, and money market accounts even though some of these would be dubbed retirement accounts and not savings. Knowing the full picture of your cushion will make you feel more calm even if that money won’t be touched for many years.)
- What is your minimum monthly debt payment? Look at all of your debt (or, as I like to call it, Invoices For Blessings Already Received) and total up the amount you need to pay on a monthly basis so that you’re paying the minimums on your credit cards, student loans, etc.
- What is your monthly spending total? Rounding to the nearest $100 or so, how much do you spend on a monthly basis? If you’re not sure, don’t worry. Grab last month’s credit card and bank statements and total it up, ideally breaking it down into categories. Moving forward, use a handy app like EasySpend to track your income and spending in real time on a daily basis. Be sure to include your minimum monthly debt payment total in your monthly overall.
- What’s your average monthly income? This one is really easy if you’re a salaried employee. If you’re a freelancer or a business owner, just look at the last six months of income and figure out what the average is per month.
- What’s your cushion? Now, simply deduct your monthly spending total from your average monthly income. I like to call what’s left over your financial cushion.