Should you pay off debt, save or invest?

This article is a guest article by The Dough Roller, who writes about managing money in an online world. I encourage you to visit his site.

We get this question a lot. A family has a few hundred dollars extra each month, and they want to know what they should do with it. For many families, the choices include paying off high interest credit card debt, putting the money in a savings account, or adding it to a retirement fund such as a 401(k) or IRA. So let’s take a look at these options and some factors to consider when deciding what to do with your extra cash.

The Dave Ramsey Approach

Let’s start with how Dave Ramsey would answer this question. His advice is to first save a $1,000 emergency fund in an online high yield savings account or other FDIC insured account. Once you’ve saved $1,000, then you pay off all of your non-mortgage debt. Only after all this debt is paid off do you begin investing 15% of your pay in retirement accounts.

Many people have followed Dave’s advice to financial freedom. It certainly is a conservative approach, and very easy to follow. For me personally, I’d never been comfortable with an emergency fund of just $1,000. And if I waited to pay off all my non-mortgage debt before investing for retirement, I’d give up a 7% company match on my 401(k). So while I think Dave Ramsey’s approach is a good one, in my opinion it’s not the only good approach.

So let’s look at some other factors to consider.

Interest Rates

This may seem obvious, but the interest rate you are paying on your credit cards may dictate what you do. If you are paying 15% or 20% on cards, they should be a top priority. At a minimum, you should take advantage of 0 APR balance transfer credit cards to keep the cost down while you pay off the debt. If your credit card debt is already on zero interest or low interest cards, then your choice may not be as clear.

Emergency Fund

Everybody needs an emergency fund. An emergency fund is what distinguishes between those that live paycheck to paycheck, and those that don’t. Even one month’s worth of expenses gives a family some breathing room in case the unexpected happens.

Dave Ramsey’s approach is to save $1,000. For me, that is not near enough to let me sleep well at night. Many suggest three to six months, depending on whether both spouses work or not. I think every situation is different, and you need to decide for yourself what is best. For me, I’d prefer one full year with of expenses, although I wouldn’t wait to save that much before tackling credit card debt.

Matching Funds

If your employer matches retirement contributions, contributing at least enough to take advantage of the match is wise. In the worst case scenario, you can always borrow from or withdraw retirement funds. Yes, there will be a penalty if you withdraw retirement funds in most situations, but for me, that is worth the risk in return for free matching funds.

Putting it all together

So when it’s all said and done, here’s my approach to the question of whether to pay down debt, save, or invest your extra money:

• Save for an emergency fund first. You don’t have to reach your complete goal for the fund before paying off debt or investing, but you should have one or two months of expenses saved initially.
• Contribute enough to your retirement accounts to take advantage of any matching contributions.
• Begin paying off non-mortgage debt, starting with the debt with the highest interest rate
• Remember that this is not an all or nothing proposition. You can take some of the money to pay down debt, while using some of it to save an emergency fund or invest for retirement.