One area of financial planning that may be a source of confusion for clients is prioritizing different goals. An individual or family earns a certain amount of income and may have difficulty deciding how to allocate that income against normal expenses as well as the financial goals they have established. For example, I have recently spoken to a few clients that have the following goals:
- Pay off student loans
- Pay off credit card debt
- Save money for a down payment on a house or pay off a home mortgage
- Establish an emergency fund
- Save money for children’s college
- Save money for retirement
Given a limited amount of income, how should the client approach multiple goals? The easy answer: it depends.
Every client’s situation is completely unique and a unique solution will likely be the best answer. Creating a financial plan with a Certified Financial Planner™ and then updating that plan annually as progress is made can provide excellent results over time. Here are a few concepts that I encourage when creating a financial plan.
- Prioritize your goals - the first step in attacking a multi-goal situation is to prioritize which goals are most important. However, this should be done in conjunction with a CFP® to make sure the approach makes sense. I encounter many clients who delay saving for retirement so that they can pay off debt first. The danger of this approach is that delaying saving for kids college and retirement can leave you short of those goals in the long run. Please see my recent post here Should I Pay Off My Mortgage Early for an analysis of paying off a mortgage and waiting to start saving for retirement.
- You may need to address multiple goals at the same time - instead of focusing on one goal at a time, you may need to work on multiple goals at the same time. For example, if the client can afford to set aside 10% of their income towards all of their financial goals, it may make sense to save for retirement with some of the dollars while simultaneously paying down debt with other dollars. A financial plan can help you determine the allocation.
- Capture your 401k match first - if your employer offers a defined contribution retirement plan such as a 401k, and there is an employer match, it is important to make sure you contribute enough to capture the match first. For example, if your employer matches 100% of the first 4% that you contribute to your 401k, make sure you are contributing at least 4% to your 401k to get that full match. Why? Because in this example, you are getting a 100% return on your 4% contribution (not through investment returns, but through the employer match) If your employer sponsored retirement plan doesn’t offer a match, see point 4.
- Paying off high interest rate loans and credit should be a high priority - after you have captured the full match to your employer sponsored retirement plan, focus on paying down high interest debt. For example, if you are paying 15-25% interest on your credit card, pay this down as quickly as you can, or consider consolidating it to a lower interest credit card or loan. At 15-25% interest, that is a much higher interest rate than most investments have historically offered. Paying these types of debts down or shifting them to a lower interest rate will take less of your dollars than you would gain from most investments.
- Paying off low interest rate loans should be a lower priority - if you have a mortgage or student loan, and you’re only paying 2 to 4% interest annually, there is a good chance that your investments could perform better than that over a long term period of time. So I often encourage clients to set their emotions aside and pay the low interest debt off on a normal repayment schedule placing a higher priority on other financial goals such as retirement and college savings. In the case of a mortgage and some types of student and business loans, the interest may be tax deductible which lowers the effective cost of those loans even more than the stated interest rate.
- Don’t forget about an emergency fund - statistics show that very few people in the US have an adequate emergency fund. A recent statistic showed that 66 million Americans have no money saved at all and 62% of Americans have less than $1000 saved (source: CNBC). An emergency fund is usually defined as 3 to 6 months of expenses saved in cash. Life has a way of throwing us curve balls sometimes and with no emergency fund, you may be forced to tap into high interest credit cards or retirement or college savings to meet your needs. Utilizing credit cards, retirement accounts, or college savings can carry penalties, high interest rates, and negative tax consequences and these should usually be avoided.
- Retirement may be a higher priority than college savings - for many clients, having the ability to retire is a higher priority than helping their kids with college expenses. For other clients, helping their kids with college expenses is the higher priority. If you plan to work longer because you want to reduce the expense of retirement or help kids with college expenses, beware of the unexpected. A recent study by Voya Financial found that 60% of retired US workers said they had to stop working unexpectedly (Source: USA Today) This is where prioritizing your goals with a solid financial plan becomes critically important. It is important to note that If your income is high enough or your expenses are low enough, a client can both save enough for retirement as well as save enough for kids college at the same time. Most of us have limited incomes however so this may mean keeping your expenses lower so that you can save for your goals first, and then enjoy what’s left over from each paycheck. A Certified Financial Planner™ can help you establish a budget, determine how much you will need to save for retirement to be on track, and determine how much you need to save for college to be on track. It is absolutely possible to achieve your savings goals with a budget in place.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is not an indication or guarantee of future results.
*The hypothetical investment results and growth rates are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product and/or service.