By Jim Beall
Beall Financial Planning
Here’s a scenario: Meet Broke Brad. While he hasn’t been paying off his credit cards every month, this year he found a mentor to help him get his money in order. He has changed his spending and is living below his means. He has been slowly paying the minimum payment on his credit cards and applying anything extra to the highest interest rate card. Brad has 3 credit cards with debts of $900 @ 18% interest, $4,500 @ 16% interest, and $1,600 @ 20% interest. Even though he is working on paying them off, he has no savings at all. He receives a one-time bonus of $1,000. What should he do?
Everyone’s situation will be unique. An unexpected infusion of cash is always welcome. Given the statistics on how financially stable most Americans are, this is a scenario that many don’t spend enough time thinking through the long term potential. The extra cash could be a tax refund, an account you had forgotten about, or a raise and increased cash flow each paycheck. I will walk you through a decision tree and some priorities to consider. I would do this with any client that comes to me.
First, consider your goals and the time frame in which you plan to achieve them. You aren’t in a race with your neighbors and coworkers. You and your family have your own goals and time frames for achieving them. This is also the time where you should be involving your spouse or partner in the discussion if you have one. You need to work through your various priorities and savings goals to determine where the money should go. You can even spread the wealth around to multiple purposes. A priority should be to make sure your Emergency Fund is fully funded.
The Emergency Fund is a savings account that has 6-12 months of living expenses available. Just over a decade ago, we recommended 3-9 months, but the Great Recession proved that it was not enough for most Americans. Various studies show 78% of Americans live paycheck to paycheck. The need to start having a savings account and having it grow to a true Emergency Fund that can handle most emergencies should clearly be one of the critical priorities for most Americans.
When looking at your goals, beware of lifestyle traps that increase your expenses without getting you any closer to your goals. That new boat looks nice, but it comes with a host of additional ongoing expenses. All of which would prevent you from meeting your financial goals in a timely manner.
For some, this mysterious thing called extra cash can be a way to achieve another mythical goal of lowering their taxes. If you have excess cash flow every month yet haven’t maxed out your retirement plan at work, you can increase your withholding and thereby your taxable income and have a multi-win situation. You are reducing the taxes you pay, increasing retirement savings, and possibly moving your retirement date up.
Back to our scenario about Broke Brad: He can’t pay off his credit cards each month but is slowly whittling them down. Here’s the thing: No savings account will pay more than what the credit card companies charge in interest. Therefore, he should forgo the Emergency Fund until his credit card debt is gone. He would actually lose money through interest charges on the credit card debt if he put it in savings. His best option is to pay off the $900 credit card and apply $100 to the highest interest rate card that is left. This immediately frees up the minimum monthly payment to use next month to the two remaining debts. Broke Brad doesn’t actually have extra cash. He just has money that hasn’t paid down debt yet. That credit card that is paid off can now act as his Emergency Fund until he pays off his debt and can fund an emergency fund with actual cash.
Readers will know that mathematically he will pay more interest because the $900 account isn’t the highest interest rate and he would be better off in the long term applying all the money to the highest interest rate card. Psychologically, giving Broke Brad a win by paying off one card and freeing up some more positive cash flow has mental benefits that exceed the small amount in interest that will be incurred over time on the higher interest rate card.
To summarize the extra cash decision tree:
1/ Eliminate or reduce debt to increase your free cash flow.
2/ Fully fund your Emergency Fund.
3/ Once the first two are completed, assess your goals and prioritize where you want the cash to go.