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If you point your browser towards Dictionary.com and type in “paradox” in the search field, the following definition pops up:
“Any person, thing, or situation exhibiting an apparently contradictory nature.”
Background on the Paradox
Over the past few months, I’ve been helping one of my friends evaluate his personal finances and get out of debt. In this endeavor, I’ve ran in to a lot of questions involving decisions around the topic of how personal funds should be prioritized as they are received (a decision process I like to call the Account Hierarchy).
At first, I suspected that these decisions would be quite easy, not thinking much on the matter and advising that he simply follow the My Personal Finance Journey Account Hierarchy that I laid out in the first month I started this blog and consider my most important article for readers to read (and that I follow in my personal finances to prioritize my money). This prioritized list is shown below:
1. Buy or make sure you have adequate health insurance coverage.
2. Invest enough cash in a high-yield taxable money market savings account to cover 6-9 months of living expenses
3. Pay off/get rid of your high-interest credit card debt
4. Pay your monthly mortgage payment (only the minimum amount required)
5. Invest in your employer’s 401k only up to the company match level
6. Max our your IRA (individual retirement account – either Roth IRA or Traditional IRA)
7. Finish fully funding your company 401k account
8. Prepay additional amounts to reduce the principal on your home mortage loan
9. Open up an individual, taxable mutual fund account with Vanguard.com to invest any remaining money
10. Open up a tax deferred higher education savings account for your children and fund it
The Fault in The Original My Personal Finance Account Hierarchy
However, once I really started to “get my hands dirty” and consider the details of his personal situation, I felt like I ran in to a web of contradictions about how funds should be properly prioritized (hence the paradox title of this post).
What I ended up realizing is that the account hierarchy listed above is really only applicable to someone who is 1) debt free (or almost debt free with very little credit card debt), and 2) has a average level of income that enables him or her to have a sufficient amount of money to meet their monthly needs.
So, in other words, this account hierarchy works great for someone like me (which was probably the reason I created the list the way it is).
However, the harsh reality of the citizenry of the United States is that paying off debt is simply a way of life. It is and will be a constant for the majority, if not all, of many people’s adult life. This, in my mind, is something very important that we need to accept before moving on.
Here’s an example:
Let’s say that someone in their late teens to early 20’s racked up $25,000 in credit card debt due to irresponsible spending along with almost $100,000 of student loans for attending a private college. Although it sort of pains me to admit it, in my opinion, these figures are not that far off from reality for many young folks in today’s society.
And, unless these people have rich relatives or land a job making a very good salary, money will be very tight, and they will most likely be paying off this debt until they are well in to their 40’s. In other words, if they follow the original account hierarchy listed above, they’ll effectively miss out on saving for retirement through their best investing years because they’ll only be focusing on paying off their credit card debt.
This simply won’t work. Therefore, a new version of the account hierarchy is needed for the copious number of people who have large amounts of debt and cannot expect to pay it off in less than 2-5 years. I always like to liven up sometimes-dry personal finance topics with exciting names. So, in this case, I’m going to call this the “Debt-Payoff-and-Retire Account Hierarchy.”
The Debt-Payoff-and-Retire Account Hierarchy
Note: Before we get started with this list, for the sake of simplicity, I’m going to make the assumption that it is known that prior to embarking on prioritizing funds according to the list below, that you have already met your very basic requirements for survival each month.
These include paying the rent or minimum required mortgage payment, water/electricity/sewer/gas/trash bills (other bills also), and buying food from the grocery store for your family. However, these basic survival needs do not include cable TV, internet, going out to eat every night of the week, or other frivolous spending. With this in mind, let’s get on with the list!
Part A – The Minimum Requirements
1. Pay only the minimum required payment on your credit card and other loans (student, car, etc). DO NOT PAY MORE (yet)!
In the Debt Free Account Hierarchy (what I’ve decided to call the original listing from now on), you probably noticed that debt payments weren’t addressed until Priority #3. However, if money is very tight and you have large amounts of debt to payoff, the reality of the situation is that you cannot skip out on paying back the minimum required balance on your debts. Well, I suppose you could, but no up-standing citizen wants to have debt collectors calling them up, right?!
Because of this, paying only the minimum required balance on your debt accounts is first on the list. Prioritizing the minimum loan payments ahead of health insurance (see below) was one of the paradoxes I ran in to with this exercise. I wanted to place it first, but ultimately decided against it in the end.
In addition, I would advise you to negotiate a lower APR rate with your credit card company and also discuss your “low-money” situation with your student loan provider (student loans like to see ex-students succeed and may be lenient in pushing back the terms of loan repayment).
2. Buy or make sure you have adequate health insurance coverage.
The next highest priority on the hierarchy is getting adequate health insurance. I cannot stress enough how important health insurance is. If you get in a car wreck or get injured otherwise, medical bills can rack up to be in the $100,000 range or higher, something that could result in financial ruin for the rest of your life. Because of this, you simply cannot afford to go without health insurance.
The trouble? Health insurance is VERY expensive if it is not provided through your employer, especially if you have multiple part time jobs as a lot of people do these days. Typically, if you have to pay for your own health insurance, you should expect to pay between $150-$400 per month. When you are shopping for health insurance, make sure that you find a policy that features a low enough deductible that you can actually pay it with your emergency fund money (see below for details). I personally like to see my deductible be between $500-$750.
Also, remember – with the new health care regulations, you can still be covered under your parents’ health insurance until you are age 26. This may be a viable option for some of the younger people out there.
3. Invest enough cash in a high-yield taxable money market savings account to cover 6-9 months of living expenses (Emergency Fund)
After first paying the minimum payments on your loans so that you don’t have debt collectors knocking down your door and securing health insurance, it is now time to focus as much money you have remaining on accumulating a secure, liquid, readily-available source of cash that you can tap in to in the event of an emergency. Often, this fund is used to pay the deductible on your health insurance (or other forms of insurance) mentioned above. It is very important to state also that the purpose of this account is NOT TO MAKE TONS OF MONEY. It is to provide you with peace of mind and security.
In today’s low-interest landscape, it’s important to be very selective in choosing where to park your emergency fund. I prefer to use a high-yield online savings money market account. These accounts offer much higher interest rates/returns than savings accounts at brick-and-mortar banks and are still FDIC insured! A no-lose situation if you ask me!
So, this all sounds well-and-good. However, you might be asking yourself the following question at this point. – “But Jacob, funds are really tight for me right now. If I’m doing this math correctly, at the current $1000 monthly expenses level at which I am operating, this would sum to $6000-$9000 total. I currently have $0 saved up. This might take me 9 years to accumulate! How do I proceed?”
This is actually a great question! It’s quite tempting to recommend that people only really need a minimum level of an emergency fund (maybe only $500), and after they accumulate this amount, they can move on to higher-earning investments and credit card debt payoff. This is even more tempting given the plethora of options available to people for personal loans in the event of an emergency. For example, you can compare loans online and very quickly narrow down your choices to a loan with suitable terms.
However, at the end of the day (and although there might be some disagreement on this), I believe that the peace of mind and safety that comes from having a sufficient emergency funds outweighs the benefits of being “debt free.” So, my answer to this would be that if it does take you 9 years to accumulate an emergency fund, then so be it. Your debt balances may accumulate significantly, but at least you won’t experience financial ruin if an emergency occurs and you cannot work.
Part B: Beyond the Minimum Requirements
Having fulfilled the absolutely essential requirements listed in Priorities 1-3 above, you can now shift your focus to actually becoming debt free and saving for retirement.
Enter our next paradox: traditional financial wisdom states that if you had to choose between investing in mutual funds for retirement (which at best can earn you 10-11%) and paying off credit card debt balances which carry a 20% or higher interest rate, the clear choice would be to pay off the credit card interest rate first because it represents an AUTOMATIC and GUARANTEED savings.
Indeed, this is the wisdom that applies for myself and many others who are lucky enough to be consumer debt-free. However, if you have large amounts of consumer debt that you cannot possibly pay off in less than 5 years, the choice becomes much harder. On one hand, we need to pay off our credit card debts to capture the automatic savings on the extraordinarily higher interest. However, if you are 24 years old and will be paying off your huge debt balances for 20 years to come, you cannot put off saving for retirement until that time. That would be both very unfulfilling and unwise due to the power of compound interest over long periods of time.
Because of these facts, in the Debt-Payoff-and-Retire Account Hierarchy, I now recommend the following hybrid approach:
4. With the money leftover from Priorities 1-3 above, split the balance in to two (2) sub-accounts – one for paying off debt and one for saving for retirement.
4.1 Use the debt-payoff sub-account to pay off your various debt accounts beyond the minimum balance
In this exercise, funds should be prioritized to pay off your highest interest debt balances (probably credit cards) first and then moving down the chain from there.
4.2 Using the funds in your “saving for retirement” sub-account, invest in your employer’s 401k only up to the company match level
Matching employer contributions represent free money, and we should all take advantage of this! After that, continue working your way through the priorities listed below. This order pretty much remains the same from the original Account Hierarchy.
4.3 Max our your IRA (individual retirement account – either Roth IRA or Traditional IRA).
4.4 Finish fully funding your company 401k account.
4.5 Prepay additional amounts to reduce the principal on your home mortage loan (if you have one).
4.6 Open up an individual, taxable mutual fund account with Vanguard.com to invest any remaining money.
4.7 Open up a tax deferred higher education savings account for your children and fund it.
So, there you have it folks – the updated, new, shiny, revised, and expanded My Personal Finance Journey Debt-Payoff-and-Retire Account Hierarchy priority order!
As you saw in this post, a very different priority order is needed depending on whether or not you have large amounts of debt. But, I believe that this list will be very helpful for the millions of Americans out there who will be dedicating a large portion of their adult lives to paying off debt. While it’s definitely true that being in severe amounts of debt will drastically hinder the speed at which you accumulate wealth, overall, it is not the end of the world. I firmly believe that you can still live a happy, fulfilled, and meaningful life even if you are paying back debt.
And, I sincerely hope that this updated priority order will help you on your way to becoming debt free and also living the fulfilled lifestyle we all hope for! Thanks for reading!
PS – I’ll be sure to update the original account hierarchy page with the details of this alternate priority order so that everyone can easily find it!
How about you all? Should paying off debt, saving for retirement, having an emergency fund, or securing health insurance be your highest priority? Does the answer to this question change depending on whether or not they have loads of debt?
Do you agree with the order of priorities listed above?
Share your experiences by commenting below!
***Photo courtesy of http://www.flickr.com/photos/wlscience/2121691688/sizes/l/in/photostream/