(continuation of Create a workable budget)
Phase 1: Pay the minimum on your debt until you build up some savings
You probably heard the saying you’ve got to walk before you can run, and that’s even more true when it comes to managing money. If you’re in a tight financial situation right now, you’ll have to start out by taking it slow.
For the short run at least, plan to make the minimum payment on your loan debt. Your first financial priority – even ahead of paying off the debt – is to create an emergency savings account. That’s the financial cushion which will protect you either from unexpected expenses, or from a disruption in your income. That’s why it needs to be a priority.
It’s generally recommended that an emergency fund hold an amount equal to at least three month’s worth of living expenses. If you’re self-employed or primarily commissioned, that number should be closer to six months.
Any extra money you have in your budget should be directed into your emergency fund until you reach one of these thresholds. Not only will that put you in a better financial position, but it will also make your entire financial situation feel more tolerable.
Once you have your emergency fund fully stocked, the next priority should be enrolling in your employer’s retirement plan (if your company offers this). You won’t be in a position to go heavy on this allocation – and you shouldn’t. But you should at least begin making a small contribution to the plan as soon as you are able. It’s all about taking full advantage of the time value of money.
The general advice is that if your employer provides a matching contribution to your retirement plan, you should contribute an amount that will result in the largest employer match possible.
For example, if your employer matches 50% of your contribution up to 4%, then you should make an 8% contribution. That will give you a combined 12% annual contribution, and the 4% being kicked in by your employer will represent free money. That’s too good to pass up!
Phase 2: Once you’ve got basic savings goals covered, it’s time for a new strategy
Only when you have those two savings goals in working order, should you consider accelerating payment on your loan debt. So, if you have your emergency fund in place, and you’re contributing to your retirement plan — and you still have extra money in your budget – it will be time to develop a new strategy.
This is the time when you will have to decide your actual priority. Do you want to throw all of your extra resources at the loan debt? Or, do you want to increase your contributions to your retirement plan, or to some other savings goal?
Though this often comes down to personal preference, there’s also a bit of math involved.
Reader tells us that the interest on a loan debt is usually 10% to 20%. If you feel that you can earn something more than that rate in your investing activities, then it may be worthwhile to continue paying the minimum on the debt, while allocating additional money to more investing.
But if you feel that it’s unlikely that you will earn 10% to 20% consistently, then it will make more sense to pay off the debt as soon as possible.
Two ways to make the student loan debt go away
If you decide you want to make paying off your loan debt a priority, there are two ways to go about this.
1. Increase your monthly payments
If the minimum payment is P1000, and you have an extra P500 in your budget each month, then increase your debt payments to P1500.
If you owe P5000 on the debt, with an interest rate of 20%, you’re only paying the interest at P1000 per month. But by increasing the payment P1500, the loan will be fully paid off in 10 months.
2. Create a “Sinking Fund”
It’s a simple strategy: you make the minimum payments on your debt, but allocate your additional payments to a savings account that will be used to pay off the debt in the future.
The sinking fund method will actually take a little bit longer to finally pay off the debt, though only by a few more months. The reason is that since you are not allocating extra money toward your monthly debt payments, the balance remains higher, and so does the interest being charged on that balance.
The advantage however is that you will have control of the money in the sinking fund. And in that way, you can pay off the debt in your own time.
For example, you can either wait until you have sufficient money saved to pay off the debt completely, or you can make periodic lump-sum payments to reduce the debt. If you have P3,000 in the sinking fund, you can use P2,000 of it to pay down the debt, and then work on rebuilding the remaining balance.
Either method will get the job done, it’s just a matter of which one you’re more comfortable with.
(to be continued…)