Friday, August 13, 2010

The Best Use of Your Money

There are so many productive ways to spend our money: saving for retirement, paying off the house, paying down consumer debt, and don't forget about reasonable spending to make life more enjoyable. So what should take priority? Here are some things to consider.

401(k)

First, determine whether your employer's 401(k) has a match. For instance, many 401(k)s match your contributions dollar-for-dollar up to 4% of your salary. A match like this is simply too beneficial to resist. Think of it this way -- we hope to obtain a rate of return of 8 to 10 percent on our investment portfolio, but if our employer offers the match described above, we are guaranteeing ourselves an immediate 100% return on our investment.

However, depending on circumstances, it may or may not be wise to contribute more to your 401(k) than your employer will match, and if your employer offers no match, there are other factors that need to be considered.

Consumer Debt

I frequently see individuals with credit card debt with interest rates between 20 and 30 percent. If we are not getting an additional match from an employer on retirement savings, does it make sense to invest in the market where we hope to obtain a 10 percent return when we can essentially guarantee ourselves a rate of return of 20 to 30 percent by paying off these debts? One would be better off paying down debt with these high interest rates before investing elsewhere.

Emergency Fund

After paying off consumer debt but before investing in the marketplace, I suggest you establish an emergency fund, which should consist of enough money to pay for three to six months worth of spending. If your household only has one source of income, a six-month reserve is probably more appropriate. Having this reserve will protect you in the event of a job loss or medical emergency.

Other Retirement Planning

After paying off expensive consumer debt and having an appropriate emergency fund, you should shift your attention back to retirement planning, regardless of whether your employer matches 401(k) contributions. In fact, your employer's 401(k) may not even be your best option. Investors can frequently build a more diversified a technically sound portfolio via the thousands of investment options available within an IRA. Consequently, in many cases, it makes more sense to contribute to an IRA than to a 401(k). Keep in mind this does depend on your personal circumstances.

Mortgage

People frequently wonder whether they should attempt to quickly pay off their mortgage. This often comes down to your tolerance for risk. Again, the market has historically provided even a conservative portfolio with an annualized rate of return of 8 to 10 percent. If your mortgage rate is only 5 to 7 percent, it likely makes sense to invest rather than pay off the debt. This conclusion is exaggerated when we consider that the interest on our mortgage is tax deductible. However, if you simply can't be comfortable investing in the market, paying down the mortgage may be acceptable way of essentially guaranteeing yourself a rate of return: your mortgage rate adjusted for the loss of a tax benefit.

Note:
This list of priorities is always impacted by your personal situation. I recommend speaking to a fee-only financial planner about your circumstances before taking action.

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