Not sure whether to attack your student loan debt first or invest in your IRA? It can sometimes be difficult knowing what to spend your money on first in the journey to financial independence. There are many different approaches to this. People will give you different answers to the question of “What should I spend my money on first?” Let’s dive into it and get a basic road-map planned out for how to allocate your income efficiently.
What Should I Spend My Money On First?
This was a question that I grappled with a lot when starting my journey to financial independence. My student loans had an average interest rate of 5%, so I wasn’t sure if I should put as much money into that as possible, or just pay the $300 minimums at first and also put money in my retirement funds to get the compound interest ball rolling.
After plenty of research and asking around, it seemed like there was no right answer. Some people’s philosophy was to just pay off all the debt as soon as possible. Other people seemed to think it was OK to pay the minimums on debt with low interest, and to start building wealth, even with the lingering debt.
I understood the philosophies behind both options, so there is some gray area in certain decisions you can make, leaving it up to you to decide. Despite this, we can put together a basic road-map that can be followed in many situations. Take a look at this spending flowchart. We’ll go over the different sections below:
Go ahead and download this flowchart and save it somewhere that can be easily referenced. Now we’ll breakdown the different categories so that you can get a little bit more information on exactly where you are in the flowchart.
Note: This flowchart is based on something similar I saw on Reddit, but I was unable to find it again. So I created my own flowchart to reflect what I believe is the best spending roadmap to reach financial independence.
*Disclaimer: Some of the links in this post are affiliate links. This means if you click on the link and purchase the item, I will receive an affiliate commission at no extra cost to you. All opinions remain my own. Read more about it here.
Spending Flowchart Breakdown
1. Create an Effective Budget
Before doing anything else, you’re going to want to create an effective budget. I have a guide on how to do exactly this here.
The amounts that you budget for in each category will result from where you are along this flowchart. If you’re currently in the building an emergency fund phase, then you’re going to be allocating more money for your emergency fund in your budget.
A good rule of thumb is to “have a home” for every single dollar you make. This is called “zero-based budgeting.” If you know where every single dollar is going in your budget, you are already in better shape than most of America.
Your budget is your blueprint for success, use this flowchart to supplement your budget creation to receive the best results.
Once your budget is created, you can begin to execute.
To make it easy for you, I built out a highly effective budgeting template just for! All you have to do is enter your expenses and it’ll automatically calculate everything out for you, give it a try!:
2. Immediate Expenses
In terms of spending, the first area of allocation is the “Immediate Expenses” category. This includes 3 main sections:
1. The bare essential bills/expenses: This includes your rent/mortgage bills, utilities, basic groceries, toiletries/hygiene products, and healthcare expenses/insurance.
In this section, it is imperative to evaluate the differences between what you need and what you don’t need. Things like eating out, buying expensive make-up, and new clothes do not fall under this category. Only your basic needs.
2. Income-Earning Expenses: These are the expenses that are required for you to continue making an income. This includes transportation to get to work, a phone, internet connection, etc.
Again, you will need to evaluate your needs vs non-needs in this category. For example, if you need a phone but are having trouble making ends meet, don’t buy the newest iPhone model. Buy a cheap, used phone to get you by, and pay the bills on it.
3. Minimum Payments on Loans/Credit Cards: Next up, you need to make sure you’re not taking late fees. Always make sure you can at least pay the minimums on all of your loans/credit cards.
3. Build Your Emergency Fund
Once your immediate expenses are covered, you need to start your emergency fund. For now, you just want to build it up to either $1,000 or one months living expenses – whichever is greater. This serves as a baseline safety-net.
This should be considered a basic requirement for everyone. Most people don’t do this, despite pretty much every single financial guru out there stressing it’s importance.
Among the most outspoken of them, Dave Ramsey holds this as “Baby Step One” in his plan for helping people reach financial peace. Do this step before putting large sums of money into your debt or retirement accounts.
This money can be stored in a safe savings account, one that can be easily accessed in times of emergency. I personally use CIT Bank’s Savings Builder which offers a 1.78% interest rate. This is a very good interest rate for a savings account.
This is your priority after your immediate expenses are covered. Once this is on track, you can start paying your non-essential bills such as internet, phone, cable, etc. (Although I’ve been a big advocate for avoiding paying for cable.)
We’ll contribute more to our emergency fund later on.
I prefer giving my emergency fund a fun name, which honestly makes it easier to save to it. To read more about emergency funds and different names for it, read 21 Fun Names For Your Emergency Fund.
4. Employer Retirement Match
Many employers offer an employer match program for their retirement accounts (This is focused on U.S.-based folks. I am not familiar with retirement plans in different countries, my apologies).
If your employer does offer a match, contribute that percentage into your retirement plan. For example, my employer offers a match for the first 6% I contribute to my 401k. Therefore, I’m going to want to designate a 401k contribution of 6%, but nothing more.
This is essentially free money that your employer is giving you for retirement, which is why it’s important to meet the match amount.
If your employer does not offer a match, I would still recommend putting 2% or 3% into your 401k depending on your situation so that you can at least start contributing to your nest egg. If you’re hundreds of thousands of dollars in debt however, you need to be putting everything you’ve got into that.
Later on, we will increase the amount we contribute, but for now there are other categories that must be addressed.
5. Eliminate High-Interest Debt
We are going to consider any loans over 8% as high-interest debt. This stuff needs to go as soon as possible. You cannot be losing that much money to a loan, this is compound interest working against you.
To pay it off, there are two main debt payoff methods:
1. Avalanche Method: This method is where you pay off your highest interest-rate debt first. Doing so will save you the most time and money in paying off debt. Debt Avalanche is my preferred method of paying off debt.
2. Snowball Method: With the snowball method, you pay the debt with the smallest amount first, and work your way up to pay the highest debt last. This method has better psychological effects, and can increase motivation for paying down your debt.
Like I said, I personally prefer the avalanche method, but I’ve known people that prefer the snowball method. It’s completely up to you.
Many people get stuck on this step for many many years. The best way to get out of debt is to stop accruing it. No more loans, no more credit cards. If you can’t afford it with cash, DON’T BUY IT!
If you are struggling to make ends meet at this stage, I’d recommend increasing your income. Here are 30 Side Hustles that you can start today.
6. Emergency Fund and Debt Clean-up
At this point, you should have your baseline emergency fund of at least $1,000 and all of your high-interest debt paid off. This is great news, and you should be extremely proud of yourself. You are now further along than most people out there!
The next step is to upgrade your emergency fund. The amount that you put into it varies depending on who you ask. Most people will say 4-6 months living expenses, some say 8 months, some say a full year.
I say let’s average it out to 6 months living expenses, then over time contribute small amounts until it gets up to a years-worth of expenses (which may take a while).
However, once it hits about 6 months worth of expenses, then start attacking your remaining debt. This includes any mid to low-interest debt. As stated above, my student loan payments were at a 5% interest rate.
Meaning, before I start paying more than the $300 monthly minimums on my student loans, I should first cover my immediate expenses, have an emergency fund that covers 6 months living expenses, be rid of any high-interest debt (10% or greater), and be contributing 6% to my 401k – up to my employer match amount.
Once all of those conditions are met, then I may start putting all remaining funds towards paying off my low-interest student loans using the avalanche method.
7. Building Wealth For Retirement
Max Out Yearly IRA Contributions
Congratulations, you are now at a big milestone! You’re debt free and well on your way to financial independence. Now you can finally focus your money on building wealth.
First up, max out your monthly IRA contributions. As of 2019, the IRA contribution limit is $6,000 per year. So you’ll want to contribute $500 a month to max it out.
If you’re familiar enough with the concepts of the Roth IRA, you may explore the Backdoor Roth IRA.
Prepare For Large, Upcoming Expenses
Once you’re on track to max out your IRA for the year, you’ll want to look down the road and evaluate whether or not you have any large expenses coming up within the next few years.
This could be anything from car/home down payments, continuing education expenses, or perhaps a wedding (This category consists of large, necessary expenses). Open a separate savings account for this large expense, and save-up to pay for it with cash.
The more you plan ahead for this, the less likely you’ll need to take out a loan or use a credit card. From this point on, you should always avoid borrowing money. You worked so hard digging yourself out of the hole, don’t climb back in.
Maximize The Rest of Your Tax-Advantaged Accounts
Now you’ll want to increase your 401k contribution amount based on how much you’re making. I would recommend that a good baseline would be 15% of your income, but the more the merrier.
This is a tax advantaged account and should be utilized to a good extent. I plan on maxing this out at $19,500 (in 2020) per year when I get to this point. Max it out if you can, but do what works best for you.
Next up, if you are able to contribute to an Health Savings Account (HSA), it is highly recommended that you do so. These are typically only available for people under a qualified high-deductible health plan (HDHP). This account is also tax advantaged, read more about it here.
You also have the option to start contributing to a 529 plan to help your child pay for college. This is yet another tax advantaged account that should be utilized if possible.
8. The Groundwork is Set
Upon reaching this stage, you should have enough financial literacy to know what you want to do with your remaining income. There are many different routes you can take.
Consider the groundwork set here: a job well done. You’re debt free, you’re maxing out your retirement contributions, your future is secure. Now what?
At this point you can start partaking in the riskier investment strategies. This – if done correctly – is what will set you on the path to become a millionaire. Here is where you open up your individual brokerage account and starting contributing to that.
This is also where you can begin investing in real estate and rental properties. Or, even riskier yet, take the time to invest in starting a business. Do your due research before you start throwing your hard-earned dollars around.
Make smart decisions with your money, and build your empire.
In addition to investing, you also can put some of your money into a savings account to start saving for the more lavish-lifestyle decisions, such as buying a nice car, or expensive vacations.
It’s up to you where you go from here. It is completely dependent on your values and your retirement goals. Just promise me one thing:
Never ever borrow money for anything again.
Now that you have a general pathway to financial independence, you can begin your own journey to freedom. Use this flowchart in tandem with your budget so that you can make the smart financial decisions.
Knowing where to allocate your money is half of the battle. Actually sticking to your plan is the part that everyone struggles with the most.
This flowchart should be used at your discretion as a general guide. There are plenty of other strategies out there that work better depending on the situation, but you can’t go wrong with these principles.
Personally, despite still being deep in low-interest student loan debt, I am still contributing a small amount to my Roth IRA on a monthly basis since I am young and want to start building my nest egg.
Those kind of decisions are up to you, but you should do your due research before straying from the plan.
I would also make the point that when you begin building wealth, you should be seeking opportunities to give back. Identify a couple charities or foundations that you fully believe in, and donate to them. Or take it a step further and start your own charity!
I hope you learned something from reading this, if you found it useful, please let me know, I’d love to hear from you!