First Priorities: Paying Off High-Cost Debt and Building a Safety Reserve

By Eric Tyson

Plenty of younger folks have debts to pay and lack an emergency reserve of money for unexpected expenses. High-cost debts, such as on a credit card, can be a major impediment to investing, in particular, and accomplishing your future personal and financial goals, in a broader sense. A high interest rate keeps the debt growing and can cause your debt to spiral out of control, which is why dealing with such consumer debt should be your first priority, just before establishing an emergency reserve.

Pay off high-cost consumer debt

Paying down debts isn’t nearly as exciting as investing, but it can make your investment decisions less difficult. Rather than spending your time investigating specific investments, paying off your debts with money you’ve saved may indeed be your best investment.

Consumer debt includes borrowing on credit cards, auto loans, and the like, which are often costly ways to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business, because consumer loans are the riskiest type of loans for a lender. Risk means the chance of the borrower’s defaulting and being unable to pay back all that he or she borrowed.

Many folks have credit card debt that costs 18 percent or more per year in interest. Some credit cards levy interest rates well above 20 percent if you make a late payment or two. Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.

For example, if you have outstanding credit card debt at 18 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 18 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you would need to earn more than 18 percent by investing your money elsewhere to net 18 percent after paying taxes. Earning such high investing returns is highly unlikely, and to earn those returns, you’d be forced to take great risk.

Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or otherwise investments) because it encourages you to borrow against your future earnings.

Tapping credit card debt may make sense if you’re financing a business. If you don’t have home equity, personal loans (through a credit card or auto loan) may actually be your lowest-cost source of small-business financing.

Establish an emergency reserve

You never know what life will bring, so having an accessible reserve of cash to meet unexpected expenses makes good financial sense. If you have generous parents or dear relatives, you can certainly consider using them as your emergency reserve. Just be sure you ask them in advance how they feel about that before you count on receiving funding from them. If you don’t have a financially flush family member, the onus is on you to establish a reserve.

You should have at least three months’ worth of living expenses to as much as six months’ worth of living expenses as an emergency reserve. Invest this personal-safety-net money in a money market fund. You may also be able to borrow against your employer-based retirement account or against your home equity, should you find yourself in a bind, but these options are much less desirable.

If you don’t have a financial safety net, you may be forced, under duress, to sell an investment (at a relatively low price) that you’ve worked hard for. And selling some investments, such as real estate, can take time and cost significant money (transaction costs, taxes, and so on).

Riskier investments like stocks aren’t a suitable place to keep your emergency money invested. While stocks historically have returned about 9 percent per year, about one-third of the time, stocks decline in value in a given year, sometimes substantially. Stocks can drop and have dropped 20, 30, or 50 percent or more over relatively short periods of time. Suppose that such a decline coincides with an emergency, such as the loss of your job or a health problem that creates major medical bills. Your situation may force you to sell at a loss, perhaps a substantial one. Stocks are intended to be a longer-term investment, not an investment that you expect (or need) to sell in the near future.