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If you had an extra dollar in your pocket right now, where would that money go? Would you drop it off in the stock market and let it grow over time?
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If you had an extra dollar in your pocket right now, where would that money go? Would you drop it off in the stock market and let it grow over time? Or would you try to pay off loans? Maybe your car loans, maybe high interest debt, or maybe student loans. If you look this up online, most people will tell you this is a simple problem.
Look at the interest rates, run the math problem, and then figure out from there what you should be doing. But here's what I see, people aren't just math problems. We have feelings, we have stress, we have different backgrounds that make up our decisions differently. Today, I want to explain a framework of how you can look at this situation.
I want to run through the math and what's behind it, but then more importantly, I want to talk you through the mindset and explain to you how these two things can work together to make for the right decision. Hi, my name is Prejean. I'm a certified financial planner and wealth management. I created this channel to help professionals and families to align their money with what matters most with them, their values.
Every single week, I break down how money works so that it can be clear, honest, and easy to understand. My goal with this channel is to help you to be able to make better decisions with the money that you work so hard for. So, if that sounds like you, make sure you subscribe, and now let's get into it.
Before we can even talk about safety or paying down debt, we need to first talk about safety. In the financial term, we call this an emergency fund. Think of an emergency fund like a shield. The goal is to have 3 to 6 months of expenses safely put away into a bank account or something to where the money is safely kept.
Let me explain why this matters in the first place. Life is unpredictable. Water pipe leaks, car breaks down, people lose their jobs. I mean, for example, let me tell you about my own experience. I remember when we first bought our new house, we had a water leak happen in the basement. And in that moment, we were so grateful that we had an emergency fund more than any investing or any pay paying down debt that we could have ever done in that moment.
So, let's say you put all your extra money in investing in in the stock market or trying to pay down old debt, and you have zero money in the bank or anything like that. What do you think will happen whenever rolling mercy happens? You're going to go back to using credit cards and that's going to bring you back down to the trap that you're trying to escape out of in the first place.
An emergency fund really changes the game. It gives you breathing room. So that's why it's so important to try to save between 3 to 6 months of expenses. And if you can't do that, at least try for 1 month of expenses or at least $1,000 of savings. This at least gives you that buffer and that shield for whenever life eventually happens.
And then once you have that set aside, then you can look into the conversation between investing or paying off your debt. Now let's look at the first option, putting your money to work through investing. Now why would people want to do that? Because investing allows for you to put your money to work and let it grow over time quietly while you sleep.
Now there's three main tools that people use to accomplish this and now we're going to cover each one of those. First is the 401k master work. Many employers say that if portion or put a portion of your money into savings, we will match that dollar for dollar. For example, you look at a 3% match.
If you put in 3% of your salary into the 401k, the company says that they will match that 3% back. That's an instant 100% return on your money right then and there. But here's the detail that most people often miss. And this is called the vesting schedule or the cliff schedule. It pretty much states how long you have to be at your employer before the money that the company has given you is yours.
So this is important if you say that you want to leave your job within a year or two, but the vesting schedule at your job require you to be there for at least 3 years. It's important that you're aware of this because if you're contributing to a 401k, if you were to leave within that time span, that money would not belong to you.
So this is important to make sure that you read over your employee policy to make sure that you know these rules and best of schedules. The second tool is a Roth IRA. The way this works is that you're able to put after-tax contributions into this account and let it grow over time into the future.
And the beautiful thing about this account is whenever you hit retirement or 59 and 1/2, you're able to put the pull this money out without any tax consequence. This essentially means that the government can't touch your money. You've been able to let that money grow over time and then whenever you reach retirement, it belongs to you.
And the third account is a standard brokerage account. This doesn't have any special rules or anything like that, but it gives you a lot of flexibility. Unlike a retirement account, a 401k or a Roth IRA, they don't have any specific requirements around taking the money. It's very flexible as to when you can buy and sell stocks.
This gives you a lot of optionality and it gives you that opportunity to bridge for medium-term to long-term goals in the future. Now, let's look at the second option. Using your extra money to pay off debt. The biggest argument for paying off debt is high interest rates. I'm talking about payday loans, credit cards, high interest loans.
Let's say for example, you have a credit card that has a 22% interest rate. There's no math that can beat that. There's no investment vehicle or investment that can outperform or has consistently outperformed a 22% rate. So, for example, in that same analogy, if you have a 22% interest rate that you paid off, you can essentially say that you made a 22% return on that investment.
But beyond the pure math, everybody has a different psychology when it comes to that. Like for example, I would love to share my own experience with that. I've always never been the biggest fan of debt. I've tried to stay steer as much as I can away from it. The only type of debt that I have is with my home.
And I still remember even to this day whenever I use my credit card for a normal monthly expenses, I still have this ache feeling of having to feel like I'm in debt, even though there's still that 30-day grace period that I have to pay it off. So, that showed me that it's more comfortable for me to be out of debt completely.
And that could be same for you as well. So, just understanding the psychological side of that as well can help you make the decision of whether you should pay it off immediately or you should try to wait it off in the future. Also, another big thing to think about is life transition. This could be you're looking to have a a baby or maybe you're starting a business or maybe you're starting a new family soon.
This can be a moment for you to say that you want to have a clean slate. You want to start fresh. This could be also another reason why you may say to yourself that clearing off all the debt would be important for you to do. Question is, how do you choose between these two paths?
Well, the answer is you'll have to just choose one. You can build a framework that helps you to align both of these together and make the perfect plan for your situation. Here's how I like to look at it. First, make sure that you have a base. What I mean by that, make sure that you have an emergency fund set in place.
Like I said, 3 to 6 months of expenses to help weather any storm that may happen in the future. Now, step two is to grab the free money. What I mean by this is contributing to your 401k match only up to the limit that your employer would also give that match. And here's the key.
Make sure that you're staying at your employer long enough for that vesting to actually occur. Now, step three is this. Kill all high interest debt. So, take any extra money that you have and eliminate any interest debt. The way I like to think about this is if you have interest that's over 7 or 8%, that's the cases you can use to try to eliminate eliminate that debt first.
Now, step four is the wealth pivot. Once you've completely eliminated interest debt, you can pivot this extra money to say open up a Roth IRA and contributing into that investment vehicle. This can allow you to build tax-free wealth into the future. And simultaneously step 4.2 is chipping away at low interest debt. Now, while you're simultaneously contributing into a Roth IRA, you can also be paying down low interest debt.
I'm talking about maybe your house payment or maybe student loan. Now, the key to this is to actually be intentional. Instead of just paying at the minimal payment, put some extra money on the principal to make so you can actually see the money chipping away or the principal chipping away over time. Now, step five is to fill the brokerage account.
Once you've chipped away at all high interest debt, you have your emergency fund in place, you've been contributing to your Roth IRA, and then you have your low interest debt also in place and under control. Any extra cash flow that you have, you can be chipping this into your brokerage account and letting that grow over time as well.
This helps to create flexible wealth that you can use anytime that you need to in the future. So, let's bring this all back together. Deciding on either to invest or to pay off debt isn't just a decision that you have to choose one or the other. This can be something that's done simultaneously in a schedule and in a balanced way.
Step one, make sure that you have an emergency fund in place. Step two, take advantage of any employer match if invested properly. Step three, pay any high interest debt. This you can think of this as any debt over 7 or 8%. Step four, start to contribute into your Roth IRA while simultaneously also paying down low interest debt.
And then step five, any extra money that you have, put that over into your brokerage account and let that grow over time as well. When you look at your money this way, it helps stop from being a guessing game. It helps you to understand it and helps you to grow it little by little over time.
I want to hear from you. What current step are you working on throughout this process? Please share this with a friend or anybody that can find value with this. If you have any questions, please put them below and I'll look forward to hearing from you. Thank you. Have a wonderful day.
This video is for general educational purposes only and is not personalized investment, tax, or legal advice. Every situation is different. Talk with a qualified professional about your circumstances before acting. PLC Wealth Partners is a registered investment adviser. See our disclosures.
