I'm not proud of it. But there was a time when I seriously considered tossing my credit card into a dark corner of my freezer, letting it harden into an impenetrable block of ice. I was a year out of college with a newfound salary, and in denial that I couldn't go out to dinner and drinks every night and not pay the consequences. Even more daunting than thinking about paying off the credit card was the thought of my empty bank account. How was I supposed to start saving when I was in such a financial hole? Thankfully, before my debt turned into disaster, I got a grip and slowly started digging my way out.
Whether it's credit card debt, student loans, car payments, or mortgages, most people deal with debt at some point in their lives. It can be a dangerous thing—and if neglected can quickly spiral out of control. Here’s the good news: A guide to help you pay off debt while saving for emergencies and long-term goals like retirement. It may seem counterintuitive, but before you tackle debt, make sure you have some “just in case” money and save for retirement.
1. Build an emergency fund.
Losing your job—or being hit with an unexpected expense—could force you into a financial hole, which may take years to climb out of. How much to set aside for an emergency depends on your situation. In general, saving for 3 to 6 months of expenses is a good starting point. If you are single, or in a family with 2 working spouses, 3 months may be enough. But if you are a one-income family, you may want to have 6 months of expenses saved.
Quick tip: Set up automatic payments from your paycheck or checking account into a separate account set up as an emergency fund.
Read Viewpoints on Fidelity.com: How to save for an emergency
2. Contribute to a health savings account if you are eligible
If you have a high deductible health plan (HDHP), consider contributing at least enough to your health savings account (HSA) to cover your anticipated health care expenses. If you are not sure how much you need, then at least contribute enough to cover your deductible—you can always change your contribution amount if you find your actual expenses are higher or lower than expected. If you contribute to your HSA through payroll deduction, you can change your contribution election once a month or more frequently if permitted by your employer.
If you enrolled in an HSA-eligible health plan but haven't yet started an HSA, consider opening one if it fits your needs. Keep in mind that many employers contribute to their employees' HSAs—but you need to open an account to get the employer contribution. By contributing to and paying for qualified medical expenses from an HSA instead of paying those expenses out-of-pocket you are effectively converting after-tax health care expenses (you have to pay your medical bill anyway) into pretax expenses. For example, if your combined federal and state marginal tax rate is 25% and you contribute $3,000 to your HSA, that's a tax savings of $750.1
3. Don't pass up "free" money at work2
Paying down debt is important, but if your employer matches money you put into a 401(k) or 403(b), don't pass it up. Think of it as "free" money. Let's say your company matches 50 cents on every $1 you contribute, up to 3% of your salary. If you make $60,000 a year and contribute 3%, or $1,800, your company kicks in another $900. If you do that every year, in 10 years that $2,700 a year could grow to more than $37,000, assuming a hypothetical return of 7% per year.3
Quick tip: Give this money a chance to grow. If retirement is years away, that means considering investments such as stocks, stock mutual funds, and exchange-traded funds (ETFs).
Read Viewpoints on Fidelity.com: 3 reasons to invest in stocks
4. Pay this debt down first: high-interest credit card balances
It can be easy to run up a large credit card balance. And once you do, it's not easy to pay it off. The minimum payments are typically low, which means you are paying mostly interest, so it will take much longer to pay off the balance. And it will cost you more. So if you can, consider paying more than the minimum each month. Avoid using a credit card to finance purchases. Why? In some cases, it could double the cost of the purchase. Say you buy a $2,000 flat screen TV on a credit card with a 15% interest rate. If you make only the minimum monthly payment, it would take you more than 17 years to pay off the original debt.4 You would pay the lender more than $2,500 in interest—essentially doubling the cost of the TV.
On the other hand, if you are diligent about paying off your entire balance monthly, you may want to consider a cash-back rewards card. That way, your credit card purchases can actually help you accomplish other financial goals.
Quick tip: Check your credit card statement to see how long it will take you to pay off the balance—and how much it will cost you—if you make only the minimum payment.
5. Pay this debt down next: private student loans
Private student loans for college carry higher interest rates than government student loans, in general. Currently, rates on private student loans are from 5% to 12% compared with about 4.45% for government undergraduate student loans.5 You may be able to deduct the interest on a student loan, however, but only up to $2,500 a year, and only if you are a single filer earning less than $80,000 or $165,000 for married filing jointly. If you make more than that, you can't deduct the interest. In general, it is a good idea to pay down student debt above 8% interest as a rough rule of thumb. What you really want to do is compare your expected after-tax investment return (if you invested the money) with the student loan interest rate. If your student loan is at 9%, paying off your loan is like getting a risk-free return of 9% on your investments. All this can get pretty complicated so you may want to consult with a professional financial planner. This is especially true when this debt is not tax deductible.
6. Contribute beyond the employer match in a 401(k)
While you may still have a government student loan, car loan, or a mortgage, these loans typically have much lower interest rates. That's why it can make sense to bump up your 401(k) contributions and continue to make the minimum monthly payments on these loans vs. trying to pay them down earlier.
Your 401(k) savings can really add up. Here's an example: Assume you contribute 10%, or $6,000 a year, about $115 a week, of your $60,000 salary to your 401(k), and your company adds $900. If you do that every year, in 10 years that $6,900 a year could grow to more than $95,000, assuming a hypothetical return of 7% per year.6
Quick tip: Increasing your savings by just 1% each year could help you live the life you want in retirement. Aim to save at least 15% of your pretax income every year, which includes any employer contribution, starting at age 25.
Read Viewpoints on Fidelity.com: How much should I save each year?
7. Pay monthly minimum on government student loans, car loans, mortgages
These loans have lower interest rates, and some offer tax benefits. That's why it generally makes sense to make only the minimum monthly payments on them. For instance, mortgage interest is deductible for federal tax purposes. Homeowners can deduct the interest paid on mortgages up to $750,000 for homes purchased after December 15, 2017. For mortgages taken out before December 15, 2017, interest paid on mortgages up to $1 million may be deducted. Interest rates have been at historical lows, right now around 4% for a 30-year fixed loan. Car loans are about 4.5%. Government undergraduate student loans are currently 4.45%, and the interest may be tax deductible.
A word about student loan debt: Most college graduates have various types of debt—and various interest rates. Here are some general guidelines.
- Pay down: As we said earlier, it makes sense to pay off high-interest debt (private student loans above 8% interest) first, especially if you cannot deduct the interest.
- Toss up: It may be beneficial to pay down medium-interest-rate debt, such as Direct PLUS and Direct Unsubsidized loans for graduate students, in certain situations and not others. Many factors can affect this decision, such as current and future tax rates, how comfortable you are with risk, and your goals.
- Pay monthly minimum: Low-interest-rate debt, such as Direct loans for undergraduates and Perkins loans, or medium-interest-rate debt (see above) that is tax deductible, may not need to be paid down early because of the tax benefits and low interest rates.
If you are disciplined about making payments, you may want to extend low-interest government student loans to lower your minimum payments and use the savings to pay down higher-interest-rate loans faster. (The government allows you to consolidate and extend most government student loans at your current interest rate.) However, you may end up paying more interest because the time period is much longer. Contact your loan servicer for information.
Quick tip: If you have federal student loans, you may qualify for income-based repayment plans or public service loan forgiveness plans. If you don’t qualify for a loan forgiveness program, refinancing your loan could be a money-saving option.
Paying off debt is important. It can be difficult to save when a big chunk of your money is going toward debt repayment. That's why it's important to have a plan to get out of debt—it can save you money in interest and ultimately help you save more and reach your goals faster.
Next steps to consider
Pay bills, track spending and get ATM fee reimbursements.
Answer 9 questions to get a financial wellness plan.
To get out of debt, you may need a long-term plan.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917