Good question. Once again, the answer lies in interest rates (and your comfort level with debt). Generally, the best answer is a mix of the two options.
Here’s how it works:
- figure out which of your debts has the highest interest rate. This is probably a credit card of some kind. If you have all of your regular debts paid off, this may be your home mortgage.
- figure out what you expect as a return (in terms of interest rate) on a potential investment. This, of course, will be an estimate. Preferably look into some kind of tax-deferred retirement savings plan, such as a 401K or RRSP.
- the higher of these two should be your focus, but not your sole focus. Your debt comfort level will describe what the balance is. Debt comfort level describes how comfortable you are with having debt (even though it may be at a low-interest rate). If you are comfortable with debt you’ll tend to allocate more resources to savings, but if something goes wrong in life, or if interest rates go up, you may be in trouble with your debts that would then require larger payments than expected. If you are averse to debt, meaning you don’t like debt at all, you’ll tend to aggressively pay down your debts, even sacrificing some savings opportunities… but hey, if interest rates go up sharply, you won’t have an unruly debt to pay down.
- my highest debt is a credit card with a balance of $4,325.00 @ 16% interest.
- my retirement savings have traditionally earned around 10% interest.
- I have $350/month to allocate for savings or debt reduction.
Clearly, the credit card should be the focus. Let’s take a look at how the $350 could be allocated based on different risk comfort levels.
- if I am comfortable with debt and hope that my investment may yield a better return, I’d stay closer to the 50/50 line to keep a balance. However, since the credit card is clearly the better target for extra funds, perhaps I’d go with a 60/40 split. That means $210 for the credit card and $140 in the investment. If the interest rates were further apart, perhaps a 70/30 would be better.
- if I am not very uncomfortable with debt I may be more tempted to go for an 80/20 or even a 90/10 split. Going 90/10 would mean $315 on the credit card and $35 to an investment.
I don’t recommend allocating 100% to anything since it doesn’t prepare you for an unexpected emergency. You need to be paying at least the minimum required payment on the credit card anyway, but with extra money, you can get that down to nothing. You should always save a portion of your extra money for an emergency. If an emergency happens, it’s not going to help to have all of your debts paid off but have no cash available to you in savings. There has to be a balance. Keep in mind, this isn’t a science, but more of a gut feel based on sound principles.