After many conversations with friends and family, I realized that a basic understanding of how interest rates work for borrowing and investing was missing from the general population. Many families are faced with the decision as to where to put their money, after they have paid all their basic expenses. Should they place it in a savings account or pay off their credit cards? This consistent discussion actually led me to write an article on this same subject for the Dollar Stretcher.
The main struggle appears to come from understanding the overall affect of the interest rate. The Prime Rate (you will hear this mentioned in the news often) is the main indicator of where interest rates fall, and it directly impacts both savings and borrowing interest. When prime drops, the cost of borrowing also drops. But, the money potentially created by savings will drop as well. It is a fun game the macroeconomic government specialists play with our money. It is truly something we all have no control over, but it is important to understand this basic impact.
Once you have paid all your basic expenses and saved a few months of income for a rainy day, where should your money go next? The following scenarios should cover most family situations. So find the one that best matches your circumstances and use the information you find.
Scenario #1: You have absolutely no debt. While this is rare, there are families in this lucky boat! Maybe you rent so you don’t have a mortgage or maybe you own your home free and clear. Whatever your reason for being debt-less, the goal for your family is to put your extra money in the place it will generate the most money with least risk. You could write a book (and many have) exactly where these places are, but for basic advice, I would recommend you place your extra money in the highest rate savings or money market account you can find. Then meet with a financial planner or mutual fund representative and look to investing money where it will be protected from fluctuating interest rates.
Scenario #2: You have some debt and some savings. This is the most popular scenario for most people. Common debts include credit cards, auto loans, mortgages, and student loans. Ideally always shoot to put your money towards the highest rates, whether they are either debts or savings. If your credit card interest rate is at 18% and your money market account pays only 5%, then you should put all your money into paying down that credit card. Then once the balance is zero there, you would start putting the money into the money market account.
Scenario #3: You have no savings and lots of debt. In this scenario, the first step is to ensure you start an emergency savings – one that is at least a couple months of income held in a high paying savings account. Once you have that, then you will have to evaluate the interest you pay on your debt vs. the interest you can make with an investment. Always pay off your highest interest rate debts first. For example, say you have a credit card at 21%, an auto loan at 8% and a mortgage at 5%. After your monthly payments are paid, you will put all your extra money toward the credit card. Then when that is paid off, move towards paying off the car, then finally the mortgage. Of course you still have to make your agreed monthly payments, but the goal here is to go beyond that with the higher rate debts until those amounts are completely gone.
Related Articles:
Using 0% Balance Offers to Pay Down Debt
Cashing in with online savings accounts.