Say you have $1,000 left over from your paycheck each month after paying all your bills; what should you do with it?
As you may remember from elementary school math, PEMDAS is math's order of operations: Parentheses, Exponents, Multiplication, Division, Addition, Subtraction.
Much like math, personal finance also has its own order of operations. Finance's order of operations should be considered when planning on how to allocate the extra cash flow in your budget. So, how should you use that extra $1,000 per month?
Should you spend it?
Put it towards your credit card balance?
Contribute it to your employer's 401(k) plan?
Pay down your mortgage early?
Contribute it to your IRA account?
Save it in your bank account?
To answer this question depends on many factors, such as:
Do you have credit card debt? Student loans? Auto loans? Mortgage?
What interest rates are being charged on your debt?
How stable is your income/expenses? Do you have an emergency fund?
How much do you have saved in your checking and savings accounts?
Does your employer offer a 401(k)? Is there an employer match?
Finance's order of operations should not be considered the absolute order to follow for all people, in all situations. This isn't universal advice, but the first 5 steps are appropriate for most people's situations. As you get to the later steps in Finance's Order of Operations, the steps you should prioritize become more and more subjective. Your preferences and goals will influence which step will provide you with the most impact.
You should consult with your financial advisor to determine what order is actually right for your situation and goals. To schedule a 1-on-1 complimentary, obligation-free consultation with one of our financial advisors, please click here.
Order of Operations Step-by-Step Guide
Step 1 is to improve your financial health. This is a multi-part step: (1) increase your income, (2) make a budget, (3) reduce your spending, (4) bank better, and (5) build credit.
Increase your Income
Increasing your income is often easier for families than trying to cut spending. 'Increase your Income' does not mean magically making more money; it signifies a continual commitment to improving yourself. Here are a few actions you can try:
Continually apply for better-paying jobs. Interviewing is a skill that should be practiced. There are many great sites like Indeed and Glassdoor that help you gauge the salaries of peers in your industry, but you won't know what your own current earning potential is if you don't see for yourself. Even if you aren't planning on leaving your current job, you can use a higher-paying job offer as leverage in a raise negotiation. Remember: You can always choose not to use the leverage you have, but you can never use leverage you don't have.
Ask for a raise. Your boss won't give you a raise unless you ask for it.
Make yourself more valuable. Work towards additional degrees, designations, and licenses on the side. You can go to night school for an undergraduate degree or an MBA. You can also take online designation courses to differentiate yourself in your particular field. Many specialized designation holders command higher incomes.
Volunteer. If you cannot currently afford higher education, as you save up for night classes, volunteer for something you are passionate about. Meeting other people while volunteering allows you to network, network, network. You can volunteer in a higher-paying field before making a career switch to learn more about it. Plus you can put volunteer work as valuable, relevant experience on your resume when the time comes to change careers.
Make a Budget
Reduce your Spending
Bank Better
Build Credit
Step 2 is to Build a 3-month emergency fund.
Without an emergency fund, you are obligated to rely on debt, like credit cards, to finance unexpected expenses that will come up. To avoid falling into debt and paying unnecessary interest, you need to have some money saved up in case of an emergency.
To create an emergency fund, determine how much you spend each month on average. Save three times that amount in a high-yield savings account. This will be your emergency fund. Try to only use the money in case you find yourself in-between jobs to bridge any gaps in pay.
However, if you need to borrow money from your emergency fund to fix a burst pipe or replace your refrigerator, make repaying your emergency fund your top priority until its balance returns to 3 times your monthly expenses.
Step 3 is to Invest up to your Employer Match.
In your employer-sponsored plan, such as a 401(k) or 403(b), your employer may offer an Employer Match as one of your benefits. A typical employer match is 100% of 3%, meaning they will match your 401(k) contributions 1-for-1 until you reach 3% of your total gross income.
Say you make $100,000 per year. If you have a 100% of 3% match, that would mean if you contribute $3,000 to your 401(k), your employer will also contribute $3,000 for a combined total of $6,000. You invested $3,000 but got $6,000; that's an immediate 100% return! Take advantage of your employer match and always contribute at least up to the match's maximum, after you have a small emergency fund in place. It's free money!
Note: your employer is not required to offer you an employer match in your 401(k) plan. They can choose to offer nothing; or they can choose to offer you more than 3%, structuring the benefit however they like. Another popular matching structure you might see is a 50% of 6% match. 50% of 6% would mean your employer will match your 401(k) contributions 1-for-2 until you reach 6% of your total gross income. So, again let's say you make $100,000 per year. If you have a 50% of 6% match, that would mean if you contribute $6,000 to your 401(k), your employer will also contribute $3,000 for a combined total of $9,000. You still got the same $3,000 from your employer, but you had to save more money in your 401(k) to get it. You invested $6,000 but got $9,000; that's still an immediate 50% return!
Employer matches are great benefits that you should make sure to take advantage of as soon as you are able. A 3% of your income match is a great benefit, but you can see matches up to 6% or even higher if you are lucky. Be sure to read your employee handbook or employee benefit paperwork thoroughly to make sure you aren't leaving benefits on the table.
Step 4 is to Pay off high-interest debt (interest rates above 5%).
In my experience, this is the most commonly skipped step. I often see individuals starting to invest in their 401(k) or brokerage accounts while they still have outstanding credit card debts. I know paying down debt isn't as sexy as stock picking in your Robinhood account, but it is important to prioritize becoming debt-free. The amount of high-interest debt may feel insurmountable, but ignoring it will not make the problem go away.
We've already discussed the few steps more important than paying down your high-interest debt above. It's important to first create your small emergency fund to prevent you from falling deeper into debt in case of an emergency. The other important step to prioritize is to earn your employer match because of its 50%-100% immediate return instead of paying down your high-interest debt. That immediate return much is higher than the interest you would pay on your credit card and other debt.
Remember: debt is all about opportunity cost. If you pay down your 20% APR credit card, you are guaranteed to get a 20% return on your money. If you try to invest your money while you have high-interest debt, you can expect a 9%-10% return on your money long-term (plus you can even lose money in the short-term!) If you're invested making 10% while you are paying 20% in credit card interest, you have a net -10% return!
When you are ready to take control of your debt, look into different debt reduction strategies like the Debt Avalanche and Debt Snowball Strategies. Silverstone Financial also offers a debt coaching service where our financial professionals will help you create a plan to have you tackle your credit card, auto, student, and other debts. To schedule a 1-on-1 complimentary, obligation-free consultation with one of our financial advisors, please click here.
Step 5 is to Add 3 more months to your emergency fund (for a total of 6 months).
After you have eliminated any remaining high-interest debt (interest rates above 5%), I recommend bolstering your emergency fund with another 3 months of expenses (for a total of 6 months).
If you are a couple where you both work and have an income, you can choose to remain at a 3 month emergency fund since the likelihood of you both being out of work at the same time is low. You may also want to skip this step if your income/employment is very stable or if you have very liquid and safe investments that you can cash in, in case of an emergency requiring greater than 3 months of expenses.
However, my general recommendation to everyone is to get your emergency fund to be at least 6 full months of expenses.
Steps 1 through 5 explained above are appropriate for most people's situations. However, Steps 6 through 10 explained below are more subject to your personal goals, preferences, and situation.
6) Maximize your Roth IRA contributions
If your income is too high, you may not be able to contribute to an IRA at all. And for some, contributing to a Traditional IRA pre-tax or after-tax may be more appropriate.
The current Roth IRA contribution limits for 2022 is $6,000/year or $7,000/year for those age 50 or older. You can learn more about IRA limits here.
7) Save up for the down-payment + closing costs on a house or condo
Some may want to prioritize buying a home before saving for retirement. Others that move often for work may want to wait to buy a home. You can learn more about how to save up for a house or condo here.
8) Maximize your Roth 401(k) / 403(b) contributions
There are lots of employer-sponsored plan types, like 401(k)s and 403(b)s. Many offer a Roth (tax-free) option which may be more appropriate than the traditional contribution option for some. You can learn more about employer-sponsored plans here.
9) Pay down your low-interest debt (interest rates below 5%)
As I said before, debt is all about opportunity cost. Starting to invest before paying off your high-interest credit card is incorrect due to opportunity cost. The same can be said the other way around about putting investing off to pay off all debt, including your low-interest debt.
If you have a 5% 30-year mortgage, instead of paying it down early, you can invest your excess cash into the S&P 500 and get an average of 9%-10%. If instead you paid down your mortgage early, you would only get a 5% return. Financially speaking, it is better to hold onto your low-interest debt and invest for the long-term instead. However, this is not the best course of action for everyone. Many more conservative investors would prefer to become debt-free as soon as possible. There is a psychological benefit for some to prioritize this step higher above saving for retirement.
10) Save towards other personal goals
Depending on what your other goals are, this could be higher than other steps. If you want to start saving for your children's education expenses, contributing to a 529 plan may be higher than saving for retirement. Others may prefer to save for family vacations in a taxable brokerage account rather than maximize every penny towards retirement.
Steps 6 through 10's order are more personal than the first five steps. For example, if you have a higher risk tolerance, you may want to invest more instead of paying down low-interest debt (interest rates below 5%). Some people prefer to maximize the impact of their money; others prefer the psychological feeling of knowing they are completely debt free.
Working with a financial advisor can help you determine what is the best order for steps 6 through 10 based on your personal preferences. Additionally, they can help you find new strategies unique to you to help maximize your financial wellbeing. There are many other more nuanced strategies that are beyond the scope of this blog post like Roth Conversions, Backdoor Roth IRA Contributions, Mega-Backdoor Roth Contributions, and some other advanced strategies due to their higher complexities. Please speak with your financial advisor to see if any of these strategies are right for you. To schedule a 1-on-1 complimentary, obligation-free consultation with one of our financial advisors, please click here.
DISCLOSURE: Silverstone Financial LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Please see our disclosures page for additional information.
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