Debt, Savings, Retirement: Where Should Your Money Go?

Should you pay down your debt, put money aside for emergencies or save for your retirement? The answer is that there is no answer; there is no magical one-size-fits-all formula because each situation is different and you need to take your career, lifestyle and age into account. (For related reading, see Damage Control For A Busted Budget.)

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If you are in a secure job in a steady industry, you may not have to worry about your income, but if you are self-employed, you may(rightfully) be more nervous about setting aside short-term savings. If you live in an expensive city, you will pay more for life than someone earning the same salary in a cheaper city, which also means you will have less money to put toward your debt. If you are young and single, you can take more risks with your money because time is on your side and you can make up for mistakes in the future. However, if you are nearing retirement or you have a growing family to feed and a mortgage to pay, what you decide to do with your money has a larger ripple effect with a shorter time frame to fix it in.

So what to do?

1. Take Stock of What You Have

Debt
While taking the above into consideration, you need to have some hard numbers to use as your money goals. Look at your fixed and variable expenses, and see what's leftover to put toward savings and debt. Add up all of your debts and list the minimum payment for all your debts.

Now add an additional 20% on top of your debt minimums, which will go toward your principal, and consider that to be your minimum debt repayment to start.

For example, say your minimum payment is $500 a month. Twenty percent on $500 is $100, so you should now pay $600 a month.

The amount credit card companies calculate as your minimum goes mainly to paying the interest on your debt, and barely covers the principal. This means that in many cases, it will take you 10 to 20 years on average to clear your debt, not to mention the final amount you will end up paying in interest costs.

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Retirement
Calculate how much you think you might need in retirement and for how many years you'll need it for. The general rule of thumb says you will need approximately 75% of your current income for each year you are retired.

Emergencies
Calculate six months' worth of bare bones living expenses as your emergency fund, which includes rent, groceries, utilities, transportation and 10% on your income for miscellaneous expenses. If you are self-employed, you should save up to a year of expenses to offset risk.

2. Come Up With a Plan
To start, you should aim to clear your debt in five years, save $100 for retirement and $100 in your emergency fund per month, adjusting as you see fit.

If you are young, time is on your side, and focusing more on debt with minimal emergency savings is a good strategy because you should be able to make up for your retirement savings later.

If you are nearing retirement (within 10 to 20 years), you should focus on clearing your debt until it's gone while saving at least three months' worth of emergency expenses. Next, start putting those savings toward retirement. It's important to start with your emergency fund rather than the other way around because it is too risky to have your savings locked in for the long term without any cushion for the short term.

After you've accomplished one of your goals (debt repayment or savings), continue to set aside money for your other goals.

3. Continually Reassess Your Needs and Wants
It may seem impossible, but you can always cut back somewhere, it's just a question of what you are willing to try.

Think of it this way: If you make an effort to trim the fat, it means you will get out of debt faster, save money quicker and be financially secure sooner than you had originally projected. For quick results to your bottom line, cut back your cable TV and cell phone plans and shop around for lower insurance quotes. (For more tips, see 20 Lazy Ways To Save Money.)

Final Tips
To accelerate your plan for financial freedom, snowball your windfalls: if you get a bonus or a tax refund, put it all toward your debt or into savings. Don't spend your emergency savings unless it's a real and unplanned emergency. Finally, keep saving even after your debt is done: putting at least 10% of your net income into savings for the rest of your life will help set you up to be financially secure.

Stay vigilant and don't lapse back into your old spending behaviors and don't be discouraged if things don't go as planned - it isn't a race, it's a journey.

Catch up on your financial news; read Water Cooler Finance: The Ups And Downs Of A Double-Dip Recession.

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