The Fed just said it's still not ready to cut interest rates. Here's the optimal order for investing your hard-earned money as of spring 2024
Earlier this week, investors were closely watching Federal Reserve Chairman Jerome Powell's two-day visit to Capitol Hill for hints and clues about monetary policy.
Powell indicated that the battle against inflation will carry on. While he said it's likely interest rate cuts will begin this year and "we're not far" from when they will be appropriate, he reiterated that the central bank will wait until it's confident enough inflation is "moving sustainably" to the 2% target rate.
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“We want to see a little bit more data so that we can become confident,” Powell said to the House Financial Services Committee. “We’re not looking for better inflation readings than we’ve had. We’re just looking for more of them.” The stock market rose in response to his comments, but traders are betting the first rate cut won't come before June.
Hearing that rate cuts are around the corner will be a relief to those carrying expensive debt. The average credit card interest rate is currently sky-high at 27.94%, according to Forbes Advisor’s, but investors looking forward to smaller payments should know their card issuer won't follow suit immediately.
According to Experian, "Timing varies: Some rates change within a month, while others may take a bit longer to adjust. Check your credit card agreement to learn how your issuer determines the interest rate and when it changes."
Knowing the interest rate on your debt is essential as you get your financial affairs in order, sometimes literally. Prioritizing the right things and putting your disposable income in the right places each month based on your financial situation will help you build long-term wealth.
For example, ignoring your expensive credit card debt to boost your stock portfolio is an inefficient way to manage your money. As debt resolution attorney Leslie Tayne told Fortune, "The stock market has historically returned 10% on average, while credit cards have rates that hover around 20%. Unless you aggressively pay down credit card debt first, the math won’t ever work in your favor."
Paying down debt is key to securing your financial future, along with maintaining an emergency fund, and using tax-advantaged accounts. Here's how to order these steps.
1. Ditch the plastic
Don’t start investing until you’ve paid off debts (not including a mortgage), says best-selling financial adviser, author and radio personality Dave Ramsey, who runs personal finance hub Ramsey Solutions. Debts will hinder any investing effort, so get them out of the way so you can start putting 15% of household income towards retirement investments.
Credit card debt is crippling because it grows like a snowball. You are charged interest if you don’t pay your debt in full for the month.
That means the following month you will be charged interest on the unpaid balance. If the next month isn’t paid in full, you will pay interest on the interest. Before you know it, the snowball is at full speed, rolling down the hill.
For example, if a borrower has $5,270 on their credit card (the average balance as of the middle of 2022) and only makes minimum payments at a rate of 18.17% then it would take more than 16 years to pay it off, according to Ted Rossman, senior industry analyst for CreditCards.com.
“And [they] will end up paying a grand total of $11,875,” he says.
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2. Pay off other high-interest debt
Next up, address high-interest debts such as car or student loans. Any interest that is 4% to 5% above the 10-year U.S. Treasury rate, which lately has been hovering around 4%, is considered high, according to My Money Wizard, a blogger who saved $100,000 by age 25 and whose goal is to retire in their 30s.
My Money Wizard prioritizes debt reduction over stock-market gains because of market uncertainty and the taxes that come with investment earnings. Also, being debt-free has its mental-health benefits.
3. In case of emergency
Plan for disaster with a contingency fund.
Many experts recommend three to six months’ worth of emergency fund savings, including Vanguard Personal Investors. Financial expert Suze Orman has long advocated for at least eight months.
The idea is to have a buffer available in times of crisis so that investments and credit cards remain off limits.
Vanguard says there may be times, however, when more than six months’ of savings is justified, such as a looming recession, or when you’re in a high-turnover line of work and layoffs aren’t out of the question.
4. Max out those retirement accounts
Many large companies offer a 401(k) matching program, which allows you to direct a portion of your pay into an investment account, with your employer matching 25% or 50% or even 100% of your contributions, allowing you to invest and grow your money.
“It’s free money,” says CPA Brian Preston, host of The Money Guy Show. “We’re talking about potentially thousands of dollars of benefits annually from your employer that people just aren’t taking advantage of. If you can make 50% or 100% guaranteed just by participating, you’re crazy not to do it.”
A traditional employer-sponsored 401(k) is funded with pretax money, which means any contributions made to it are not taxed until the money is withdrawn much later. A Roth 401(k), on the other hand, is an employer-sponsored retirement account that uses after-tax money. When the money is withdrawn upon retirement, no tax is paid.
The decision to max out a traditional 401(k) versus a Roth 401(k) is generally a question of how much a person expects to be making in retirement. If a person expects to be making less, the traditional plan has the edge. If they expect to be making more, the tax-exempt Roth has the advantage. The same applies to individual retirement accounts (IRAs).
5. Taxable brokerage account
It’s time to take a few risks you can afford to take.
A brokerage account provides the flexibility of retiring early or tapping into money you might need for a golden opportunity, says financial analyst Bo Hansen from the Money Guy Show.
Unlike your tax-deferred retirement accounts, a brokerage account will be subject to capital gains tax as it grows in value. But the upside is the brokerage account has the flexibility of allowing withdrawals at any time, without incurring a penalty in the form of taxes, which are assessed depending on how long the asset was held.
“After-tax money is liquid money you have easy access to… This is the stage where you can buy a nicer car, you can travel better,” says Preston.
You can also use that cash to create margin or opportunity.
“I load mine up with index funds and other things, and it’s still very easy to get access to it. It’s a great wealth-building tool,” he says.
6. Pay off your mortgage
This one comes with a caveat. If a homeowner tapped into a low interest rate, it could make sense to invest in something like an index fund rather than pay down the mortgage right away, says My Money Wizard.
That’s because the stock market can usually outperform any 3% to 4% mortgage. But if the mortgage rate goes higher, as it has now, then paying it down before investing may make more sense.
If you’re happier being completely debt-free, it could be worth it. Preston’s advice is to ask yourself, what is the “why.”
“I had a goal to be completely mortgage-free by 50,” says Preston. “The problem I have is I have a 2.5% mortgage and I only owe $200,000 on the house... But the problem is my cash is paying me a little over 4.3%. You can see I have a dilemma.”
All things considered, It’s a pretty good dilemma to have.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
