Establishing the Foundation: Debt Management/Cash Reserves

When a new client starts to work with us, particular younger clients, one of the challenges is figuring out where to start. After all, there may be multiple goals (new home, children’s education, living today, retirement, etc.) that need to be prioritized and solved for. Should I focus on retirement first? Other goals? Should I pay down debt or build my cash reserve? It may be overwhelming, particularly in the event where there is significant debt service. While longer term goals are important to get started on, and you should most certainly take advantage of that 401(k) match at minimum, it makes sense to prioritize making the foundation solid first.

Debt management and cash flow play vital roles in helping to achieve financial stability and long-term success. This involves prioritizing debt repayments, building cash reserves, and ultimately attaining more protection against short term emergencies as well as financial freedom. By focusing on paying off short-term high-interest debt first, individuals can reduce interest costs and accelerate their progress towards becoming debt-free. Simultaneously, it is important to maintain and build cash reserves to prepare for unexpected expenses and financial emergencies. Only once you have progress established in these areas can you begin to place more emphasis on long term goal achievement.

If you have significant short-term debt, the first step is to examine how this debt came to be in the first place. Wasit a one-time unusual event, or the result of consistently spending more than you are earning? If it’s the former, that’s actually good because it’s not something that should continue to snowball. If it’s the latter, it may require you to either examine your spending to find areas to reduce or eliminate, look at finding ways to increase your income, or both.

Debt management simply means effectively handling and reducing debt obligations. It is important to prioritize debt repayment to reduce interest costs and improve overall financial health. Start by creating a comprehensive list of all debts, including credit cards, personal loans, student loans, and any other outstanding obligations. Organize them based on interest rates, with the highest interest rate debts at the top. The first step is focusing as much as possible on paying off high-interest debt. By allocating more funds towards these debts, individuals can save on interest payments over time. Begin by making minimum payments on all other debts and directing all available funds towards the debt with the highest interest rate. Once the highest interest debt is paid off, move on to the next one and repeat the process.

Windfalls like gifts or tax refunds can be used for this, with priority on highest interest rate debt, particularly debt that can be fully paid and free up a monthly payment to be applied to the next debt.

Many people may have lower interest rates on longer term debt, such as vehicles or mortgages acquired prior to 2022. Student loan debt might also fall into this category, depending on the rate. Once you get to only having these kinds of debt remaining, if interest rates are lower than current cash rates, it may make sense to simply maintain minimum payments and focus on other areas. I’m a proponent of debt management, but not a proponent of making yourself debt-free at all costs.

In addition to debt management and hopefully simultaneously to doing so, it is important to maintain and build cash reserves. Cash reserves can act as a safety net, providing individuals with financial security in case of unexpected expenses or emergencies. We typically advise that this should be 3-6 months’ expenses, which can help you avoid accumulating further debt when unforeseen circumstances arise. Where you fall in that 3-6 month range may depend on your own personal comfort, or whether you have a variable income. A small businessowner with variable income, for example, may want to hold a higher reserve due to the unpredictability of their income stream. Your need may also be higher if some of your goals are short term oriented, such as saving for a house downpayment or a vehicle.

Once short-term higher interest rate debts are paid and reserves are established, you can increase your attention on your longer-term goals, increasing your retirement plan contributions and initiating monthly savings into brokerage accounts or 529 plans or other vehicles, depending on your goals. None of this is rocket science, I’d put it in the “simple, but not easy” category. It does require examining your situation, having a plan and maintaining discipline to that plan. Once accomplished, however, the freedom, choice and more peace of mind that comes from having a solid foundation is worthwhile and puts you in a position to focus on your other goals.