By Andrew Housser
When it comes to a topic as important as your finances, it's smart to ask plenty of questions so you can make well-informed decisions. Here, we have answers to 10 of the most frequently asked money and debt questions.
1. What's better: Paying off a high-interest debt or a debt with the smallest balance?
In the long-term, you'll pay less by paying off your highest-interest rate cards first. However, several studies have shown that people have more success getting out of credit card debt if they pay off the debts with the smallest balances first; the sense of achievement from getting rid of a debt keeps people committed to their overall goal of becoming debt-free.
To work on the debt with the smallest balance first, put as much as you can toward that debt while making minimum payments on all others. Once that small debt is gone, add the amount you were paying on it to the minimum you've been paying on the next smallest debt until it's paid off. Repeat this process until you're debt-free.
2. Should I borrow from family or a lender?
Generally, a lender may be a better bet, if your credit allows it. Relatives (or friends) and money often don't mix. If you do choose this route, sign a letter of agreement that spells out a monthly payment plan including amount and due date, as well as when the loan will be completely repaid. Discuss whether you'll pay interest, and if so, how much. These types of loans often come with extra strings, like inquiries about other purchases you make or your lifestyle.
3. Should I pay with credit or debit?
Credit cards are better to use online, because they allow you to dispute payments if you're unsatisfied with a service or product. They also don't expose your bank account to possible theft. But charge only what you know you can pay off in full each month. Use debit for smaller, in-person purchases like groceries that you might otherwise pay for with a check or cash. Debit cards also can help avoid overspending.
4. Should I save for retirement or my kids' education?
There is no "right" answer to this question, as both are very important. Each individual and family needs to weigh priorities and make their own decisions. For those saving for college, one step that can be very helpful is to open a 529 college savings account. Every state offers one, but you do not have to choose your state's just because you live there. For information, visit SavingForCollege.com.
5. Do I really need an emergency fund?
Yes. You should save three to six months' living expenses for unplanned, major expenses like a health crisis, home repairs or unemployment. Figure out the amount you can contribute each month to a high-interest savings account after living expenses and debts are covered. Even small amounts will add up and help. Use the savings only for emergencies -- not a new car or vacation.
6. Should I pay extra on my mortgage?
Mortgages are generally some of the lowest-interest debts you can carry, and the interest is tax-deductible, so for most people, it makes sense to use any extra cash to pay off other debts that carry higher interest rates, to save for an emergency or to save for retirement. Accountants and financial planners can help decide what makes most sense for your particular situation. Many people subscribe to the notion of buying the less expensive term life policy and investing the difference directly on their own, rather than buying the more expensive whole life policy.
7. Do I need term or whole life insurance?
Term life insurance, which pays the face amount of the policy to your beneficiary upon your death, works well for most people. It is affordable, as you can buy it in periods of one to 30 years. Whole life combines a term policy with an investment in stocks, bonds or a money market fund, so it is possible to borrow against the cash value. However, you'll pay fees and commissions for the investment portion, and you likely will not see a reasonable return for at least 20 years.
8. What's better: a high- or low-deductible medical plan?
Even if you and your family are healthy, it can be risky to gamble with a high-deductible plan. In addition to high deductibles of several thousand dollars a year, you may also have higher co-payments for doctor's visits, hospitalizations and medications. Low-income families rarely benefit from tax breaks associated with a high-deductible plan's health savings accounts. However, carefully weigh the total costs of premiums, deductibles, co-pays and out-of-pocket costs with your overall financial situation in deciding.
9. Should I invest in a 401K or a Roth IRA?
If your employer matches a percentage of your 401K contribution, it's definitely the way to go. Consider it free money. Otherwise, weigh these pros and cons. A 401K allows you to sock away up to three times more cash (tax free) each year than a Roth. But you'll pay taxes later when you withdraw from it. With a Roth IRA, you pay taxes now and withdraw funds later tax-free. You also have a say in how to invest your Roth IRA retirement funds; 401K investments are controlled by your employer.
10. Should I borrow from my retirement fund to pay off debt?
Generally, no. Making an early withdrawal from a 401K can be costly, and endanger your financial future. While you can withdraw up to $50,000, you must pay it back in full within five years -- sooner if you quit or lose your job. If you're unable to do so, you'll be slapped with a 10 percent penalty fee, plus taxes (at about 25 percent) on the amount you took out. That's like paying 35 percent on a loan. You're also losing interest and dividends that your money would be earning if left alone.
Most of these questions are really asking, "What is the smartest thing to do with my money?" The bottom-line answer to that question is that it is most important to prioritize saving for an emergency fund, saving for retirement, and paying off (and avoiding) debt. When you put those goals into action, you'll be making smart financial choices.