How to prioritize your money goals

Dear Liz: We’re a newly married couple with an 11-year-old and hope to have another baby soon. We have $20,000 in emergency savings, $40,000 in investments, $480,000 in retirement funds, $20,000 in low-interest student loans and $43,000 in high-interest credit card debt. If we have another child, we’d like for my wife to be able to stay home. I am struggling with how to prioritize debt reduction, college savings, home improvements and building our emergency fund. I don’t want to tap our savings or investments, as there are often surprises in life and I do not want to be caught short. The problem is that aggressively paying down the debt hurts our cash flow for our other goals.

Answer: It’s understandable that you don’t want to tap your savings or investments, since it’s difficult to build up those funds. But it really makes no sense to carry high-interest debt when the returns you’re getting on these other accounts are probably much lower.

Talk to your tax pro about the implications of selling some or all of your non-retirement investments, though. If your investments have gained substantially in value, you’ll want to factor in the tax bill or consider selling some of your money-losers instead.

Once the credit cards are paid off, some money that used to go to those payments will be freed up for other goals.

Your priority needs to be saving for retirement. Once you’re on track there, you probably should focus on rebuilding your emergency fund to equal at least three and preferably six months’ worth of expenses. You may not be able to accomplish that before your second child arrives, though, so consider opening a home equity line of credit as a proxy for a larger emergency fund. Leave the line of credit open and unused, however, because racking up a balance would defeat the purpose.

Saving for college is a worthy goal, although it shouldn’t take priority over retirement, paying off toxic debt or having an emergency fund. You may not be able to save enough to pay the whole bill, but you can shoot for saving one-third or half the expected cost, and your child can use federal student loans for the rest. SavingForCollege.com has a calculator to help fine-tune your plan. Even if you can’t save as much as you’d like, you should save something. Even $25 a month over time will help reduce the amount your child needs to borrow.

Home improvements should be last on your list of priorities, and you should try to pay for those with cash. They are not an investment in your home — although they may improve the value somewhat, you’ll typically get back less than 70% of what you spend.

When to pay down your mortgage

ear Liz: Should you pay off your mortgage or keep a sudden financial windfall? I’m in that situation and was surprised to find that financial experts, including you, generally recommend investing the cash. I understand the attraction of the argument but am not sure the assumptions hold water.

The experts’ argument boils down to this: You can make more money by investing the proceeds than you’d save by paying off the mortgage. Keeping the mortgage — with an interest rate of, say, 5.8% — is fine because the returns on your investments, plus the tax deduction for the mortgage, will more than cover that cost. A mortgage is the cheapest money you can get and a hedge against inflation. This plan also gives you more liquidity.

I say: Unless I can guarantee that I can make 5.8%, I might lose money. And I’d basically be borrowing money just to invest it (and keep some liquidity). That seems risky! If certificates of deposit were earning 6% it would be a no-brainer, but they’re not. Also, it’s impossible to put a price on the sleep-well-at-night factor.

I’d like to read your thoughts.

Answer: You’re right that the investing argument requires a lot of assumptions that may not hold up in real life. But that’s not the reason most people should think twice about paying down a mortgage.

The reality is that most people have better things to do with their money than pay down a low-rate, deductible debt such as a mortgage. For one thing, they should be taking maximum advantage of their tax-deferred retirement options, especially if their company plan offers a match. They also need to pay off other, higher-rate debt before considering extra mortgage payments, and they should have a substantial emergency fund set aside as well. Then there’s insurance to consider: If you don’t have adequate life, health, disability and long-term care coverage, those policies should be purchased before considering mortgage repayment.

If you’ve got all your bases covered and still want to pay down or pay off your mortgage, then have at it. For many people, the security of a paid-off home is well worth forgoing some extra investment income.

A business loan can turn into an unintended gift

Dear Liz: My sister started a business two years ago. Needless to say, the economic conditions weren’t good, but at first she seemed to be doing okay. Lately business has dropped off dramatically and she’s asked us for a loan. We’re not sure if she was ever realistic or even truthful about her business’s prospects. What should we do? READ MORE

Inheritance advice: Pay down debt, then cut spending

Dear Liz: In about three months, my wife and I will receive close to $20,000 thanks to an inheritance. We have six credit card accounts with balances totaling about $10,000, plus two car loans with $10,000 and $11,000 balances, respectively. The smaller of the two car loans carries a 19% interest rate, so we know we’re going to pay that off. The other vehicle is financed at about 4% and has about three years’ worth of payments remaining, so we’re likely to leave it as is. With the remaining $10,000 we would like to pay off our credit card debt and close some of the accounts so as to improve our credit scores. I have heard of banks cutting credit limits when people make large payments on their credit accounts. Because of our very high balance-to-limit ratios, our credit scores are around average — in the mid-600s. Should I be concerned about this, and is it possible to avoid?

Answer: Your scores are actually below average. The median FICO credit score in the U.S. is between 700 and 720.

You’re not going to improve your scores by closing accounts (that can’t help scores, and may hurt them). And your credit card issuers may well cut your limits when you pay down your debt.

But that should be the least of your concerns. Your credit card balances indicate you’re living beyond your means. Fewer than 1 in 10 U.S. households has credit card debt of $10,000 or more, and carrying credit card balances not only erodes your financial well-being through expensive interest payments but also puts you at greater risk of bankruptcy.

So use your windfall to pay off your high-rate debt and then create a budget that ensures you spend less than you make so you don’t run up future debts.

By the way, it’s a bit unlikely that both of you are receiving an inheritance. Typically the money comes to one half of a couple and can be kept as separate property if he or she so chooses.

Fast ways to cut cable, cell bills

Dear Liz: My cable and cell companies decided this month to hike their fees on me. Do I have any recourse? It’s not like I’m getting more service for their fees (that I know of) or am automatically getting a raise.

Answer: Cable and cell companies have competitors. Start by calling one of the satellite television providers and asking what specials it offers new subscribers. Then call your cable company and let it know you’re thinking of switching. Whatever the first offer is, hold off and see whether you can get a better deal. If not, switch or consider a life without pay television. Many popular shows are available free on the Internet, while others can be purchased as downloads. If you don’t watch much TV (and you’ve got lots of better things you should be doing, right?), you can save a lot of money.

Cell service can be a little trickier, particularly if you’re in the midst of a long-term contract. Consider using BillShrink or Validas (at http://www.myvalidas.com) to see whether you can get a better deal from your current carrier. If you’re not using all your minutes, text and data, your carrier typically will let you step down to a cheaper plan without extending your contract (check to make sure, of course).

If you’re not under contract, the world’s your oyster. Those two sites can help you search among the carriers to find the best fit for the way you use the phone. Or you could consider switching to a prepaid plan with no contract.