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Whether you have outstanding credit card balances, student loans or a mortgage, paying off your debt is a sound money move that just about any financial expert would recommend.
When you allocate a certain amount of cash toward debt payoff, you save money in the long run by paying less in interest over time while building more financial security.
When you prioritize paying off your mortgage or loans, however, be aware that there is such a thing as paying off too much debt. Spending extra cash on chipping away at these balances might sometimes make sense, but not if it means forfeiting certain financial benchmarks like having an emergency fund or saving for retirement.
CNBC Select spoke with three financial advisors about the signs that indicate you may be putting too much money toward your debt each month. Here are the four red flags they say to watch out for:
1. You are short on cash by the end of the month
“You could be paying off too much debt if you’re paying extra above your required monthly debt payments, and you find yourself cash strapped at the end of the month and/or pay period,” says Kelly Welch, a Pennsylvania-based CFP and wealth advisor at Girard, a Univest Wealth division.
Making more than the minimum payments on your debt can be beneficial, but it’s a red flag if doing so means that you have no wiggle room left in your budget to afford the basic necessities, such as groceries.
Before you allocate any extra funds toward your debt payoff, create a monthly budget that allows you to see first how much money you need to cover the basics. If you outline your monthly expenses and see that there is room to pay more on your debt, then you can do so knowing that you can afford to.
2. You don’t have an emergency fund
Aggressively paying off your debt — especially your low-interest debt like a mortgage and student loans — when you don’t have an adequate emergency fund is another sign that you’re putting too much money toward your debt.
“This can leave you in a bind if you face a situation such as a job loss where you can’t get the money out of your home,” Danielle Harrison, a Missouri-based CFP at Harrison Financial Planning, tells CNBC Select. “You also can’t call up your student loan servicer and ask for money.”
Paying off debt at the expense of building an emergency fund can certainly lead to its own problems down the road. Accelerating your debt payments may reduce how much you pay in interest in the long run, but if you ever face a job loss, unexpected expense or emergency in the future, you could be left in a much worse spot without an appropriate cash cushion to fall back on, argues Joe Lum, a California-based CFP and wealth advisor at Intersect Capital.
“Having liquidity on hand gives you the ability to weather these challenges until you're in a position to consider allocating excess cash toward eliminating debt or investing,” Lum says.
Conventional wisdom says to set aside three to six months’ worth of your living expenses in an emergency fund. While that may seem ambitious if you’re just starting to build yours, you can use the 50/30/20 budgeting rule to create a plan for how much to allocate toward saving each month. According to the rule, 50% of your after-tax pay should go to your needs (rent, food, insurance, transportation, etc.), 30% toward your wants (gym memberships, dining out, clothing, etc.) and 20% toward savings, or your emergency fund if you don’t have any at all. These percentages might vary depending on where you live and how much you earn, but they're a good guideline to consider when figuring out how and where to spend your money.
To build your emergency fund, use a high-yield savings account that earns you more in interest than a typical savings. Both the Marcus by Goldman Sachs High Yield Online Savings and American Express® High Yield Savings Account* ranked as our best overall picks for offering above average interest rates, ease-of-use, good reviews and no monthly maintenance fees or minimum balance requirements.
3. You sacrifice investing to pay extra on your debt
If you're prioritizing paying off low-interest debt like your mortgage instead of investing, you might want to think twice. You could be missing out on the opportunity to make more money in the stock market.
Financial advisors like Welch suggest putting more money in the stock market versus toward paying your debt off faster. “If you’re paying extra toward your debt but haven’t invested any money that year, you can reconsider where that money should be going,” Welch says.
Keep in mind this advice only really applies to low-interest debt. Mortgage rates are currently near all-time lows, so it’s considered "cheap" financing. But the interest rate you pay on your credit card balance is likely double digits, way more than you could earn in investments. If you have a credit card balance with a high APR, you should focus on paying that off before you put money in the markets.
4. You can’t meet your company’s 401(k) match
A fourth sign that you’re putting too much money toward your debt: You're not putting enough into your 401(k) to meet your employer’s match.
If you're putting all your money debt payoff and missing out on an employer match, you're basically leaving free money on the table, Harrison adds.
Welch notes another red flag is if you’re pulling money out of your investment accounts to cover an extra payment on your debt. It's not great to take money from your future self to pay off past debts. Think twice before you make that move.
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Information about Marcus by Goldman Sachs High Yield Online Savings has been collected independently by Select and has not been reviewed or provided by the banks prior to publication. Goldman Sachs Bank USA is a Member FDIC.
*American Express National Bank is a Member FDIC
