Top financial priority: Pay off debt

NEW YORK (1/24/07)--Many people have multiple savings goals--perhaps for an emergency fund, vacation, retirement savings and college for the kids--but when it comes to setting financial priorities and investing for the long term, do you know where to start? (The Wall Street Journal Jan. 11).

Here's the right order, according to some experts:

Credit card debt. Pay off high-cost, nondeductible consumer debt first. If you pay off a credit card with an interest rate of 18%, that's like earning a risk-free, tax-free 18% rate of return. The most cost-effective strategy is to pay off the card with the highest interest rate first, while still making at least minimum payments on all other cards. However, if you need to see results quickly to stay on track, first pay off the card with the lowest balance.

Emergency fund. After you pay off the cards, sock away enough cash to live on for three to six months in case you lose your job or you're faced with a high-cost emergency. Keep the money in a fairly liquid account such as a money-market account.

Retirement savings. Next, try to put as much money into retirement savings as you can--preferably in a 401(k) if your employer offers it, and as soon as you enter the work force. Contribute at least the amount necessary to get the company match, and gradually increase the amount each year. You can contribute $15,500 a year in a 401(k) plan or 403(b) plan; people 50 and older can contribute an additional $5,000 a year to these accounts. In addition, consider contributing to an individual retirement account, especially if your employer doesn't offer a pension. Most importantly, automate it--have your contributions deposited directly from your paycheck into your retirement accounts.

College savings. Experts recommend parents save for retirement before they save for their children's college education. Why? Because there are many ways to pay for college--loans, scholarships or less-expensive alternatives such as community colleges or state universities--but you won't get a loan or a scholarship to pay for retirement. However, if you're already contributing 15% of your salary to a 401(k), put money in a college savings plan such as a state-sponsored 529 college-savings plan, which grows tax-free and can be withdrawn free of federal tax on investment earnings as long as it's used to pay for college expenses.

Mortgage prepayment. Prepaying your mortgage is lower on the priority list than putting extra money into your 401(k)--at least up to the maximum matched by your employer. Prepaying your mortgage is more important for people who are close to retirement or who already are saving enough for retirement. Bankrate.com recommends you consider prepaying your mortgage if you're in the final stages of a mortgage where interest is no longer enough to justify itemizing your tax deduction.