Deciding whether to pay off debt or build up your savings is a situation many people find themselves in. No one wants to hold on to debt longer than they need to, but saving money can be extremely rewarding as well – whether it be saving for retirement or an emergency fund. Although there isn’t exactly a clear answer that’ll tell you what to do, here are a few points to keep in mind when deciding whether you should be paying off debt or saving money.
Reasons to Pay Off Debt
Large debt is a drag on your future holding you back from reaching your financial goals. With some credit card companies charging as much as 30% interest on your outstanding balances, it can be hard to balance your finances with rest of your life. By resolving to pay off debt faster, you’ll get closer and closer to enjoy living a debt-free life.
Paying High Interest Makes it Hard to Manage Regular Expenses
When you’re consistently making high interest payments every month or making just the minimum payment, it can be hard to have enough funds for the rest of your expenses. This can have a massive impact on your motivation, as it may feel like you’re going to be in debt forever.
Paying off debt first can improve your credit score, which can improve your chances of qualifying for a mortgage or a car loan. Having a better credit score improves your credit worthiness, and you can get lower rates on loans and mortgages. When paying down your credit cards, keep the numbers 75% and 50% in your mind. Paying each credit card balance down to below 75% of your credit card limit significantly improves your credit score, and paying them down to below 50% is even better.
If you decide that paying off your debts first is the better route for you, then you should definitely start creating a personal budget if you haven’t already. Creating a budget is one of the best ways to organize your finances and make you decide what you really need and don’t need. Here’s a free budget calculator spreadsheet that you can use to track your own income and expenses.
Reasons to Save Money
Of course, depending on your financial situation and the interest levels of your debts, it could be a better option to make saving money your priority. By saving money, you can create a financial safety net that gives you a little more breathing room in emergencies, and also work on improving your own saving habits.
You Need Savings for Emergencies and to Avoid Future Debt
While it may seem like it makes sense to pay off your higher interest rate debts instead of putting away all your money into savings, you don’t want to have to revert back to credit to cover the costs when an emergency happens.
It’s very important to save some of your money to build up an emergency savings fund of at least 3 months. In fact, most people recommend a fund that can cover your expenses for 3-6 months, but if you can’t save up that much, even start with just $1000. Having even $1000 saved up can really come in handy when something out of the ordinary happens.
Once you’ve paid off your expensive debts, then you can focus on increasing your savings to last you 3-6 months. In the event of a sudden illness, job loss, or a repair, having an emergency fund will help you ride through the storm without having to rely on credit and fall back into debt.
You could earn more money from your savings than you are paying
Determining if the carry (difference you’re likely to pay in interest on debt versus what you can earn on savings or investing) works against you or for you can sometimes be pretty easy to calculate. For example, if you know you’ll pay more in interest on the credit card that charges 20% than you’ll earn investing in a market, taking care of the debt makes more sense. However, if you’ve taken out a no-interest car loan, then the carry works in your favour.
Answering this question is often more difficult if it involves trying to determine whether to pay down your 30-year fixed mortgage or invest in a diversified equity portfolio. Generally, the longer the timeframe you’re working with, the greater the chance that the market return will be greater than the interest paid on a low-interest mortgage. However, over a shorter term of a couple years or less, the variability of the market return makes the chance the carry works in your favour lower.
Use a Balanced Approach: Pay Debt and Set Aside Smaller Savings
Instead of focusing on one or the other, depending on your financial situation you could also consider a balanced approach that allows you to pay debt while building a small fund for emergencies.
After you’ve created a budget, determine whether you have enough savings to get you through an emergency. Track your expenses for a month so you can figure out how much you’ll need for groceries, entertainment, and other expenses. If you have enough savings to cover about 3 months’ worth of these costs, then you’re doing good and you can focus on just paying off debt.
If you don’t have enough money to last you through an emergency, you can still pay off your debt and work on your savings. After accounting for your fixed and personal expenses, divide your take-home pay and any extra money you get between saving and paying down your debt. This allows you to continue paying your debt off in a steady way while still building up a small savings fund that can eventually turn into your emergency fund.
Although this method will take a bit longer for you to pay off your debts and for your savings to grow, in the end you will have achieved both of your financial goals. Once you have saved up enough, you can start increasing your debt payments too to blast even harder at your debts.
No matter which route you decide to take, it’s important to remember that everybody’s financial situation is different, and no one way is better than the other here. By creating a budget and determining your own expenses, you can have a better picture of how much money you need to support the life that you’re living, and how to adjust accordingly.
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