In an ideal world, we would be saving and paying off debt at the same time, and even have resources to invest in the money market. But ideal worlds are rare and many people have to make a choice between paying off debt or saving for an emergency.
While paying off debt and saving money don’t need to be mutually exclusive, very often your personal finances don’t allow you to do both at the same time. Which one you pick depends on your financial expectations, goals in the future, and the priorities you have set for yourself and your household.
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Before you commit to either paying off debt or saving, you should see what your budget allows. Make a budget that prioritizes bills and other essential monthly expenses, so you know how much wiggle room you have with your paychecks. What you have left over is what you should use to either pay off debts or save. If you have enough to do both, then all is well. If you don’t have enough left over, however, you may need to prioritize where you commit your money: paying off debt or saving.
Here are some factors to consider.
Paying down debt over saving can be efficient because of the interest you must pay while you carry the debt. Loan rates can cause your debt to spiral out of control, and so can high-interest credit cards. Most credit cards come with double-digit interest rates that can quickly increase your balance. Rewards credit cards often end up accumulating debt instead of rewarding you, so paying them off could be the true reward.
When you pay off high-interest debt first to cut down on the interest you will owe, you can then put more into savings in the future.
There are two popular methods for paying off debt: the snowball and avalanche methods. If you go for the debt avalanche method, you are focusing on paying off debts with the highest interest rate, so you don’t pay too much in interest charges over the lifetime of your loan or credit card.
If you want to feel good about yourself, you can go for the debt snowball method, whereby you pay small debts first. The feeling of getting rid of some of your debt gives you a nice psychological boost that encourages you to keep going.
Regardless of the interest rate, you should try to pay at least the minimum every month — more if possible — to pay down the principal as quickly as possible. Since you’ll pay more in interest the longer you carry the debt, time is a factor that should be taken into consideration when paying down debt. Know how to pay down debt, and your options for doing so, before diving in.
Never put yourself in a position to worsen your financial health by missing payments altogether. If you don’t have enough money for your minimum payments and savings for one month, prioritize paying off your debt first.
While you shouldn’t ignore paying off your debt, there are times you may want to consider prioritizing building your savings account instead — especially if you don’t have one.
A savings account can help cover unexpected expenses, including large ones like a car repair. If you already have the money saved, you won’t be tempted to use your credit card to cover the cost of expenses you can’t afford. Emergencies such as a broken fridge, a leaking roof, or a medical emergency where you have to cover the deductible can happen to everyone. It’s good to be prepared.
An emergency fund may be able to help you stay out of debt in the future by providing funds to cover unexpected bills.
You can use your savings account as an emergency fund or set aside a separate account solely for emergencies.
Even a small bill can contribute to credit card debt if you don’t have the extra money to cover it, especially if you’re already in debt.
The best part is that interest rates will work to your advantage within your savings account and emergency fund. Putting just a little bit of your paycheck in the right savings account can allow your money to grow, even during the months you can’t afford to contribute.
You know by now the benefits of paying debt as well as how useful a savings account can become. But how do you decide what’s best for you?
Assess your current financial situation. This involves your debt, income, expenses, and savings accounts.
Create a detailed budget that outlines all your income sources and expenses, including minimum debt payments and essential living costs. This will give you a clear picture of your financial health and help you identify areas where you can make adjustments. Without the numbers, you won’t know which choice to make.
One of the key factors in making this decision is the interest rate and annual percentage of your debt.
High-interest debt, such as credit card balances and personal loans, can quickly accumulate and become unmanageable. If you have high-interest debt, it often makes more sense to prioritize paying it off to reduce the amount of interest you’ll pay over time.
Conversely, lower interest rate debt, such as some student loans or mortgages, may not be as urgent to pay off. This lets you focus on saving. Another thing to remember is that if you pay off your high-interest credit card, you have financial wriggle room in case of emergency. But if you pay more toward your mortgage, for example, you can’t tap into this extra equity unless you refinance your mortgage.
An emergency fund provides a safety net for an unexpected expense, such as a medical bill, car repair, or job loss.
Ideally, your emergency savings should cover three to six months’ worth of living expenses. If you don’t have one, it’s a good idea to start building an emergency fund before aggressively paying down debt. This means you’re prepared for unforeseen financial challenges without relying on credit cards or loans. In this case, an emergency fund may well save you in the future from going into debt.
For many, a balanced approach to debt repayment and saving is the most effective strategy. In practice, this requires a process like the following:
Your financial goals and priorities will determine how you prioritize debt reduction against saving.
If you have short-term goals, such as saving for a vacation or home purchase, you might prioritize saving. But if your credit score is not so stellar, you might want to focus on your debt repayment to improve your score and land a better interest rate for your mortgage.
Some people set becoming debt-free as their primary goal where they focus on debt repayment. In this case, saving comes second.
Also, consider your long-term objectives: if you are close to retiring, you may want a solid retirement plan. If you are beginning your professional life, you can expect your income to improve with your career, so you may have more room for debt.
The psychological impact of debt can’t be overlooked. For many, carrying debt is a significant source of stress and anxiety. Following a debt management plan to pay off debt can provide a sense of relief and financial freedom.
On the other hand, having savings can offer peace of mind and financial security: people are ready to face unexpected emergencies. Reflect on which option provides you with more emotional and psychological benefits.
If you have high-interest debt and no savings, prioritize building a small emergency fund first, then focus on paying down debt quickly and in a targeted way.
If your debt has moderate interest rates and you have some savings, balance your approach by making extra debt payments while continuing to save.
If your debt has lower interest rates and you have a solid emergency fund, focus on other financial goals, such as investing, putting money in high-yield savings accounts and money market accounts, or saving for retirement, while making regular debt payments. You have the luxury to help your savings grow by investing them wisely.
If you’re still unsure about the best approach regarding savings and debt management, consult a financial advisor for personalized guidance. A financial advisor can explain the pros and cons of your options and help you create a tailored plan that fits with your financial situation and goals.
If you are struggling to make your minimum payments each month, you could benefit from professional debt relief. Contact a ClearOne Certified Debt Specialist at 866-481-1597 today to discuss your situation, explore your best debt relief options, and get a free savings estimate.