Budgeting Debt

Pay Off Debt vs. Saving: An Overview

When trying to get back on track with your finances, it can be challenging to know where you ought to start. Financial planning experts express differing opinions on what should be prioritized in getting your financial situation sorted. However, the two most common actions recommended are debt repayment and saving money. 

Deciding between these two priorities is where it can get tricky because what is right for you may not be suitable for someone else. While there are some essential rules of thumb within personal finance, a great deal of smart financial choices come down to the unique situation and needs of the individual. 

To break this down, we will dive into an overview of the importance of handling high-interest debt, building your savings, and why an emergency fund should take precedence over everything else.

The Importance of Paying Off Debt

When left to build, debt, especially high-interest debt, takes on a vampiric quality to your life. It sucks you and your finances dry. If you aren’t careful, debt payments can take up a substantial portion of your monthly budget, and the interest rates can become so high that those payments become meaningless.

The journey to pay off debt is vital to getting back on track with your financial life. Whether you are aiming for debt reduction or a debt-free lifestyle, the goal is to relieve this financial burden, so you have more say in where your money goes. Exiting the workforce still tied to your debt can have detrimental effects on your quality of life. Just like it is necessary to have a comfortable savings when you go into retirement, it is also necessary to have all or most of your debt paid off.

The Importance of Saving Money

Living paycheck to paycheck is not a lifestyle anyone would choose to stay in. If you spend your entire income until your bank account hits zero each and every month, you will never be able to achieve what you aim for. Furthermore, whenever an unexpected expense pops up, you are stuck with the choice of accruing more debt or relying on others. 

It’s a vicious cycle that goes like this: minimal saving increases debt reliance, and too much debt decreases the ability to save. This cycle can go on and on, repeating itself until you are faced with severe consequences that force you to change. 

When you reach a certain age, you will want to have the security of a plentiful retirement savings so you can live the rest of your life in peace. But, even before that, you deserve to have the funds set aside to pursue all the things you dream of, from traveling the globe to paying for your child’s education. 

First Thing To Do: Create An Emergency Fund

While there is debate on whether long-term saving or debt reduction should be prioritized, one thing should take precedence over all of them before you can determine which is more time-sensitive for you. Before you do anything else, create an emergency fund. 

An emergency savings is the most foundationally helpful thing you can do to improve your finances. Prioritize saving money for an emergency fund of $1,000 before you decide what to do next. 

Of course, you will have to maintain the minimum payments on all your debt while you build the emergency savings. But outside the minimum payments, direct every spare dime you make towards that 1,000 dollars until you have it sitting safe and sound in your savings account. 

Setting up an emergency fund will allow you to break the cycle of debt and reckless spending by ensuring you always have cash on hand when life throws a wrench in your monthly budget. When you need an unexpected car repair, you have a surprise medical bill, or your dishwasher breaks; you will not resort to using credit card debt or money set aside for living expenses.

Once you have your emergency fund set up, you can then determine whether you need to pay off debt or save money first.

When Paying Off Debt Is a Priority

A true sign that you need to prioritize paying off debt is when you have high-interest debt that is eating away at your monthly paycheck. High-interest credit cards only get worse over time, with charges so high that the minimum payment doesn’t even make a dent on the principal balance. 

While credit card debt is the most common debt with high-interest rates, debt payments should also take priority when you have loans with a high-interest rate like easy payday loans. Debt can become a problem when it gets out of control, and reckless spending goes unchecked.

Credit Card Debt

Credit card debt has a variable interest rate which means that the annual percentage rate (APR) changes over time. Your interest rates can get higher until your balances grow exponentially before your eyes. Nipping this in the bud as soon as possible is the best way to regain control of your money.

Credit card accounts that are making it impossible to save money because of their high minimum payments need to be handled before you can reach your other financial goals. Pay off your high-interest debts faster, and you will be better positioned to increase your savings.

Problem Debt

If your debt has gotten out of control and you notice it is affecting your quality of life, prioritize paying it off before you address other aspects of your finances. Even if you have the resources to pay extra money in interest rates, allowing problem debt to get further out of hand could lead you towards distressing situations that you cannot control.

If you believe your credit card debt may be a result of compulsive spending, reach out for help from a psychologist, certified financial planner, or nonprofit credit counseling agency so you can face this issue head-on and pay off the debt as soon as possible.

When Saving Is a Priority

As mentioned above, saving should always be the priority if you don’t have an emergency fund. But if you already have your emergency savings in order, then the circumstances in which savings are a priority narrow a bit. 

One stand-out reason for saving more money before debt repayment is you are currently working somewhere with a 401(k) employer match program. This kind of program for your 401(k) savings account should be taken advantage of to the fullest extent. Contributions to your 401(k) will be matched, i.e., doubled, by your employer. You will want to contribute as much money as possible up to their maximum employer match limits, especially if you have lower interest debts.

Low-interest debts like mortgages and federal student loans can take the backseat for a while to build substantial savings for yourself. This is especially the case if you are meant to retire soon and don’t have much in your individual retirement account.

Living Paycheck to Paycheck

Sometimes a bare-bones emergency savings of $1,000 is not enough for someone who has been stuck living paycheck to paycheck for a long time. If your debts are not too urgent, it might be wise to put some extra money away before moving on to tackling other debt. 

Adding a month’s worth of income to your savings account could help you get out of living paycheck to paycheck, making it significantly easier for you to handle your debt payment. Once you have cushioned your savings account further, you can feel confident in your ability to afford your living expenses, emergency expenses, and pay all your debts.

Low-Interest Debt & Retirement Is Soon

Loans with a very low-interest rate can be placed on the back burner while you beef up your savings accounts. If retirement is on the horizon for you, it’s best to focus on your high-yield savings account to ensure you have enough money to live comfortably. 

We recommend you keep paying your monthly payments on all your other lower-interest debts while putting the rest of your disposable income into your retirement plan. Once you have enough total savings to handle necessary expenses in retirement, move to a balancing act of paying other debts and contributing to your investment account.

Steps To An Emergency Fund

Now that you know an emergency fund is necessary before making any further financial decisions, what steps do you need to take to create one?

Here are some money-saving tips for getting your emergency fund in order so you can move on to the following steps:

  1. Designate or Open a Savings Account 

Do not keep your emergency fund and the money you use for paying expenses in the same account. Open a savings account or designate one you already have specifically for your emergency savings. There are online banks that offer high-yield savings accounts that can help you earn interest on the money you put aside for emergencies.

  1. Pick a Goal for the Total and Monthly Contributions

The most commonly suggested amount for a starter emergency savings fund is $1,000. As you get a better hold of your finances, that goal may shift, but it’s an excellent place to start. After picking an overall goal, determine the amount of money you can realistically contribute from your income every month. Make sure it is reasonable and that you will still have enough to cover all your necessary expenses.

  1. Set Up a Direct Deposit or Transfer

Schedule a direct deposit for transfer from your main bank account into your emergency account. Have it scheduled so that it moves from one account to the other directly after your paycheck clears so you don’t accidentally spend the money designated for saving.

  1. Be Open To Increasing the Contribution If Circumstances Allow

If after a few months you notice that you can spare some more money, then don’t be afraid to increase the contribution you make to the fund every month. The more you can contribute, the faster you will reach your goal.

  1. Move Unexpected Money To the Fund

Put any windfall that strikes you like a bonus, cash gift, or tax refund towards your savings. We all deserve to treat ourselves sometimes, and that is the biggest temptation when you get an unexpected chunk of cash. There is nothing wrong with that but avoid it at all costs while you are building your emergency fund. Once the goal has been reached, you can use those windfalls for more fun purposes.

  1. Once You’ve Met Your Goal, Redirect the Contributions to Debt or Further Savings

After you’ve hit your $1,000 goal, or otherwise, redirect your attention towards paying off your debts. You can use the contribution goal you met each month for your savings as a target for the money you want to put towards paying debts. However, if most of your debt is low-interest, you can stay focused on building your savings until you feel satisfied.

References:
Should I Pay Down Debt or Focus on Savings? | Equifax
Saving Vs. Paying Down Debt – Forbes Advisor