When we talk about budgeting or money management, we often face difficult choices and questions. One of those tough questions is whether you should pay off debt or save money.
Getting ahead financially means focusing on a few different aspects, primarily saving money and paying down debt. Saving for the future means putting away money on a regular basis that you can then use for other things. Paying down debt is eliminating loans and payments you are required to make to other people.
But, which one should you focus on if you want financial freedom?
Everyone’s situation is different and there could be reasons to focus on different strategies. That said, the simple answer is often that paying off debt is more important than saving.
Why Should You Pay Off Your Debts First?
Paying off your debt first can be a powerful strategy for reaching financial freedom. This is because interest on your debt keeps piling up, which is more than what you could earn with interest on your savings.
However, it also depends on your financial situation. In some cases, you are better off saving than paying low-interest debt.
It would be best to pay off your debt first when you have high-interest rates, like credit cards. If you have to pay 15% or more in credit card interest rates, it makes sense to focus on eliminating it.
Interest charged on debt can be much higher than the savings interest rate. If, for example, your savings account has a 0.50% interest rate. On the other hand, your credit card may have a 15% APR.
By saving $100 and putting it in a savings account, you would earn $0.50 at the end of the year. However, a $100 credit card debt would accrue $15 in interest. It is clearly more beneficial to avoid paying the interest than to save at a low interest rate.
Types of Debt to Pay Off First
If you have multiple types of loans, it is a good idea to focus on paying off the highest interest accounts first. This method will help reduce your total costs, helping you maintain your budget.
Common forms of high-interest debt are credit cards, store card debts, unauthorized overdraft, catalog shopping, pay-day loans, and home credit. Student loans can potentially fall into this category since some of them are over 6%.
The key is to look at the amount of interest that you have to pay on your loan. If it is more than the interest you would make in a savings account or by investing, you should probably focus on paying them down.
Types of Good Debt to Leverage
While many types of debt is generally harmful to your overall financial wellbeing, there are some loans that can be beneficial.
No-interest loans are the absolute best because they cost nothing to you. The benefit is that you can spread payment out over a period of time at no cost to you.
Credit cards can work this way as long as you are careful of the payment deadlines. If you can pay off credit card bills before their deadline, you do not have to pay interest. However, you will have to pay extra interest due to late submission of payment.
One of the best ways to avoid paying fees is to pay off credit card bills as soon as you can and within the same month.
Other forms of good debt can include a mortgage. A low-interest mortgage will allow you to invest in real estate. Leveraging low interest rates can help you create a positive cash flow and build equity.
Should I Use an Emergency Fund To Pay Off Debt?
Do you have an emergency fund to take care of the unforeseeable future difficulties? You may be tempted to use those savings to pay off your debt all at once.
This is one way to pay off your present or future debts and is a strategy to stop incurring more debt. Before using your emergency fund, you need to consider a few things:
- How much savings do you have in your emergency fund?
- Could you increase your emergency fund while paying off your debt?
- What is your emergency fund meant for?
- How long will it take for you to rebuild your emergency fund?
- Are you willing to let go of your goals for the emergency fund in the meantime?
- Do you have enough to cover another emergency on top of paying off your debt?
In summary, it is crucial that you prefer paying off all your debts as this will decrease the financial burden on you and give you peace of mind.
Are There Any Exceptions to Paying Off Debt First?
Some of you may ask whether there are exceptions to the rule of paying off debt first. Debt vs. Savings is always a challenging debate, but here are some arguments for savings. Here are a few scenarios:
Penalty Charges For Paying Early
In some cases, loans or mortgages may have penalty charges if paid earlier. However, it would seem nice to have paid back your loan earlier than expected lenders do not actually like it.
This way, lenders are missing out on much interest that they could have earned. If per se, you paid off your five-year loan 2 years earlier, lenders are missing out on interest for 2 years. Due to this, lenders may charge early payment fees, and it does not make any sense to incur extra charges to your debt.
Make sure to read the fine print and understand if there are early payment fees.
Interest-Free Debt
If you have been shrewd and found a way to get an interest-free loan, then you could refrain from paying off your debt first, but again, it is a personal preference.
Many credit cards have a 0% interest rate for an introductory period, which means no extra payments. Just be sure to pay off the balance before that 0% interest free period expires.
Student Loans
These loans differ from other loans and are different from debt, depending on their plan. When you are a new grad with a new job, you probably don’t have much extra money to pay off your loans. Plus, certain jobs may help contribute towards paying off your loans, or the government may forgive them all together.
Exceptions to the rule differ for everyone above are a few examples, but how you pay off debt is everyone’s personal preference.
Should I Still Save?
I have heard of saving ever since I was a child, and until I grew up, I never realized the importance of saving. Many people ask, should we still save while paying off debt?
The answer is yes! The beauty of budgeting is that you have so much control over your life’s financial aspect that you have something like an emergency fund to protect you if something unfortunate does happen.
There are many scenarios to look into when we tackle this problem. In some cases, if your debt is costing you more than you actually earn from savings, it would be best if you took care of your debt first.
This will reduce the financial burden on you, and with debt gone once and for all, you can focus on savings.
Saving and Paying Off Debt Together
At times, the best approach to the question Save Vs. Pay Debt is to do both.
Take the COVID-19 pandemic as an example. This years has been full of unfortunate incidents that could never have been predicted. Millions of people have lost their jobs, which has made it harder for people to survive.
This is where your emergency fund comes in, which is why it is essential to save at the same time as paying debts. You have to find the right balance between the amount you pay towards your debt and the amount you save.
Budgeting is vital; it will help you have more control over the financial situation.
Saving vs. Investing
When we say to save money after paying off debt, that should be inclusive of investing. Some money can be saved as cash, but you’ll see the greatest benefit by investing the rest.
There is a difference between simply saving money in a bank account and investing it in something that will earn more interest. Most savings accounts offer much less than 0.5% interest and just hold your money. The benefit is that they are very safe from losing your money.
On the other hand, investing is a way to earn higher returns, although with more risk. One of the best ways to build wealth is by investing in the stock market. Over the long run, the stock market has averaged around 10% each year. Much better than a normal savings account!
Of course, investing in stocks, real estate, and other vehicles comes with risk. Do your research and understand what you are investing in before jumping in.
If you’re looking for how to get started investing, here are some great tips for beginner investors.
Conclusion
Whether you should save or pay off debt is dependent on your various financial positions. What will work for one person may not work for another in a different situation.
If you decide on paying your debts, first make a budget to stick to your plan until fulfilled. You could earn extra income from home, which would help increase income; hence you save some money.
For most people, it makes the most sense to attack your high-interest loans first to try to pay them off quickly. Once you get rid of your debt, you’ll be able to save money for both your cash account and to invest.
Over time, this is a strong strategy for growing your net worth and putting your money to work for you.
