This is one of those chicken and the egg type questions. No matter which side you of the argument you take there are strong reasons to believe the other side.
Many Americans are wondering which financial task they should tackle first. The chicken or the egg? Pay off debt or save money?
Simple math suggests it’s better to get rid of your debt before saving money for an emergency fund and/or retirement. If you look at the current interest rates for savings accounts (currently hovering around 1%) and compare it to the interest rate on your debt (credit cards usually charge about 18%), you’ll quickly see your money would go farther paying off your debt first.
So is that the end of the argument? No. Rarely are financial decisions so black and white. Like most decisions, this too is about striking the right balance for you and your unique situation.
Building savings before paying debt
Every personal finance expert believes that having money stocked away for an emergency fund, a rainy day and retirement is paramount. To some it’s the most important pillar to finding financial success.
The idea is you need to be prepared for the unexpected – like job loss, car repairs, health issues, etc. If you aren’t then you’ll simply add on more debt should you be unprepared.
Although other personal finance experts advocate you sock away 3-6 months’ worth of monthly expenses in an emergency fund; I believe in these tough economic times you need to have six months to a year’s worth of salary saved up. If you do lose your job, it’s a tough market out there and you may not find another job quickly or you may only find ones that offer you less pay than your previous job.
While your dollar may go further by paying off debt when you compare interest rates there are a number of situations in which it makes perfect sense to save money before paying down debt. Generally speaking, any time your employer offers a matching program for retirement you should put your extra cash towards that instead of using it to pay off debt. Doing this essentially doubles whatever you save, plus it goes into the stock market which typically sees returns of 10% or higher a year.
You should also build savings instead of paying off debt when the interest rate on your debt is low. Usually interest rates on car loans are zero or very low interest rates. In these cases you’d do better to make monthly payments on your vehicle and using any extra money each money to build up an emergency fund or put it towards retirement.
Other than these scenarios it’s tough to justify channeling your extra cash towards savings accounts that are earning virtually no money. Especially when your debt is costing you way more each month that you have a balance. For every dollar you put in savings, several more are lost to loan interest.
Paying Debt Before Building Savings
Given that math, paying down high-interest debt before building up any savings makes good financial sense. If a man has $10,000 in savings (earning 1%) and $10,000 in credit card debt (at a rate of 14%), he is losing 13% of his money unnecessarily each year.
Unfortunately, even though the math makes sense, many people do the opposite. Most people find more joy in numbers that go up, rather than down. This causes people to save money rather than pay down debt. Often times, people who just pay down debt get depressed and give up when they see how slowly a repayment process works.
Even though the answer to this riddle is pay debt before diverting your money to high-interest savings accounts, most people need to do both. This way they get good emotional feedback by seeing both their savings balance rise and their debt load go down.
The added benefit of this approach is that you train yourself to develop good money habits. Cultivating sound spending and saving habits will benefit you even after you pay off your debt. Once the debt is gone, you should divert that money you were spending each month to your savings account rather than use it for spending. It may be easier to do this if you’ve been doing it for any length of time and have gotten used to not being able to spend that money.
How much should you pay towards debt while building up savings? This really depends on the size of your debt. The more debt you have, the more money you should put towards paying it off. I recommend using the 80/20 rule. Put 80% of the money you have after paying your monthly bills towards your debt and the remaining 20% towards building up a nest egg. Once you’ve built up a sizeable amount in your nest egg – enough to cover at least six months’ worth of expenses – change that ratio to 90/10. Put 90% of your money towards your debt and put the remaining 10% in savings.
Whatever method you prefer, make paying off your debt and saving money a priority. You’ll never find financial success if you have debt and no savings to speak of. You also won’t find success if you have debt and savings. The only way to be financially free and live a stress free existence is to eliminate your debt. For helpful suggestions on how to pay off your debt faster, read my article on debt repayment plans.
Keeping Money in Your Pocket,