Should I pay off debt or save?

Deciding where your money should go

Paying down your debt can feel like a great relief. At the same time, getting your savings headed in the right direction can reduce lingering anxiety that you’re not preparing yourself for the future. So how should you pay off debt or build savings?

The short answer is you should do both. 

It becomes a matter of how much goes to the debt and how much goes to savings. Here is a simple guide:

• If you have high-interest debt, you may want to put more of your money on eliminating it.
• If you have loans with reasonable interest rates, you may want to put more toward your savings.

Of course, every situation is different. So read on to understand some of the things you might want to take into consideration before making your decision.

The first step: figure out what you can put towards your debt or savings

We need to know what we’re working with. That means understanding what you spend each month on your needs. That includes your rent or mortgage, your utilities, groceries, minimum debt payments, and other essential bills and expenses. Check out this easy-to-use budget method to get started. Once you understand that, you can figure out how much you can comfortably put towards your debt or your savings.

The second step: build an emergency fund

Life happens. It can be a car repair. A trip to the emergency room. And more. We need to be able to handle these speed bumps in life without going further into debt. This is why we need a speed bump emergency fund. In most cases, it makes sense to get an emergency fund in place before paying down debt beyond the monthly minimum payments. A good rule of thumb is to save up $1,000 to handle any of these speed bumps without having to resort to credit cards or payday loans.

Also, get a decent savings account - one that pays more than the piddly national rate. After all, your money should be doing something besides just sitting there.

Dealing with debt

Okay, you know how much you have to work with. And you’ve built your $1,000 speedbump emergency fund. Now it’s time to figure out how to handle your debt.

LEANING INTO THAT HIGH-INTEREST DEBT

You’ll want to put more of your money into paying off debt if you:

• Have high interest credit card debt - a good rule of thumb is anything above 15%
• Have a payday loan
• Have a car title loan

You can attack this debt with the Snowball, Avalanche, or Consolidation methods. Check them out to find the one that fits you. Because knocking out this ridiculously high-interest debt should be your priority.

SPREADING OUT REPAYMENT OF SOME DEBT

It may be okay to spread out some debt over time. This can include an auto loan, your home loan, and government issued student loan. It all depends on your interest rate.

If you have a reasonable rate on these loans, it may make sense just to make the monthly payments over the term of the loan. 

Supercharging your savings

While paying down high-interest debt is important, you also don’t want to ignore saving for the future (and maybe even miss a golden savings opportunity – an opportunity that can include free money!

GETTING THE TRIPLE BONUS

You may have a workplace savings plan like a 401(k) where the employer offers a match. It’s worth contributing at least enough to the plan in order to get the maximum employer match. It’s like getting free money for something you already were going to do (save for retirement). That’s the first bonus.

Here’s the second bonus. Savings in a plan like a 401(k) could be made pre-tax. In other words, you could put the money you earn into retirement savings before giving Uncle Sam his cut. In fact, you don’t have to pay taxes on that money until after you retire and start taking withdrawals. That means more of your money could take advantage of the magic of  compound interest (that’s where you start earning interest on your interest - ka-ching!). 

And here’s the third bonus. Since that money comes out before taxes, you’re reducing the amount of taxable income you have - potentially lowering your taxes.

Even if you don’t have a workplace savings plan, you can open a personal IRA and get some of these benefits.

SAVING FOR THE DETOURS

Beyond the speed bumps we talked about, life can drop detours in our path. It could be an injury that keeps us out of work for months. Or losing a job. We need savings to help us handle these situations without sinking deep into debt. The typical recommendation is to put away 3 to 6 months of living expenses. A year’s worth is even better.

Having this in place can help you feel more confident that you’re ready for whatever lies ahead.

ACCOUNT FOR THOSE OTHER GOALS

You may want to start saving for some of those other big goals in your life as well:

• A wedding
• A down payment on a house
• A child’s’ education
• A once-in-a-lifetime trip

Prioritize your goals. Set an initial amount you’ll think you’ll need as well as a time frame so you know how long you have to save for the goal. This helps you figure how much you need to put aside each month.

Putting it all together

Now that you have examined your situation, you know how much you have to work with and what areas need the most attention. That should help you prioritize your debt and savings. And decide how much to put towards each.

BONUS TIP

Paying down debt or saving takes a plan. But that plan can be accelerated with windfalls that come your way. Maybe you got an unexpected tax refund. Or a bonus or inheritance. You can use this influx of unplanned cash to shorten the time to reaching your goal. Plus, you don’t have to deny yourself the joy of a windfall. For example, you could take 20% of what you received and do something fun while the other 80% goes to knocking down the debt or boosting the savings. 

For more information on Dominating Debt and other smart money know-how, check out our free ebooks.