2020 turned out to be a challenging year in so many ways. The COVID-19 pandemic highlighted economic inequality in the US and left many Americans struggling to make ends meet. As a result, many people across the country are resorting to emergency savings or loans.
Having debt hanging over your head can be overwhelming, more so if the debt prevents you from adding to your savings. Many people who find themselves in such situations ask the common question: Should I pay off the debt or save money?
Choosing between paying off debt and saving money can be one of the most significant decisions you may have to make during these trying times. While there’s no perfect answer for everyone, paying off debt often seems like the priority. But the truth is; you should save some money while paying off the debt to stay safe. Having at least some cushion of emergency money will prevent you from going even deeper into debt when an unexpected expense is unavoidable.
Fortunately, there are winning strategies that you can use to tackle debt and savings at the same time. In this post, we will help you understand when to prioritize paying off debt, when to prioritize saving money, and how to strike a balance where you can pay off the debt while saving money. Let’s dive right into it.
Paying down your debt is rarely a bad idea because it eliminates the interest cost associated with the debt and frees up your cash flow. However, when you commit to paying off the loan, you cannot get the money back. So, before you make that decision, it’s important to first consider the implications of paying off the debt at the expense of saving money.
If you are contemplating an early payoff, there are many options:
Normally, the best way to go about it depends on the loan type, the terms of the loan, and the risks associated with an alternative approach.
To cut through the clutter, you should pay down your debt first if you have many credit card debts with relatively high-interest rates. By cutting down on the high-interest rate loans, you also reduce the interest rates that you have to pay every month. This path will save you more money than you would earn from a savings account.
If yours is a fixed-payment loan, like a student loan or a mortgage, paying down your debt first will go a long way in reducing the timeframe of your loan repayment.
And if you’re worried about losing a tax deduction if you pay down the debts first, you should know that the tax deduction will certainly be lower than the amount you would pay in interest for an additional year on your loan.
There are scenarios where saving money becomes a priority over paying down debt. These scenarios are:
If you have a credit card debt or a loan with a relatively very low-interest rate, it doesn’t make sense to pay the debt off at the expense of saving.
The other situation where it makes more sense to save first before paying down debt is if you can conveniently access your retirement savings through your employer. This is only possible if you have an employer match to help. In this case, you must strive to contribute at least just enough money to attain the maximum employer match. If you have the opportunity to do so and you’re not, you’re just turning away free money!
It’s crucial to note that putting off saving for retirement until you have paid off your debts might cost you another valuable asset: time, especially if there’s a compound interest associated with your retirement savings. With compound interest, even small monthly allocations towards your retirement plan can grow considerably over time.
To reiterate, the most important reason to make saving money a top priority over paying down your debts is to have an emergency fund to cushion you in case of an unforeseen incident. If you don’t have any savings, you could easily end up adding to your debt to take care of the emergency, and then the debt becomes a constantly revolving door.
In the context of the pandemic, things could easily go from bad to worse. In fact, according to a survey by Bankrate, a whopping 23 percent of Americans’ confessed that their biggest regret during the COVID-19 pandemic was not having saved enough money to take them through trying times. So, saving first and allocating a decent emergency fund might be the difference between going through the tough times smoothly or filing for bankruptcy. Automate your saving with GuardianWealth today.
The greatest financial challenge facing many Americans is that their debts are so huge relative to their monthly incomes that it will take years to completely wipe off the debts. While it might seem sensible to focus on paying down the debts, that is not always the best path to take. Even households with huge debts still want to get mortgages, raise kids, and provide for their aging loved ones, all of which require at least some savings.
The solution, then, is to strike a balance that works for you or your household by devising a plan, committing to the plan, and sticking to it.
Consider prioritizing paying off the debts with the highest interest rates and make some payments towards your savings simultaneously. Once the debts are paid down to zero, you should avoid debts and save more aggressively. If possible, add the whole amount you were paying towards the debts to your monthly savings.
To recap, however much you’d want to pay down your debt first, it is more important to make emergency savings your priority, even if it’s just a small amount to see you through unforeseen incidents. A sudden dent on your car, a child falling sick, or an ER visit can significantly throw a wrench in your financial plan. Without an emergency savings fund to fall back on during these predicaments, you may resort to high-interest loans to cover the bills, and doing so will only compound your debt and make your financial situation worse.
If you’re just considering savings, it’s generally recommended to cut down on unnecessary expenses and save at least half a year’s worth of the expenses. While that’s a common text-book approach, it may not be a realistic solution if you are already struggling financially. If you have difficulty saving at that level, consider three months’ worth of expenses instead of six. That way, you will have some money in savings, which is better than none. Then you can focus on saving some more once you pay down your debt to a certain level or to zero.
When you start saving towards the emergency fund, skim through your options and open the highest-interest savings account so that your money can grow even as you work on paying off the debt. As you proceed with putting money away towards the emergency fund, it is also crucial to make minimum monthly payments towards your loan so that it doesn’t attract penalties that might negatively impact your credit scores.
Next, you need a debt repayment plan. It’s essential to note that a repayment strategy that works for other people out there may not necessarily be the one that will work for you. Your unique loan repayment plan will depend on the type of debt you have. For instance, some types of loans, like student loans, may allow for deferment, forgiveness, or forbearance. Other loans, like credit card loans, may have more stringent terms.
No matter the kind of debt you owe, there are two standard practices for paying the debt down:
Either of these two options will help you pay off your loan but in different ways.
The avalanche method starts by ranking your loan debts, starting with the loan with the highest interest rate. This method focuses on paying off the loans with the highest interest rate first, while at the same time making the minimum monthly contributions towards the other loan balances. This strategy is best if you have a student loan and a credit card loan because interest rates are generally high on credit card loans.
On the other hand, this method entails listing your loan debts by total dollar amount and paying off starting with the smallest amounts first. If you want to enjoy the psychological benefits of paying off the debts—the satisfaction of getting the debts off your list, then this is the method to opt for. Many Americans who choose this strategy do so mainly because of the satisfaction they derive from clearing the small amount debts, which motivates and encourages them to work their way up in clearing the large amounts.
No matter the path you take towards paying down your debt, always strive to make sacrifices that will allow you to allocate more than the minimum monthly payment required of you. One tip to help with this is to earmark all unexpected or extra incomes for loan repayments. It also helps if you cut down on groceries, eating out, and other luxuries. Learn more about budgeting with GuardianWealth.
In the end, it is in your best interest to strike a balance between the money you contribute towards paying down your debt every month and the amount you save. It’s not a good idea to forego one at the expense of the other, so find a way to split the money between paying off debt and saving money. The balance might mean that you pay a little bit more in interest on the loan, but you will be comforted by the thought of having some savings to keep you out of the cycle of debt, earning you interest and ensuring that your retirement years will be brighter. Start saving for the future with GuardianWealth today.