When it comes to paying off debt versus saving, most people struggle with which one should be a priority. Depending on your level of debt you can either decide to make paying off debt your number one goal for the next few months or you can decide to save more money. Alternatively, it could be a mix of the two where you pay off debt and save as much as you can. That’s why the answer to the question of whether you should save or pay off debt is a personal one.
There are various factors that will impact which option you prioritize. Depending on what is going on in your life one may be more favorable than the other because of the impact it would have on your financial wellbeing. I for example still have student loan debt that I frankly hate paying for. I have been trying to decide if I prefer to save or get rid of the debt. Going through the different scenarios in my head resulted in this article.
Questions like should I save for a future event or pay off the car have been running through my mind? If you are thinking about buying a home like me have you set money aside for it or is credit card debt impacting what you qualify for in terms of a mortgage? As I try to answer whether you should save or pay off debt and which is more advisable, I will go over the merits of both.
Table of Contents
Reasons to Save Before Paying Off Debt
Debt is Often More Expensive Than Saving
The reason I say this is because of interest. No bank pays more in interest than you will be charged on debt. This means that your money works better for you if it gets rid of debt verses seating in your account earning a small amount in interest. You may argue that investing may yield a high return but often it doesn’t cover what credit cards and loans charge in interest.
Currently the average credit card interest rate is 17.35% which is an astronomical amount compared to 2.2% that you may get form a high yield savings account.
Based on this interest rate if you have $5,000 in credit card debt and it takes you 5 years to pay it off you will pay approximately $2,500 in interest. That’s $500 per year for five years. Clearly no savings account will pay you $500 a year on $5,000. This makes it more advisable to pay off the credit cards verses saving because you will save more money in the end by avoiding these interest charges.
See this Mistakes You Should Avoid When Paying Off Debt.
Restore Your Credit Score
As detailed here the importance of debt to income ratio when you are shopping for a home is high. That’s why paying off debt to restore your credit score is important. The amount of debt that you have when applying for mortgages or other loans plays a big role in how much you can borrow and interest rate charges.
Paying off debt improves the debt to income ratio and decreases how much debt you have outstanding. Remember the more you have in borrowings the more unattractive you are to lenders. A borrower who doesn’t use too much credit is easier to lend to because it shows they know how to manage debt.
Don’t max out on cards or keep high balances on your credit card. Also don’t get personal loans for day to day expenses. Pay off what you spend on your credit card every month and avoid just paying the minimum payments or you will be in debt for an incredibly long time.
It is advisable to use less than 30% of the credit you are approved for to maintain a healthy credit score. Remember to make your monthly payments and to avoid late charges because these factors influence your credit score.
Not Owing Anyone
When I paid off my car a few years ago there was a huge sense of pride and relief in knowing that I owned the car outright and that I didn’t have this monthly bill every month. Also, the savings I made by paying it off faster was a moral booster. There is a degree of emotional stress that comes with owing people money.
Whether it’s knowing that if you stopped making payments for whatever reason your car or house could be taken from you or general stress of having a monthly bill that comes with debt, I personally know that debt is stressful.
People who decide to pay off student loans, credit card debt, mortgages and car loans are often trying to get out of the debt cycle. The debt cycle is where you make payments to a lender without ever putting a dent on the amount that you owe. It is ridiculously frustrating to make payments for years while the balance doesn’t seem to get as low as you think it should. This is why not owing anyone is a reason to pay off debt verses saving just to get out of the debt cycle.
The rationale is that not only will you pay less in interest but then you can save whatever you have been paying out later with more peace of mind. This can be a struggle for some people and will involve sacrifice.
Discipline – Stop Spending Money You Don’t Need to
When paying off debt is a goal there will be a lot of sacrifice involved as mentioned above. You will probably have to give up shopping sprees, vacations and you will become more disciplined in that you will stop spending money you don’t need to. You will also find ways to ensure that you track what you spend because your money will be budgeted for debt pay off.
If most of your money goes towards regular bills and paying off dent it is implied that you will probably spend less on frivolous things. In a way paying off debt forces you to more frugal. Difficult conversations can be avoided later by paying off debt because no one wants to marry someone who has too much debt. See here questions you should ask your partner before moving in together.
Reasons to Save Before Paying off Debt
Set Up an Emergency Fund
Saving I general is great because it safeguards your financial wellbeing. It means that you don’t have to rely on debt in case of a future event that you aren’t prepared for. Debt as I mentioned can be more expensive than saving but you should always have money set aside for emergencies at a minimum.
Additionally, it is recommended that you save at least 6 months of your regular expenses. That’s because you could get laid off, you could get sick and not be able to work or a catastrophic event could happen that could impact the money you make. All these are things that you cannot plan for, but you can be prepared for them by saving.
An emergency fund is important for expenses that come up that require your immediate withdrawal of money. If your car breaks down, you have a co-payment at the doctors, the boiler or heater breaks down in your house and such life events that require money immediately.
Avoid putting yourself in a situation where you would have to borrow from family and friends or use credit cards and personal loans to cover such expenses. Even as you think about whether you should save or pay off debt consider setting money aside for an emergency.
Paying Yourself First
What I mean by paying yourself first is prioritizing your future. In addition to having an emergency fund and saving for 6 months’ worth of regular expenses you should also be putting money aside for retirement. I am constantly surprised by how many of my friends do not take advantage of retirement plans at their workplace.
You should consistently max out on your retirement savings because you are paying yourself first and protecting your future. No one wants to work forever and that should always be at the back of your mind. If your company offers retirement plans as a benefit, ensure that you are contributing towards it to get the match which is essentially free money. If it’s not a benefit that’s provided where you work, consider finding one through your local bank or investment companies.
Read how delaying on saving for retirement will impact how much you end up with. The earlier you start the better because if you don’t invest in your future you will work even after you retire.
Saving for your future makes sense when you consider the power of compounding interest if you elect your portfolios wisely. Put that money into your future verses paying off debt to protect yourself.
Conclusion
There is no right or wrong answer to whether you should save or pay off debt which is a great thing because everyone’s situation is different. If you are starting a family, then your priorities will be different compared to someone just getting out of college at their first job. Find a balance that works for you in the sense that if it makes more sense to pay off debt now to be able to buy a house later then make it a goal.
On the other hand, if you need to set up an emergency fund for medical emergencies, home repairs and life in general make that a priority right now and then revisit paying off debt later.
