Pay Off Debt or Save – What’s More Important?
It’s the age-old question for anyone struggling with their finances. Is it more important to save money or pay off debt? The answer depends on several factors.
Analyze Your Debt
Your debt isn’t just one giant number but a collection of smaller numbers. There may be revolving accounts such as credit cards or lines of credit. You can spend them up, pay them down and then spend up again. And you also may have installment accounts, like car loans, student debts or personal loans.
Installment loans can only be paid down. They generally have fixed rates and payments and make budgeting easier. The downside is that paying down your balance does not reduce your monthly payment. And in an emergency, you can’t go to the lender and ask for those extra payments back.
Paying down revolving balances generally reduces the minimum monthly payment. And it makes more credit available in the future if you need to tap it for emergencies. But revolving accounts can make it very easy to be trapped in never-ending debt.
Look at Your Savings
OK, now let’s take your eye off your debt for a moment and think about savings accounts. As of this writing and for some time now, savings accounts have unfortunately paid very low interest rates. Meanwhile, the average credit card interest rate is about 17%, according to the Federal Reserve. Directing your funds to pay down the accounts with the highest interest rate can mean you’ll save on interest charges and reduce the required payment if you experience an interruption in income.
There are other forms of savings, however, that don’t have such straightforward implications. Retirement savings can reduce your tax burden today and provide money in the future. You may also get matching contributions from your employer. Those would be foolish to forego.
So what to make of this? In most cases, you’re going to want to pay off high-interest revolving debt before saving. But not necessarily installment debt with low interest rates. And not by sacrificing contributions to better-paying investments.
Attack Your Debt: Snowball and Waterfall
There are two main ways that experts usually suggest bringing down revolving debt. You can do the “snowball” plan or the “waterfall” plan (sometimes called the “avalanche” plan).
You start your snowball plan by paying off your smallest balance as fast as possible. So if you have three credit card debts, you make the minimum payment on the two with larger balances and throw all your extra cash at the one with the smallest balance. When that debt is gone, then you take aim at the next smallest balance and finally the last one.
In other words, the money you are putting towards your debts gets larger and larger like a rolling snowball, trampling over your debts. It works because paying the smallest account first gets you motivated to keep going.
The waterfall method is actually smarter from a math standpoint. For that strategy, you target the account with the highest interest rate regardless of the size of the balance. You make minimums on accounts with lower interest rates. Once you clear the first account, put your money into the one with the nest-highest rate, and so on. This method minimizes your interest cost.
Replace Your Debt
Replacing revolving accounts with a personal loan or home equity loan may help you save money, improve your credit rating and simplify your finances. Do this only if you know that you won’t carry balances on your cards again or you’ll make your situation worse. A few helpful things to remember:
- Personal loan interest rates are often lower than credit cards.
- Personal loans have preset terms, usually from one to five years. You know when you’ll be debt-free if you stop carrying credit card balances.
- You can replace several payments with one.
- Personal loan interest rates and payments are usually fixed, making it easier to budget.
- Zeroing out your credit card balances can increase your credit score.
Once you pay off your higher-interest debt, put that monthly payment into savings. You’ll be on your way to long-term financial health.
You Need a Financial Emergency Plan
In case of a financial emergency, you need savings or access to credit. As a rule, it’s safer to have emergency funds in the form of savings rather than being able to borrow your way out of trouble. Credit limits can be lowered, after all, or your account could be closed. And it’s just better for you if you can avoid going into debt and take your own money from a savings account.
But getting enough money for an emergency can be tough. Experts recommend that you save enough to cover two-to-six months of living expenses. How much you need depends on the stability of your income.
So start thinking about what you’ll need for an emergency. For instance, if you spend $2,000 a month for essentials, you’d want access to $6,000 to $12,000 in a major emergency.
Next, start looking at your current financial picture, so you can figure out how much you need to save or borrow for emergencies. For instance, if you have an unused $3,000 line of credit, and $1,000 in the bank, you could apply for a $2,000 increase in your credit line. Or you can divert income into savings until you have $3,000 in the bank.
What’s Better for Emergencies: Saving or Borrowing?
Try both. You can apply for a credit line or an increase to your current limit. But only do this if you know you have a healthy amount of willpower and aren’t going to use the extra for anything other than a real emergency. And every month in which you don’t have an emergency, put as much of your income into your savings account as you can.
Because obviously it makes good sense to have an emergency fund. And you should start saving right away, with the goal of having enough in an account to pay two-to-six months’ worth of bills. Even a few dollars a week will at least eventually create a financial cushion that will help you navigate financial problems. But because that can take time, and if you don’t have enough in savings to cover emergencies, it might make sense to set up a personal loan for emergencies now.
Personal Loan for Emergencies: What it Costs
Credit cards are easy to you and great for covering costs. But they can be a terrible to finance those costs over a longer term. In May of 2019, according to the Federal Reserve, the average interest rate on a personal loan was 10.63%. Contrast that to the 17.14% rate charged on the average credit card balance.
That said, with some financial emergencies, you need the money now and may not have time to apply for a loan and get the funds by the time you need the money – and if it’s a cash crisis, such as needing to pay off a huge debt, that could make it harder to qualify for a loan.
That’s why having a personal line of credit handy – one that you may or may not use, but you have access to immediately – can help serve as a ready-to-go-to life preserver. A line of credit is a commitment from a lender to loan you money whenever you need it, obviously within certain parameters of how much you can borrow and for how long.
That’s why it’s always a good idea to compare programs to find the least expensive one for your situation.
Reducing Emergency Loan Costs
Having a line of credit can be an economical way of securing a personal loan because you only have to pay interest when you are using the money. That said, there are some additional maneuvers you can take to make this strategy more affordable:
- Plan multiple uses for your line of credit.
The cost of procuring and maintaining a line of credit just in case you have a financial emergency is a bit like purchasing a fairly expensive form of insurance. Still, if you have several uses for your line of credit, such as a series of repairs or home improvements you plan to tackle over time, the costs involved can become more worthwhile.
- Avoid using a line of credit like an ATM.
While a line of credit can give you easy access to money on demand, don’t treat it like your own personal ATM. Or, rather, do think of it like an ATM – but one with fees. You may receive transactions charges in a fixed dollar amount, which means they can represent a huge portion of the money if you’re borrowing small amounts. Plan your transactions to come in larger chunks to reduce the relative impact of transactions charges.
- Shop around for the best terms.
Like loan terms, the interest rates and fees associated with lines of credit can differ a lot from lender to lender. You won’t know if you’re scoring a great deal until you familiarize yourself with what type of lines of credit are being offered.
How to Build Emergency Savings
Using a line of credit as a life preserver can be a good way to protect yourself from a complete financial meltdown, but it will always be a more expensive strategy than having some emergency savings on hand. Consider this approach for transitioning from depending credit to being financially secure.
First, if you take out a loan, whether it’s a line of credit or a personal loan, you’ll eventually have to repay it. So take a look at your budget and figure out how much room you would have for loan payments under normal circumstances. Add that to your budget. That number can decide how much you’re willing to borrow.
Second, during the months you don’t use your line of credit, the budgeted payment can go into savings. By doing that, you can create emergency savings over time. And then when you’re able, you can pay yourself instead of a lender.
Don’t Forget Retirement Savings
If retirement seems like a million years from now, saving me not be a priority. But you should rethink that, because much of what you’ll have to live on when you quit working naturally hangs on when you start saving. If you start saving for retirement at age 20, and you manage to put away $6,000 a year and get an average return in the stock market, you’d have over $1.3 million by the time you’re 60. But if you put it off saving that same $6,000 until you’re age 30, you’ll have less than half (about $610,000) at age 60. The extra ten years makes a huge difference.
Typically, the order in which you tackle your financial health should be:
- Eliminate your high-interest debt.
- Create an emergency savings fund.
- Fully-fund retirement accounts.
- Pay off low-interest installment debt.
If your employer offers retirement plans and matches your contributions, max out your matchable contributions. Anything less would be stupid and wasteful.
It’s also very helpful if your employer allows you to borrow against your 401(k) plan for emergencies. In that case, you may want to not worry so much about the emergency savings fund and focus on getting rid of your high-interest debt as soon as possible and get into your company plan as soon as possible. Automatic payroll deductions for your retirement should hopefully prevent you from spending it when you shouldn’t. And it should give you some peace of mind, knowing that if any true financial emergency crops up, you can borrow against the account.
Frequently Asked Questions
Q: My wife and I are recently married. Between us we have about $20,000 in bills and $25,000 in savings. I’m concerned that if we take the savings and pay off the debt, it will leave us cash poor with no emergency funds. Also, I own a house that is about $10,000 upside down, but we’d like to buy a different house. If we use the savings to pay off the bills, there goes the down payment on the house. What’s the best course of action?
A: Your question touches a central aspects of financial planning, and that is prioritization. People often find themselves with competing financial goals, so they need to go through the process of deciding which is most important.
Before discussing the goals raised in your question, it’s important to address two missing pieces of information:
- Do you and/or your wife have steady jobs?
- Are you living within your means?
If you don’t have steady jobs, then the strategy would be to hold onto as much cash as you can, paying just the minimum bill payments to avoid delinquency. Also, if you are racking up new bills at a faster rate than income is coming in, your first priority should be to cut your expenses.
On the other hand, if you have good jobs and are living within your means, you can turn your attention to the financial goals raised in your question. One thing that might help you prioritize those goals is a look at some interest rate differentials:
- Interest on savings accounts is down to an average of 0.09 percent.
- Current mortgage rates are below 4 percent.
- Credit card interest is running at about 13 percent.
What this adds up to is that you don’t get paid much for savings, while credit card interest is very expensive. Current mortgage rates are a good deal, so if you have to have debt, it is much better to have it in the form of a mortgage than in credit card debt.
Given this environment, you might want to think about applying your savings to pay off your outstanding bills. This will still leave you with $5,000 for emergencies, and assuming you are steadily employed and living within your means, you can start rebuilding that savings. This approach will sharply cut your interest expenses, and should help your credit record. That record will enable you tap into credit in an emergency, and will help with your eventual goal of getting a new mortgage.
However, that new house may have to be put off for a year or two. This will let you rebuild both the equity in your current home and your savings for a down payment.
Q: I owe approximately $70,000 on a mortgage. The home was purchased in 2005 for $149,000, and now the interest is fixed at 4 percent. Current payments are just under $800 a month. I have saved $70,000 that is earning 1 percent, and have no major bills or debt besides the mortgage. I would like to keep enough for six months in an emergency fund, and put a big chunk toward the mortgage. Is this OK?
A: There is a recurring theme to questions like this: There is no one right strategy for all people, because it really comes down to the specifics. In your case though, you have certainly set yourself up to deal from a position of strength.
Prepaying your mortgage is a worthwhile option to consider, because it is hard to imaging refinance rates getting low enough to justify your refinancing again (assuming that is how you got a 4 percent rate after originally buying in 2005, when rates were considerably higher). Thirty-year mortgage rates are currently at around 4.5 percent, and 15-year rates are at a little above 3.5 percent, so unless there is a major slide in refinance rates, 4 percent is probably the best you are going to do.
So, as for the prepayment option, here are some things to consider:
- Potential tax benefits. While your mortgage is at 4 percent and interest on savings accounts is at 1 percent or lower, keep in mind that the deductibility of mortgage interest does narrow this gap somewhat — if you are in a tax position to take advantage of it. Just make sure you have factored this in when weighing your options.
- Prepayment penalties. Check your mortgage to make sure there is no penalty for paying off the loan early. If so, those penalties often have expiration dates, meaning you might want to invest the money for now, and pay off the mortgage after the prepayment penalty expires.
- Income. It sounds like your balance sheet is in good shape, but what about your income? Are you earning enough to cover your bills, and most importantly, how confident are you in your source of income? If you have any doubt about your income, lean toward keeping your money liquid.
- Retirement savings. You might consider putting some of your money into retirement savings rather than your mortgage. Between the tax deduction of mortgage interest and the tax deferral of retirement earnings, you stand an excellent chance of earning more on money invested this way than you are paying on the mortgage.