Having outstanding debts is pretty overwhelming and more so if it interferes with your ability to save. When in this situation, you can’t help but grapple with what to prioritize between paying off debts and saving.
Whether you want to save for a rainy day, for a house, or retirement, you could face a hurdle if you have a huge debt hovering over your shoulders. Worst is, it’ll delay your financial goals.
While it may be tempting to put off saving and pay down debt, the debt may be too great compared to your disposable income. Thus, it’ll take several years to pay the balance down to zero, making paying off debt first an unrealistic option.
But even with significant debts, you still want to save for retirement, purchase a home or pay for college, which requires substantial savings. Fortunately, there are winning approaches that can help you balance both paying off debt and saving money.
If you understand the advantages of both, it can help create a customized plan for mastering your finances to reach your financial goals. This piece will help you understand how to strike a balance between paying off debts and saving money.
When to Make Saving Money a Priority
There are three main reasons why you should prioritize saving money:
If You Don’t Have Emergency Savings
When you don’t have any money saved for a rainy day, it’d be prudent to add some of your disposable income to such a fund. An emergency fund is money used to cover an unexpected expense or meet unforeseen financial needs like job loss, car trouble, HVAC issues in your home, etc.
Why Create an Emergency Fund?
While you may have debts pushing you over the edge, most personal finance experts recommend prioritizing emergency savings. Putting aside something small will create a safety net when the unexpected occurs.
You could lose your job or get ill, which requires savings to fix such a financial crisis. That means you won’t turn to high-interest credit cards, payday loans, or personal loans to cover such abrupt costs that would push you further into debt.
It’s recommended to have savings of at least six months worth of your expenses such as rent, food, and utilities soaked in an emergency fund. However, this may be a challenge if you’re dealing with debts or still having financial struggles. In such a case, you can set aside savings for three months’ worth of expenses instead.
Make small efforts and remember that having something for a rainy day is better than having nothing at all. Start by opening a high-interest saving account for your emergency fund so your money can grow. Then, to make it easy, set up a standing order or direct debit to regularly transfer money into your savings account. Finally, make sure to set savings goals so that you know:
- The amount of time it’ll take to reach your goal
- How much you’ll save
- The tax you’ll pay and tax-efficient savings to go for (e.g., ISA allowance)
While saving for an emergency, at least pay minimum amounts to settle some of your high-interest debts.
If You Have Access to a Retirement Plan and an Employer Has a 401(K) Match Program.
In such a case, it would help if you try to contribute at least enough to reach the maximum employer match. If you don’t do this, it means you’re leaving free money on the table. Keep in mind that if you put off saving until you’re debt-free, it could cost you ‘time,’ which is pretty valuable. Small retirement contributions can grow significantly with compound interest.
For example, if your employer saves up to $250 in your retirement account, match it up with an equal contribution. After meeting the income requirement, you qualify for the saver’s tax credit of up to $1,000. This tax credit is also available if you decide to add an equal amount to an individual retirement account instead of the 401(k). This helps minimize the overall cost associated with funding the retirement account.
When Your Debts Have Very Low Interest Rates
If your debts have low interest rates, then it’d help to save more while making minimal payments towards debt settlement to avoid late fees and prevent hurting your credit scores. Typically, it’s a good idea to save and have some outstanding debt provided you:
- Clear off your credit card bill monthly
- Keep up with mortgage payments
- Don’t have other bank loans, credit cards, or credit commitments with high interest costs that you could earn on your savings.
When to Prioritize Paying off Debt
One of the main factors that help determine what to prioritize is the interest cost versus interest earned. If you’re spending more on borrowing than you are receiving on your savings, focus on paying off loans first. Then, determine the savings plus interest versus the net financial results of the reduced interest on the debt.
How to Pay off Debts
Here are two methods to consider when you want to pay off your debts:
This involves creating a list of your debts by total amounts and prioritizing the smallest ones. Then, you gradually work your way up to the most expensive ones. The benefits of this method are more psychological than financial. Most people who use this strategy enjoy the satisfaction of paying off small amounts first as it helps lessen the burden of debt.
This method involves ranking your debts based on interest rates rather than the overall dollar amount. With the avalanche method, you prioritize clearing off the balances with the highest interest rates while still making minimum payments each month on other loans. So, when you have a mix of credit like student loans, credit cards, personal loans, title loans, payday loans, etc., your objective should be to clear off the expensive ones first. Here are some examples of high-interest loans:
- Credit card debt (most of them)
- Unauthorized overdraft
- Store card debts
- Catalog shopping
- Door-to-door lending (home credit)
- Payday loans
Experts recommend trying to make payments beyond the minimum amount each month. Thus, if you get extra money, say a gift or some savings on groceries, you assign it to pay those debts.
Pros of Prioritizing Paying off Debt
Prioritizing paying off debt comes with numerous benefits:
- It helps improve your credit score
- You reduce the total amount of interest paid over time.
- Once you clear all debts, you can fully focus on your savings goals
- Alongside financial relief, paying off debt can also offer mental and emotional relief
Pros of Prioritizing Savings
On the other side of the equation, getting a head start on saving money has numerous advantages:
- The sooner you begin saving money, the more time you’ll have to gain from the compounding interest. Compound interest is the interest earned in an investment account, savings account, CD, or money market account. So the more time your money remains in these accounts, the more it’ll grow.
- Savings offer a safety net. When you have some money saved up, you can avoid getting new debt when a financial crisis occurs. Without emergency funds, you may be forced to use a high-interest credit card or to take out a loan (e.g., payday loan) to fix the issue. Adding such debts in the process is counter-intuitive to clearing off your debts.
- When you have more time to save, you don’t have to wait until your debts are fully paid to work on your financial goals.
- Starting early and saving up for retirement will increase your nest egg. You’ll accumulate more if you save over a longer period.
- If you get a head start on saving, you’ll attain long-term financial goals such as traveling, buying a home, or saving for college.
Can You Pay off Debt and Save?
Yes! You can pay off your debts and save simultaneously. However, this requires planning, strategizing, and streamlining some of your spending habits.
You can start by reviewing your budget to determine the money you’re using towards debt repayment each month. Then find out if there are ways to make your debts less expensive. For example, you can consider refinancing your student loans or transferring your high-interest credit card to a new card with a 0% APR. This can help reduce interest rate charges and allow you to pay more toward the balances you owe.
Another strategy is to check if you can cut back on certain expenses or fully eliminate them. Whatever the amount you squeeze out of your budget should go towards both your debt settlement and savings account. Decide how you’ll split them for a good result. In the long run, this will help you achieve financial freedom.