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When I finally realized that having savings built up for emergencies was something I needed, I had to make the hard choice of deciding to pay off my current debt or to start saving my money. This was a hard decision since I knew both were important. So how did I chose which one to tackle first?
I started crunching numbers. It's easy to feel the pressure of needing to save but sometimes it's just not worth it. For example, I had multiple high-interest credit cards that were maxed out that charged anywhere from 20%-25% interest. Just to keep up with my credit card payments, I was paying over $160/month in interest. The hard truth was that even if I paid the minimum payment and allocated my extra funds towards savings, I would still lose money.
Today, if you are trying to make the hard decision of whether you should pay down debt or start saving, I hope this article gives you the knowledge to make the right decision for you.
PAYING DEBT BEFORE SAVING
I have learned from experience that it's better to get rid of high-interest debt before saving for an emergency fund or adding to your retirement. In general, if you have high-interest debt with interest more than 5%-7% and it is not tax-deductible, you should pay it off before saving. The simple truth is, you will not earn that much in interest on your savings but you have to pay interest on your debt. The simple math concludes that if the interest you pay is higher than the interest your earn, you are losing money.
Keep in mind, paying off debt before you begin to save is not for everyone. If you decide to pay off your debt first, this means you will not have money set aside for emergencies which could mean setting you up to take on more debt when an unexpected expense hits.
The main debt you need to be focused on is consumer debt. Consumer debt is used to fund consumption rather than an investment and includes things like credit card debt, payday loans, and rent-to-own agreements.
Consider this example. Suppose you have $1,000 in your savings earning 0% interest and you have $1,000 of credit card debt that costs you 10% interest. Essentially, your net worth is zero, since your assets ($1,000 in savings) minus your liabilities ($1,000 of credit card debt) equals zero. Every single month, your net worth will decrease as you accrue interest on your debt while you earn nothing on your savings.
If you pay off your credit card debt with your savings, your net worth remains unchanged but you essentially stop losing money. The hard part is that you might not have the $1,000 sitting around to give you comfort, but that comfort comes with a low return at a very high cost.
There is also another great benefit to paying off high-interest debt first. If you are struggling to improve your credit score, making the decision to tackle your debt first can really jump-start your plans to improve it. Consumer debt like credit cards and loans factor into your FICO credit score and it has a huge impact. In fact, the amount you owe accounts for 30% of your score. That's HUGE!
The number one thing you need to do to improve your credit score is to prove your credit worthiness. You can do this in a relatively short amount of time by paying off what you owe and lowering your balances. This will give you the opportunity to be eligible for lower interest rates for which you could use to pay off your debt faster. This is the exact method I used to pay off over $7,500 in credit card debt using balance transfer.
- Related: How to Create a Plan to Pay Off Debt
SAVING BEFORE PAYING OFF YOUR DEBT
I would only recommend this option if your debt has a very low-interest rate. If you decide to save money before tackling your debt, I highly suggest building your emergency savings first before you focus on saving for anything else. Consider a Savings Builder account from CIT Bank.
Unexpected costs are a huge reason on why people get into debt in the first place. If you have low-interest debt and you are only focused on paying it off, it can have huge consequences if unexpected needs arise. This might lead to you having to borrow again and it becomes a vicious cycle that's hard to get out of.
If you are wanting to focus on saving, I suggest you focus on a small emergency fund of at least $1,000. This will cover minor emergencies and gives you a great place to start. In you are wanting to plan for the long run, I suggest you save enough for 3-6 months worth of expenses. The best way to figure this out is by adding all of your monthly expenses (bills, groceries, kid's expenses, etc.) and multiplying that amount by 3.
Another area you should focus on is your retirement fund. If you have an employer that offers a retirement plan with an employer match, this is something you should definitely be taking advantage of. You don't have to devote all extra funds to your retirement but you should be contributing at least enough to receive the employer match. That's basically free, guaranteed money that you can't afford to miss out on. Thanks to compounding, even the smallest contributions to your retirement plan can have huge rewards in the long run.
YOU CAN DO BOTH
To this day, I still have debt that I am trying to tackle. Sometimes you just don't feel comfortable with any strategy, no matter how financially logical it may be. This is where I found myself. If you are like me and need the peace of mind of having savings set aside and still need to pay down debt, you can come up with a strategy to do both.
For example, if your goal is to build a mini emergency fund of $1,000 and pay off debt at the same time, maybe you can set aside $50/month for savings while using the rest of your funds to pay off debt.
Having savings built up to fall back on will give anyone peace of mind. The fact is, no matter what strategy you focus on if you are uncomfortable or feel stressed, it will only prevent you from sticking to your financial plan. It's important that you do what's best for you regardless of what you might read or hear.
I was able to save over $4,000 and still pay off over $7,500 in credit card debt by completing both strategies, paying off debt and saving money. I started with putting a huge chunk of my extra funds towards paying off my high-interest credit cards. At the same time, I put small amounts into my savings account every single pay-day. It was a small amount, only $25/twice a month at the time, but it gave me peace of mind that I was building savings that I could fall back on if something happened. It was this peace of mind and comfort that gave me the right financial mindset to continue on my financial journey.
As time passed, my credit score slowly improved and I was able to use balance transfers to help me cut down my credit card debt even faster.
If you have a ton of high-interest debt with limited income and not a lot of extra funds, I suggest you tackle paying off your debt first. After 6 months, if you feel like you are making significant progress, try putting $25-$50/month into a savings account. It's important to remember that you don't have to do only one or the other.
What strategy are you using to improve your financial life?