Should you pay debts first or save? Use these guidelines to decide.
In the last post (“Dec 2020 – You Can Accomplish a Lot with the Right Budget”), I discussed managing your budget. This post will suggest some ideas about paying debts.
The struggle is always whether to save or pay debt first. This year has stressed everyone’s finances in some way. Many have tapped into their emergency savings, if they had it. Others have fallen further into debt.
Juggling debt and worrying about building your savings at the same time can really weigh on a person. There is no right answer but here are scenarios for each choice to help decide a method that suits you.
Sometimes saving is preferable. If you have access to a credit card with low interest rate (not double digit!!) This method may be easy but it truly is only a short term solution.
If your 401k has an employer match then you should contribute at least enough to get the maximum employer match. If you are not doing this, you are effectively turning away free money. Delaying saving for retirement until you are debt-free could cost you your most valuable asset, time. With compound interest, even small contributions to your retirement plan can grow significantly.
The most compelling reason is saving to build your emergency fund. Without some money saved, any unexpected event, like a car repair, will cause you to incur credit card debt when it may be very expensive. Avoid incurring and paying off debt seem like a revolving door.
This year has shown us that many things can go wrong, and all at once! There are reports that 23 percent of Americans say their biggest regret is not having enough money to weather the crisis. Saving first to build up a decent emergency fund could spell the difference between weathering tough times and bankruptcy court.
The common advice has suggested an emergency fund to cover 3 to 6 months of expenses. The events of this year seem to indicate that even more is needed. Carefully look at how dependable your sources of income are. Let that be a guide. Just start with the objective to have enough for one month. Do not let the scale of a financial project deter you.
For those who are fortunate to still have an income and the ability to work from home, this could be a great time to build your savings. Expenses are related to saving, so look carefully at your bills to adjust some plans, like TV entertainment access or home cleaning service, to opt for a plan which is cheaper and still meets your needs. Even small reductions can help with a savings program.
Do not be shy about managing debt. You may want to contact your lenders and providers to discuss temporary payment relief options. Often the amount on your monthly bill may be more adjustable than you expect. Sometimes subscription services like telephone, cable and internet service are negotiable. This can help prioritize your bills and free up some of your available cash to go to your savings
Interest rates are very low right now, which means there is not much incentive to save, but there is incentive to borrow. Keep your perspective. Your savings is for protection. It may not pay much interest but that is secondary. Easy access and flexibility are the characteristics you want. Low interest rates may be the price.
Now to paying debt and setting priorities. High interest consumer debt is an obvious target to manage your money and avoid larger problems. Cutting your interest payments is a certain investment return. If you do not send it off, then you have saved it!
Here are four points to consider about repaying your debt.
First calculate what money remains after taxes, bills, and food. Then list all your regular expenses, even if not monthly, to identify anything you can eliminate. Create a budget based on that number and include paying down debt as a part of the budget plan. Give the debt repayment as much personal priority as a regular bill. Leave some slack so you can have some fun!
Consider a credit card balance transfer. This can allow you to consolidate all of your credit card debt onto one low-rate card and save you money on finance charges.
If you already have adequate savings in your emergency fund, you may want to focus on quickly eliminating debt. If you are making only minimum payments on debts with extremely high-interest rates, those debts are a financial “leak” reducing your ability to achieve your overall financial goals. Therefore, you may want to focus on paying off that costly debt.
Sometimes I hear people resist paying a tax-deductible debt versus saving. The deduction is almost certainly worth less than the interest you would have paid on the loan. Do not let the tax “tail” wag the dog.
The best method is to strike a balance between saving and paying off debt. You might pay more interest than you could, but having savings to cover sudden expenses will keep you out of the debt cycle.
Additionally, having sufficient savings provides peace of mind. Some people are most comfortable with a minimum level of savings. Saving and paying down debt might be the best approach. They certainly are not mutually exclusive. A sound financial position can provide stability in many ways.