The material presented here is for educational purposes only, and is not intended to be used as financial, investment, or legal advice.
Should You Save Money, Pay Off Debt or Both?
You have big financial goals you want to reach. Maybe it’s buying a new car, taking a trip abroad or being the first one in your social circle to start saving for retirement. But you also want to pay off your credit cards and student loans. You might be asking yourself, “Should I save money or pay off my debt first?”
The answer depends on multiple factors, including your debt load and budget. Ideally, you probably want to work toward paying off debt and save for your goals, but that may not be possible right now. Here are some things to look at when deciding whether to pay off debt first, build your savings now or do both at the same time.
Your Credit Card Interest Rates
According to WalletHub's Credit Card Landscape Report, the average credit card interest rate on new offers is nearly 20%!1 And that’s not counting the higher rates most credit card companies charge for cash advances.
With your 20% interest card, you’d be paying about .055% interest daily (20% divided by 365 days), which doesn’t seem like much. But if you carried a $2,000 balance for a year, you’d be paying an extra $200. Just imagine what you’d pay in interest on a $5,000 bill or a $15,000 bill!
That’s why it’s so important to pay down credit card balances as quickly as possible. Paying only the minimum required payment, it can take years or even decades to pay off a large credit card bill in full.
What Can I Do?
If you have higher interest credit cards, start by shopping around for a better deal. Compare rates online, or contact your credit union or bank directly to ask about lower interest credit card options. Don’t be swayed by sexy intro rates or cash rewards; focus on getting a low rate without strings attached.
In the meantime, look at your budget and see where you can trim from entertainment, clothing or other optional categories. Put as much as possible toward your existing credit card debt. Even if you only have an extra $10 or $20 a month to put toward your credit card bill, you’ll get to a zero balance that much faster.
Your Credit Card Balances
Low interest cards are great, but you’ll also need to look at the balances you’re carrying. Are you constantly paying off credit cards only to put more on them right away? Do you have high balances in comparison to your income? The numbers don’t lie.
If you make $80,000 a year and have $8,000 in credit card debt, that’s only 10% of your income. Still not great, but you could probably pay that off in a year or two without making huge sacrifices.
But if you make $32,000, you literally owe a quarter of your salary just to credit card debt. That could potentially take a lot longer to pay down.
What Can I Do?
If your credit card balances are high, the first thing you should do is STOP. CHARGING. Try to live within your means for a while as you pay down that debt. Take a breather from making new purchases and tap into savings only if an emergency arises.
Many people find the snowball method of debt repayment helpful. The idea is simple: just start with the lowest credit card balance you have and work toward paying it off. Once you’ve done that, move to the next one and so on.
But if your debt load is high and/or you have high-interest cards, you may want to opt for the avalanche method instead.2
How it works:
- Make the minimum monthly payment on all of your credit cards.
- Channel any extra money you have into paying down the highest interest credit card first.
- When that’s done, move to the card with the next-highest interest, and so on.
Your Loan Balances and Interest Rates
When figuring out how you’ll save money while paying debt, look at your loans too. Let’s imagine you took out a $20,000 loan to buy a new car a few years ago. By making regular monthly payments of $230, you’ve whittled your balance down to around $5,000. Is it worth it to save $5,000 cash to pay off the balance on your car loan in one big chunk? Should you pay more than your monthly car payment each month to pay the loan off faster? Or would it be better to put that extra cash into savings or investments and just make your standard monthly payments until you’ve paid off the car?
You’ll need to do some math to figure out the best answer (on paper) and some soul-searching to discover what would work best for you.
- Find out how much you still owe, and how much you’ll be paying in interest on that amount.
- If you’re thinking of paying more each month than the minimum, use an Early Payoff Calculator to see how much you’ll save in interest.
- Check rates on money market accounts, savings accounts and other investments you’re considering to see how much you could earn if you deposit that extra cash instead.
What Can I Do?
Existing loans aren’t always set in stone. Loans can often be refinanced, either through your original loan holder or another financial institution. Check with places you’ve already built a relationship with first (e.g., your loan holder or local credit union). You may be able to refinance your loans at a lower rate, saving yourself big bucks on interest in the long run.
Is Your Debt an Emergency?
That depends on the debt. Some personal finance blogs, like Mr. Money Moustache, consider any debt a “HUGE, FLAMING EMERGENCY!” The ‘Stache, aka Canadian-born author Peter Adeney, advises buckling down and paying off debt as soon as you take it on.3 Then again, his blog focuses on retiring early, so if that’s not your end goal, you might not want to treat debt as a fire drill.
Here are a few more reasons to pay down debt first:
- Peace of mind. 68% of Millennials say that debt is damaging their lives, according to a Harris Poll survey.
- Your debt-to-income ratio is high. If you’re looking to buy a car, a home or another major purchase, lenders will look at how much of your monthly income goes toward debt. Bringing this number down may increase your likelihood of being approved for financing.
- Creditors are knocking on your door. If you’re behind on loan or credit card payments, you’re at threat level orange. If you’re behind more than a month or two, it’s Code Red! Alert! Alert! Before you start saving, get back on track with your creditors and make sure you get your account to “current” status.
The Verdict: Match Your Solution to Your Situation
At the end of the day, some of your decision to save or invest money and/or pay down debts might be dictated by how much extra money you have and the situation you’re in.
- If your budget is super tight, you may have to choose one over the other.
- If your debt is at crisis level, you may want to address that first.
- If your debt is mainly low-interest loans, you may come out better funneling your extra funds into a savings or money market account.
There’s a lot to consider. By taking the time to research your debts and your savings options, you’ll be able to make the right choice for your current situation. Plus, you’ll know what options will be waiting for you as your financial health starts to improve!