Should I pay down debt or save?
Digging out of debt and building savings are equally important goals. Consider tackling them in tandem.
Outstanding debt and the interest charges that come with it can derail your financial plans. But although paying down debt in a timely fashion is good practice, repayment shouldn’t come at the expense of saving for emergencies or your future. Instead you could repay debt while you build savings. The question is how best to divide your money between those goals.
If you channel the majority of your money into repaying debt, you risk having nothing to draw on in case of a financial emergency. What’s more, the longer you wait to save for retirement, the less time you give your money to benefit from potential market growth.
On the other hand, ignoring debt repayment can eat into the savings you have, and cost a lot over the long run. Ultimately you can take on both with a little planning.
Here are a few things to keep in mind as you work toward the right balance.
The interest on some debt (credit cards in particular) can be very high—much higher than the interest you could earn by saving or investing money.
Take a credit card with a $5,000 balance and a 13 percent APR (annual percentage rate):
In this case it makes sense to prioritize paying down the debt. Ultimately you save more by paying off the debt and leaving its 13 percent rate behind than by saving or investing your money elsewhere.
Generally speaking, it’s probably a good idea to pay down a debt as quickly as you can if the interest rate is several percentage points higher than what you believe you can make on the money you save or invest.
Broken appliances, car repairs, health crises — it’s a good idea to set money aside to cover unexpected expenses. Otherwise you could end up taking on more debt or even need to tap into retirement savings.
- Many experts suggest saving the equivalent of three to six months of living expenses for an emergency fund.
- If you can’t sock away that much at first, start with a smaller goal such as $1,000.
- As you pay down high-interest debt, put away a little money in savings each month so you work toward increasing that emergency fund.
Thanks to the power of investment growth — your investment earnings may produce earnings of their own — the earlier you contribute to retirement accounts, such as 401(k)s and IRAs, the more potential your money has to grow. Remember, however, market returns are never guaranteed, and you could lose money.
If you pay down debt, you may not be in a position to save as much as you like, but you could still aim to increase what you save. Increasing contributions by just one percentage point each year can potentially increase your savings over time. If you have an influx of cash because of a tax refund or bonus, consider applying a portion of it toward debt repayment, and put the rest into a retirement account.
What about saving for other medium- and long-term goals, for instance your kids’ education? Financial advisors often suggest retirement savings should come ahead of education because you can borrow money for education but not retirement. Saving for shorter-term goals like a vacation, can come after you establish that emergency fund.
Ultimately how you allocate money to debt repayment and savings depends upon your circumstances, including the interest on the debt you carry, and the emergency and retirement savings you already have.
Be sure to consider all these factors when creating a plan that meets your family’s needs and goals.
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