Imagine you’re unexpectedly awarded a $1,000 bonus at work. Score! You decide you’re not just going to spend it but instead either pay off debt or keep it as savings. Then, you wonder: “Which options makes the most sense financially?”
This question can be difficult to answer. Both choices have a positive effect, but which makes the most sense?
Ask yourself these questions to point yourself in the right direction when deciding to pay off debt or save the money instead.
Have Any Savings?
Most experts agree that having at least some cash savings is a must, especially in the case of emergency. At the bare minimum, consider keeping a small emergency fund of at least $1,000 no matter what your debt situation is. Having this fund will help prevent you from relying on credit when disaster does strike and further compounding your debt woes.
When considering building a full-fledged fund for emergencies before paying down debt, your decision should take into account how much risk you can tolerate. For example, do you feel your job is stable? Or is your company laying off workers? If you lost all income, how many months of savings would you need? Generally, if you’re more likely to experience a cash shortage, it’s best to consider beefing up your savings first.
What’s the Math Say?
If you’re after the answer that makes the most financial sense according to the numbers, doing some simple math and making comparisons will point you in the right direction. The basic principle: Will you benefit more from paying off debt or earning interest or returns on your savings?
When your debt is high-interest, like credit cards or other types of expensive debt, you’ll almost certainly benefit more from paying off debt before concentrating on savings. This is especially the case now as interest rates paid by savings accounts are barely offering any return. When looking at investments, even if you’re expecting an above-average return in the stock market, it’s unlikely to overtake the high interest rates of credit cards that can exceed 20% APR.
However, if you’re paying a lower interest rate on your debt, such as with a home mortgage with a 4% interest rate or a government-backed student loan, you might be better off paying down this debt gradually while padding your savings account. Even estimating a fairly-conservative 5% return in your retirement account means that investing would benefit you more than accelerating debt payments.
Mentally, Which Is More Important?
Sometimes we’re forced to make decisions that might not benefit us the most financially but are necessary for our mental well-being. Psychology and emotion certainly factor into our financial decisions, and planning for debt and savings are no exception.
Dealing with debt can be stressful, and if it’s ruining your life, you might be dying to pay off your debt right away. If you’re motivated to take action because you’re bothered by the situation you’re in, use that energy to your advantage to conquer your biggest challenge.
No matter how you proceed, be aware of what the best options are financially are so you can potentially adjust your strategy down the line. For example, once conquering all debt except your mortgage, you might think it’s a good decision to pay off your home before saving or investing. While your anti-debt mentality is admirable, you might be doing harm for later in life when you have a paid-off home but little money saved or invested.
Whatever you decide, don’t over-think the situation so much that you don’t take any action. If you’re someone that likes to plan carefully, start putting money aside immediately and be prepared to either apply that money towards debt or keep it as savings once you reach your decision.
Looking to Borrow? How’s Your Credit?
Do you anticipate applying for a loan within the next few months? If your credit score could use some help, consider choosing debt payments over savings since lowering your debt should have a positive impact on your credit score. Of course, failing to make even the minimum payments on your debt will surely damage your credit, so anything like this must be avoided if you’re looking to borrow money.
On the other end of the spectrum, having savings won’t help you improve your credit score anyway. While having money in the bank for a down payment is necessary, you won’t get to use your savings for that purpose if you aren’t able to get approved for a loan.
Can You Pull Off Both?
You don’t need to adopt an “all or nothing” strategy in every case.
Perhaps there’s room for both options within your budget and no need to completely dedicate yourself to one side or the other. While it’s important to have an emergency fund, there are plenty of other reasons to save, too. Retirement, college expenses, and vacations are all big expenses that are much easier to pay for when the saving takes place over time.
There’s no one answer that’s always right in this case. It’s going to depend greatly on personal situations and preferences. Do your best to figure out what path makes sense for you and get going!