Should You Save Money or Pay Off Debt?
Paying debt and saving money are both very important financial goals. They’re also steps you have to take to reach a bigger life goal—living well during retirement. You may want to go into retirement debt-free, but focusing on debt repayment now could mean you have to sacrifice building up your retirement savings. But how do you choose the best place to spend your money?
You might need to adopt a blended approach and save some while you pay down some of your debt at the same time. When you understand the pros and cons of paying only debt or only savings, you can better assess your own situation and see how to tweak your savings and debt-payments to move your goals forward in each area.
Paying Debt and Skipping Savings
If you pay your debt first and put no money in savings, the downside is that you'll have nothing but your credit cards to fall back on if you have a financial emergency. You can count on some type of expense coming, and it's usually when you least expect it. Using your credit cards to fund an emergency only makes it harder to pay off your debt.
When to Put Debt Payment First
Pay your debt down before saving if you have credit cards with high interest rates. By reducing your owed balance, you'll also reduce the dollar amount of interest you pay each month. This can give you a bigger break financially than gains you could be earning in the stock market, and certainly more than you'll earn in a savings account.
When it comes to fixed-payment loans, such as a student loan or mortgage, extra payments can reduce the duration of your loan because your lender will apply the money to future payments. However, be aware that the lender won't recalculate the loan to lower your monthly payments. If you're worried you'll lose a tax deduction by paying off either of these types of loans early, the tax deduction is likely smaller than the amount of interest you would have paid for the year on your loan.
When you make an extra payment on a mortgage, student loan, or auto loan, be sure you indicate that the extra amount should be applied to the principal. Otherwise, the additional amount will be applied to a future payment rather than reducing your overall balance due.
Saving Without Paying Down Debt
If you save first and don’t focus on paying down your debt, you'll pay more money over time in credit card interest charges. Since credit card interest rates are often higher than savings interest rates, you end up spending more money on debt interest than you'd earn on your savings investment.
The other problem with prioritizing savings is that you risk entering retirement with debt. You may find that you can’t live comfortably on your retirement savings while also paying your debt. This may force you to either live on a strict budget to pay off your debt or go back to work until your debt is paid off.
When to Save First
While it might feel uncomfortable, there are actually some situations where it makes sense to pay into your savings first and then work on your debt. If you're lucky enough to have debt with a low interest rate, it makes better sense to put most of your extra money into savings first, at least until you've filled up your emergency fund. Once you jumpstart your emergency fund, then you can put the focus back on paying off your debt.
The ideal emergency fund would cover three to six months of living expenses. However, if this seems difficult in the short term, focus on building a small $1,000 emergency fund. That money can cover many small but urgent expenses like car repairs that would otherwise be charged to your credit card.
If you delay your retirement savings until your debt is paid off gone, you're sacrificing time for your savings to grow. The longer you wait to start saving, the more you have to pay to reach your retirement goal.
If you start saving earlier and put your money into an interest-bearing account, you get the benefit of years of compound interest on your investment. For example, say that Bill, a 28-year old, starts investing $5,000 per year and continues until he retires at 58. He will have saved $150,000 with 30 years of compounded interest, which will bring his total retirement savings to just more than $470,000, assuming an average 7% annual yield.
His friend Larry started putting away $5,000 each year when he turned 18, until he also retired at 58, with $200,000 invested with 40 years of compounding. Those 10 extra years of compound interest grew Larry's total savings to just under $1 million or more than twice the amount of his friend Bill's nest egg.
You can fuel your retirement savings by taking advantage of your employer’s offer to match contributions to your 401(k) plan—don’t turn down this free money. There are also tax benefits that come with retirement savings. The money you contribute to a 401(k) can often be excluded from your taxable income, resulting in a smaller tax burden. Even if you put money into a 401(k), you may be able to budget your spending and find money to allocate to paying off your debt.
The Best Approach Is to Pay Both
Ultimately, it's best to find a balance between the amount you spend on debt and savings each month. It isn’t wise to put off either of these in lieu of the other, so devise a way that you can split your money between the two. For example, if you have an extra $1,000 each month, put $500 toward your debt and $500 toward saving. You might pay a bit more in interest, but you'll have the peace of mind that comes with having money in the bank to keep you out of the debt cycle and make your retirement years more pleasant.
Internal Revenue Service. "Retirement Plans Topics Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits." Accessed Jan. 31, 2020.