Paying down debt vs saving
Paying down debt vs saving—it’s a balancing act that many of us face. But how do you strike that perfect balance? The answer depends in part on whether you’ve got enough money already stashed for emergency savings and how much high-interest debt you’re carrying. In some cases, you may want to undertake saving and paying down debt at the same time.
It’s really about understanding opportunity cost.
Here’s an example that shows opportunity cost when considering whether to priortize paying down your debt or saving. If you’re likely to earn 6% in annual returns from retirement savings, but you’ve amassed credit card debt with an APR (annual percentage rate) of around 18%, your best bet likely will be to first clear out the debt. Why? Because paying 18% credit card interest will more than cancel out the 6% you’ll earn from your savings.
Here are the top factors to consider when deciding whether to priortize saving or paying down debt:
1. Interest Rates
Compare the interest rate on your debt with the rate you can earn on savings. High-interest debt, like credit card debt, tends to have interest rates that are much higher than what you can earn from traditional savings accounts, or even a high-interest savings account.
2. Emergency Fund
Before aggressively paying down debt, it's generally a good idea to have an emergency fund in place to cover unexpected expenses without taking on more debt. The general best practice here is to have enough saved to cover your expenses for three to six months.
3. Debt Type
High-interest, unsecured debt (like credit card debt) should be a priority to pay down, while low-interest, tax-deductible debt (like certain student loans or mortgage debt) might be manageable to maintain while saving.
4. Upcoming financial goals
Are you considering make a big purchase such as a home soon? If so, you might want to prioritize saving.
5. Credit Score
Paying down debt responsibly can positively impact your credit score, which can affect future borrowing opportunities and interest rates.
Credit card APRs are the highest they’ve been in 20 years
Considering how the average interest rate on credit cards is close to 21%, it's crucial for consumers to compare options before applying for new credit, as this could lead to expensive debt.
Credit card APRs have been increasing alongside the Federal Reserve's interest rate hikes, which are intended to slow down the economy and curb inflation.
How to be smart about what debt to target
The “golden rule” dictates that you first pay attention to high-cost debt without any collateral, such as high-interest credit card debt or a high-interest personal loan. If you’re fortunate enough to be free of high-interest debt, be sure to reduce any remaining debt balances while still carving out money for savings.
Paying off any debt that’s overdue should always be your top priority. Overdue debts can hurt your credit score, because of late fees and—if it’s mortgage payments we’re talking about—even lead to foreclosure.
Once your high-interest and overdue debts are paid, you can move on to paying off the rest of your debt using either the debt snowball method or debt avalanche method.
- Debt snowball: This method has you list your debts in order from the smallest amount to the largest. Starting at the beginning of the list, pay off your debts from smallest to largest (while making minimum payments on all debts).
- Debt avalanche: This method has you arrange your debts by highest interest rate to lowest. Disregarding the debt amounts, start by paying off the debt that has the highest interest rate (while making minimum payments on all debts) before working your way down the list.
Find your balance
The problem for many Americans is that their debts are so significant compared to their monthly income that it will take many years to pay the balance down to zero. While it might be tempting to simply postpone saving while you’re paying off debts, that often isn’t a realistic option. Even families with high debt want to be able to purchase a home, have a child, pay for college or provide support for ailing loved ones — and that requires substantial savings.
The key, then, is to find the balance that works for you and your family, agree on a plan and stick with it. Many experts recommend prioritizing paying down significant debt while making small contributions to your savings. Once you’ve paid off your debt, you can then more aggressively build your savings by contributing the full amount you were previously paying each month toward debt.