Paying off debts can make it difficult to save and there’s no one-size-fits-all best way to accomplish both goals. Some advice calls for paying off all debts as soon as possible and waiting until you are debt-free to try to save. Other experts suggest focusing first on accumulating sufficient emergency savings and only then trying to pay off debts. A third method is to balance savings goals against debt payoff, devoting a portion of available cash flow to building savings while directing the remainder to paying off debt, focusing first on high-cost debts. Get a financial advisor to help you balance debt payoff, savings and other financial objectives.
Debt vs. Savings Basics
In purely financial terms, it is smarter in most situations to pay off debt first rather than directing available cash to a savings account. That’s because savings accounts pay much lower rates of interest than the majority of loans. This is especially true when it comes to credit card debts, which typically charge rates of 15% to 20% on outstanding balances, many times the 0.1% that has long been the standard interest rate paid by banks and credit unions on savings account deposits.
However, a number of other considerations may make this decision less obvious. For instance, much personal financial advice calls for prioritizing the accumulation of an emergency fund consisting three to six months of living expenses in a bank savings account before focusing attention on debt reduction. Also, some debts, such as mortgages, may provide tax deductions that can make it less beneficial to pay them off.
Personal considerations such as age, number of dependents and health can also impact debt v. savings decisions. Younger people may be better off putting money into a long-term retirement account than paying off current debts, for instance. And, if an employer matches contributions to a retirement account, that can increase the benefits of saving so much that using money to pay off debt rather than save for retirement makes less sense.
In addition, emergency savings aren’t the only reason to accumulate money. Purchasing a home, for instance, usually requires a buyer to have a large amount of cash as a down payment. If all available cash goes to pay down debt, a home, new vehicle or other large purchase may be difficult, impossible or at least long delayed.
Debt Payoff Pros and Cons
Paying off debt first unquestionably has significant benefits most of the time. Those include:
- When the debt is paid off, it will free up more cash to save or invest.
- Paying off debts sooner reduces overall interest charges, which helps build wealth.
- Borrowing money and paying it back on schedule has a large positive effect on credit score.
Debt payoff also has some drawbacks:
- Diverting money to pay debts means less is available for recreation and entertainment.
- Early payment of some debts, such as mortgages, may mean loss of tax deductions.
- If you don’t have a long credit history, paying off all your debts early may actually hurt your credit score.
Savings Pros and Cons
Saving money also has some attractive features, including:
- If you have savings, you may be able to avoid taking on more debt in an emergency.
- Interest earned on savings helps counter the cost of interest paid on loans.
- Compound interest, or interest earned on previously earned interest, is a potent long-term wealth builder.
- If an employer matches retirement contributions to the maximum, which for 2022 is $20,500, it may be hard for debt reduction to compete with that much free money.
Balancing Saving and Debt Reduction
For many people, considering their individual situation and taking a balanced approach makes more sense than following a strict savings-first or debt-first method. This means devoting some money to debt payoff and some to savings accumulation. Creating and executing such a plan involves some preparation and thought, including:
- Making a careful budget of household income and expenses
- Setting goals for both reducing debt and increasing savings
- Looking for ways to cut expenses and increase income
- Identifying and prioritizing reducing high-interest debt
- Regularly saving at least a small amount in order to create a rainy day fund
When adding to savings, consider how easily you can access the money in addition to the potential return. Money put into a tax-advantaged retirement fund, for example, can’t readily serve as an emergency fund, since you’ll have to pay penalties if you withdraw from it before you’re near or at retirement age.
Paying down high-interest debt generally makes more financial sense than putting money into savings instead. However, when considering how to prioritize debt reduction and savings accumulation, rather than adopting a cookie-cutter method calling for devoting available resources completely to pursuing one goal at the expense of the other, consider your personal situation and try a more balanced approach. Run the numbers, assessing the interest rates on your debts, the amount of emergency savings you have banked and other concerns, such as employer matches on retirement plan contributions and your future savings goals. Your specific circumstances can tip the balance, at least temporarily, toward either saving or paying down debts.
Financial Planning Tips
- A financial advisor can help you create a financial plan to save and manage debt. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you already have money saved up and are deciding between investing or paying off debt, this guide could help you prioritize competing financial goals.
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