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How to Choose Between Saving Money and Paying Debt

The choice between paying down debt and saving that money, for say retirement, is a matter of numbers. If we are thinking of credit card debt, in particular, the numbers seem quite clear. The average interest rate people pay on credit cards is about 15 percent while the interest paid to consumers on money sitting in savings accounts is mostly less than 1 percent.

Find out now: How much do I need to save for retirement?

Paying off high interest debt first appears to be the right choice from a strictly mathematical point of view. The numbers don’t lie — carrying debt is expensive and the longer you take to pay it off, the more expensive it becomes. That’s because credit card companies compound interest. In effect, you’re paying interest on top of interest. And that’s why it’s important to consider interest rates and choose the credit card with the lowest interest.

The Big Decision

There is no magic dollar amount of credit card debt that is too much. Generally, it is less important to worry about a specific number and focus more on the percentage of your available credit that you are utilizing. Most experts believe that if you are using more than 30 percent of your available credit you are over-extended. Others allow up to 50 percent before they think you’re in trouble. Your credit utilization ratio is a component of your credit score and can affect whether you qualify for a loan and at what interest rate.

Once you have the debt, there are two schools of thought about what you should do. The first says that saving rather than paying down your debt is like investing in a business that you know is going to lose money year after year. This is because you are accruing more debt while not earning much money in your savings account.

Find out now: Which credit card is best for me?

The other school of thought is that you got into debt in the first place because you spent money you didn’t have because you didn’t have savings on hand to turn to. Folks with this mindset believe that the best way to avoid repeating the cycle is to have savings available in case of an emergency instead of falling back on credit and getting deeper into debt. Some suggest building up a small emergency fund while paying off debt so you won’t go right back into credit card debt if something unexpected happens.

Finding a Balance

Even if you decide that paying down debt is your priority and that saving is best postponed until your debt is at least under control, there is one form of savings that you should not pass up: employer-matched 401(k) contributions. In fact, it’s a good idea to take advantage of any employer-matched savings program by maxxing out your contributions up to at least the full match (if possible). This is free money.

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Your balancing point can be using 80 percent of your available funds for debt service and saving 20 percent or 90/10 or 70/30. The point is that this is a personal decision that only you can make. However, whatever split you settle on should be a commitment you can keep.

Photo credit: flickr

Frank Addessi Born and raised in the center of the known universe, Brooklyn NY, and currently hiding out in the bucolic hills of northeast Pennsylvania writing about personal finance. His expertise includes personal loans, credit cards and retirement. It's not easy living the American Dream but someone has to do it!
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