One of the questions that many people ask themselves in times like these is this: should I pay down debt, or build my savings? This is a tough question. But many financial planning folks believe that paying down debt ought to be a priority. This is especially true in times like these, when you don’t know whether or not something unforeseen will make it difficult to make your debt payments. It is important to pay down your debt as much as possible so that you are better prepared for the future.
Rate of Return vs. Interest Charges on Debt
The first thing to realize that the rate of return on your savings account is not very high. Indeed, even on a high yield account you’re barely getting more than 3% these days. Additionally, the average return on a retirement account and other investment accounts for most of us is between 7% and 11%. But the interest charges on a credit card are 13% on the low end and can go as high as 31% in some cases. You can easily see the wide discrepancy between your rate of return for saving money and the amount of money you pay in interest charges.
Interest charges represent payments you make for borrowing the money on your credit cards. It’s straight outflow. You don’t get anything back. Interest charges are the equivalent of flushing the money down the toilet. Only in this case you are handing straight to a credit card company CEO. Imagine if you paid that debt off quickly, and then could put the money you are no longer spending on debt into savings. Your savings would build up much faster.
Revolving Debt vs. Installment Debt
There are different kinds of debt. Revolving debt are those that, like credit cards, have a certain limit. You can keep using the account as long as you have room left below the maximum balance allowed. This means that as you make payments, you can keep accessing the debt. Installment debts are those that have a set amount, and a set term. Car loans are installment debts. You make payments and gradually pay down the balance, but you can’t just add more to the money available for you to borrow.
It is generally best to pay down revolving debt first. These debts generally have higher interest rates, costing more in the long run. But when you pay down your revolving debt, it is important keep your balances at zero.
Save a Little as Well
While paying down debt should be a priority, it doesn’t mean you can’t save. Sit down and figure out how much extra you have each month. You can divide that extra amount up so that 80% of it goes toward debt reduction and 20% of it goes toward savings. If you can manage to find $200 extra in your budget, that means that $160 goes to paying down debt, and $40 goes to savings (or investing). Setting money aside is a good habit to get into.
When you make paying down debt a priority, you will find that you keep more of your money, and that you have greater financial freedom.
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Step one should be to have an emergency fund in place, this will keep you from adding to your debt. after the emergency fund you will be able to pay down your debt.
Paying off debt is so important, especially credit card debt and any other unsecured debt. Lots of people don’t even look at what they pay in interest each month on their cards. Do it and you’ll be sick first, then you’ll pay off the card and cut it up! Some of these little boogers are closing in on 30% interest, especially if you’ve made even one single late payment.
Not all debt is created equal, and for those of us with sizable emergency funds, there is a case to be made for investing some money that would otherwise have been used to pay down debt. I wrote an article about this here:
http://www.dontfeedthealligato.....erest-debt
My apologies…
this links works better.
http://www.canadian-money-advi.....8/04/which credit card debts should you pay off first.html
It’s important to save money AND pay off debt at the same time. It takes longer but at the end you have a nice emergency fund which will keep you out of debt.
Hi Donna
couldn’t agree with you more, my wife and I have always been good at paying off debt (and running it back up again) but terrible at savings. It’s the lack of savings that has always gotten us in trouble, we’ve never been good at having money in the bank. that is slowly changing, we’ve set a goal up of saving money over the summer and keeping it. We’ve had some savings but I usually had to draw it down to pay a bill or something.
BTW dana like the name of your blog!
I see this kind of logic employed all the time on this subject, this comparison of interest rates between a savings account and a credit card account. It really bothers me. Savings accounts are not investment vehicles. The pittance you make in interest accrual on a savings account is just the bank’s way of thanking you for making cash available for them to lend to other people.
The whole point of a savings account is to put something aside in case of emergency. No matter what your debt status, you NEED to do that. If you have a bunch of debt and suddenly a kid throws a rock through your car window, you are better off paying for the replacement with cash than adding yet more debt to your credit card that you are busily paying off in the first place.
I would go so far as to say that if you are making so little income that all your debt accounts are going into collections, you might as well squirrel away what little surplus you might have rather than tying it all up in debt payments because if it’s foolish to run up more debt when your accounts are current, it’s *impossible* to run up more debt when you can’t even afford to make minimum payments, and then you really *will* be stuck if your hot water heater goes splut or you need a hundred bucks for an urgent care visit. You can’t hope to pay off all your debts if you can’t even function because you can’t take care of yourself in an emergency.
Let me be clear that I absolutely agree we have an obligation to pay off our debts and that it is best to not get into debt in the first place, but we are speaking here from the assumption that the debt already exists. Murphy is not going to politely sit by and wait if you’ve got debt; he’s going to go right ahead and smack you.
I would say that as a rule of thumb, go ahead and put aside that $500 to $1000 right off, as soon as possible, before you get into serious debt repayment, and then do repayment and emergency funding about 50/50 until you get three to six months’ worth of expenses put by. After that, by all means throw it all at the debt. But don’t leave yourself without that cushion. Not having savings is exactly why so many Americans rack up debt to begin with (whether that’s emergency savings, saving money for gizmos and gadgets, or what have you).
Following Dave Ramsey’s Baby Steps, I saved enough for my baby emergency fund first and then attacked my debt with a vengeance. Once that debt is completely eliminated, I will move on to saving and investing.
I would always take paying off debt before saving. You always get charged more interest then you can earn on savings so in the long wrong you are better off clearing the debt first.
Good points. For me, paying down debt is futile if it does not involve changing the lifestyle that got me into debt in the first place. If I didn’t change my lifestyle, and spending habits, it would not only make it harder to focus on debt reduction but I would eventually end up right back where I started. Staring at my credit card statement and wondering where it all went!! With 3 kids and my wife being a stay at home Mom, I feel so lucky that we were able to make the changes to make it happen!
I absolutely agree that paying down debt, especially revolving debt, should be a priority. But, I also agree with Rebecca.
I ended up with credit card debt just after I got out of college. Part of the debt came from not having an emergency savings and having to turn to credit cards for unexpected situations (like when my parked car got smashed by a crazy driver, and I had to pay an insurance deductible). It becomes a vicious cycle. You charge more, so your payments increase, and you’re left with even less money in your pocket. Pay down debt, but make sure you have a little saved just in case!
Hi! I agree paying down debt is important, but if you do not have an emergency fund (at least $1000) when an emergency occurs you will head right back to credit cards to pay it. Pay minimum on debt, save $1000 in an emergency fund, and then aggressively attack the debt.
I learned the hard way, but am now debt free. -Becky R in NJ
I think that it is important to pay off debt first – starting with the one with the highest interest rate first. If you do have credit cards, then it seems pointless to me to keep much money in savings earning a little amount of interest. Better to use the money to pay off the debt and save the interest and if you do have an emergency you can use the credit card. You may think twice about using the money then and if you had it in savings you may spend it on something which isn’t such an emergency.