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.
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.
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.
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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I'm just an average mom, trying to live a frugal life and get out of debt. I write about things that have (and haven't) worked to improve my family's financial situation. What works for me may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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