Is It Better to Pay Off Debt or Save?
Debt is a significant crisis many people face. The average credit card balance for U.S. consumers in Q2 2019 was $6,194, according to Experian. That can be a massive burden on your finances when you consider other financial obligations.
If you have debt and are short on savings, it can be difficult to decide where to direct your extra cash. If you’re wondering whether it’s better to pay off debt or save, here’s what you need to know to make an informed decision.
- Is it better to pay off debt or save?
- Paying off debt vs. saving: Ask yourself these 6 questions
- You don’t have to choose between paying off debt and saving
Is it better to pay off debt or save?
Unfortunately, there’s no clear-cut answer that works for everyone. Whether it makes sense to pay off debt or save money first is dependent upon your situation.
For example, if you have credit card debt with interest rates over 20% and little savings, your money may be more effectively used to pay down your debt. By contrast, paying down your mortgage early may not make sense if it has a low interest rate, and if you don’t have an emergency fund yet.
In general, having some money set aside is important. Experts recommend saving at least $1,000 in an emergency fund to start, but as you become more financially stable, you should work toward saving six months’ worth of living expenses.
Paying off debt vs. saving: Ask yourself these 6 questions
- Do you have debt with low interest rates?
- Do you have high-interest debt?
- Does your employer offer a 401(k) match?
- Are you looking to boost your credit score?
- Do you have an emergency fund?
- Is your debt secured?
1. Do you have debt with low interest rates?
If you have debt with low interest rates, such as your mortgage or federal student loans, it probably makes sense to dedicate more money to savings than debt repayment.
With low interest rates, fewer interest charges will accrue, and you can use the extra money to build your emergency fund. Having a safety net will ensure you’re prepared when faced with unexpected expenses and help you avoid taking out new debt to handle them.
Plus, some forms of low-interest debt have valuable tax deductions. For example, you may qualify to deduct the interest you paid on your mortgage or student loans on your taxes, reducing your taxable income.
2. Do you have high-interest debt?
If you have high-interest debt, such as credit card balances, it’s more cost-effective to pay down that debt than to stick your money into a savings account.
As of August 2019, the average interest rate on credit card accounts assessed interest was 16.97%, according to the Federal Reserve. That’s much higher than the average APR on savings accounts, which is just 0.09%.
By putting your money toward your debt rather than savings, you’d save more money in interest charges.
3. Does your employer offer a 401(k) match?
With a 401(k) match, your employer matches your contributions up to a certain percent each year. For example, your employer might match 100% of your contributions up to 4% of your salary each year. If you made $50,000 a year, that means your employer would contribute up to $2,000 per year to your 401(k).
An employer contribution is a huge perk. If your employer offers a 401(k) match, contribute enough to qualify for the full match before paying down debt. If you don’t contribute enough to your 401(k) to qualify for the full match, you’re leaving money on the table that you’re otherwise entitled to receive.
4. Are you looking to boost your credit score?
If you’re trying to improve your credit score, allocating money to pay off your debt makes more sense than saving it.
Your credit utilization — how much of your available credit you use — accounts for 30% of your credit score. Keeping your balances low on your credit cards and paying them down, can help improve your credit utilization and boost your credit score.
5. Do you have an emergency fund?
Nearly 40% of Americans wouldn’t be able to cover the cost of a $400 unexpected expense, such as a medical bill or car repair, according to the Federal Reserve’s Report on Economic Well-Being. Instead, they’d have to borrow money, use a credit card, or sell household items to pay for it.
If you’re one of the millions of people who wouldn’t be able to pay a $400 bill, you’d have to rely on credit cards or loans if an emergency pops up. That issue leaves you vulnerable, and high interest rates can make it impossible to get out of debt.
If you don’t have an emergency fund yet, it makes sense to set money aside in a savings account before accelerating your debt repayment. Financial experts recommend saving $1,000 at first to give yourself a cash cushion.
6. Is your debt secured?
If you have secured debt — meaning you had to put down property as collateral — the debt is riskier than unsecured debt. If you fall behind on your payments, the lender can seize your collateral to recoup their costs. In the cases of secured loans like car title loans, which tend to have high interest rates, you risk losing your property.
If you have high-interest loans secured by collateral, focus on paying off your debt as quickly as possible before saving money. Eliminating high-interest debt will help you save money, and once the debt is gone, you’ll have the peace of mind that your property is safe.
You don’t have to choose between paying off debt and saving
If you’re behind on your retirement savings or emergency fund, but still have debt, you may want to consider a hybrid approach to your finances. Instead of focusing on just one goal, you can split your money between both.
For example, if you had $500 in extra cash each month, you can dedicate $250 toward additional debt payments and $250 toward your savings account or retirement fund. With this strategy, you’ll pay more in interest charges than if you allocated the full amount toward debt repayment. However, that trade-off can be worth it to build up your nest egg and take advantage of compound interest.