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Save Money or Pay Off Debt?

Posted by Goyo Large on Monday, August 17, 2020 Under: Technical Analysis


What we’ll cover:

  • Not all debt is equal, and everyone needs an emergency fund
  • When prioritizing your debts, you might want to consider paying down the higher interest ones first
  • Look at all of your debts and savings/retirement accounts along with the interest rates

It’s the million dollar question. And as a nation of borrowers – mortgages, auto loans, student debt, you name it – prioritizing saving vs. paying off debt is a dilemma for many.

Before we dive in, let’s start by addressing two assumptions:

  • Not all debt is equal 
  • Everyone needs an emergency fund

The first point may seem obvious, but remembering that different loans come with different interest rates can help you decide which to pay down first. Many homeowners take decades to pay off their mortgage, and that can be perfectly normal. However, paying down higher-interest debt over several years can be really costly.

Before you prioritize paying off debt or saving, at the very least, you should have an emergency fund in place. Otherwise, an urgent trip to the vet or a costly home repair could put you right back into debt, wiping out any of your efforts to pay it down.

It depends on your situation, but it’s generally recommended that you set aside three to six months of living expenses somewhere safe, like a savings account. Depending on your circumstances, you might need more or less. 

There is no one-size-fits-all solution to prioritize saving vs. paying off debt (sorry!). A lot of it comes down to your personal circumstances and a good old-fashioned numbers game. So, let’s get to it. 

When you might prioritize paying off debt

Start with understanding the type of debt you have.

Take a look across all of your debts, including your student loans, and figure out which ones carry the highest interest rates. 

According to Jill Schlesinger, CFP® and host of the Jill on Money podcast, “Your first priority is to pay off the highest interest consumer-related loans (credit card and autos) and then systematically work your way down to the lower interest ones.”

Let’s look at this approach, starting with higher interest debt. 

If you have high-interest debt

Higher interest debt can add up quickly – here’s how this could work. 

Say you pay for a $5,000 couch on your credit card, which has a 14% interest rate. If you had a $100 monthly minimum payment and only paid the minimum, you’d end up paying $2,547.85 interest over six years. 

That money would work a lot harder for you in a savings account or retirement account.  

Take a look across all of your debts, including your student loans, and figure out which ones carry the highest interest rates. 

So the numbers make it clear why higher-interest debt can be costly. But how do you pay it off?

After you’ve accounted for everything in your budget, see if you can put any extra cash toward paying it down. That should be a no brainer.

You may also consider consolidating higher-interest debt or getting a personal loan to help. We know this may sound counterintuitive, but if you qualify for a personal loan, the interest rate may be lower than what you’re paying on higher-interest debt. 

Try to make paying off this debt a priority. A word of caution here: think twice before borrowing against your 401(k) to pay off any kind of debt. Borrowing from your future to pay for today’s debt could really mess with your retirement savings.  

If you have student loans

Taking out a student loan to pay for college may seem like a rite of passage these days. But interest rates on loans can vary, depending on the type of loan. 

According to Nerdwallet, in 2019, interest rates on private student loans range from about 4 to 13 percent, while government loans (for undergrad) are about 4.5 percent. 

The benefits of living debt free can be enormous, both financially and psychologically.

No matter the type of student loan, determining how you want to pay down this debt can be tricky, especially since you may be able to deduct some of the interest on a student loan – up to $2,500 if you qualify – when you file your taxes. 

According to Schlesinger, slowly paying off your student loan debt, by only making the minimum payment for instance, “may be costing you a lot down the line.” For instance, say you have a student loan with a 5.25% interest rate. Every dollar you put toward paying that loan down will be money you don’t have to pay 5.25% interest on. 

If your debt stresses you out

On top of the logical reasons to pay off debt, there can be plenty of emotional ones too. For many people, managing debt is a constant source of anxiety.  

According to research compiled by the Aspen Institute, people who struggle to repay debt “are more likely to report lower life satisfaction and higher anxiety.” For young adults with student loans, “those with high levels of debt stress reported feeling more tense and anxious, troubled by physical problems, and having greater difficulty getting to sleep.”

These feelings can be just as important as crunching the numbers, and shouldn’t be dismissed. 

The benefits of living debt free can be enormous, both financially and psychologically. And emotional reasons for paying off debt may be the only reasons you need to make it a priority. 

Making saving a priority  

You may not like the idea of saving a percentage of your income when you still have debt to pay down. But if you look at the numbers, in some cases, it can make sense to put saving first. 

We’ve already covered the importance of saving for an emergency fund, but saving for retirement can be just as important. 

If you work for a company that offers an employer-sponsored retirement plan, you might consider making this a priority. You may have already auto-enrolled in your 401(k), but if you haven’t yet, speak with someone in HR about setting one up. The contribution limit is $19,000 annually ($25,000 for those 50 and older) in 2019, and money you put toward this account grows tax-free until you withdraw it in retirement.

If your company doesn’t offer a workplace retirement plan, you might consider other retirement plan options. You may qualify for either a Traditional or Roth IRA, both of which have tax advantages and allow you to contribute up to $6,000 annually ($7,000 for those 50 and older) in 2019. 

How much should you contribute? You may have heard that you should save anywhere between 10 to 15 percent of each paycheck for retirement. However, if you’re grappling with paying off debt, that number might seem unrealistic. 

You can always start small and then gradually increase your contributions over time. And don't think that small amounts can't go a long way. 

Let’s say starting at 30, you invest $250 from every paycheck and put it towards your retirement plan. Assuming an average annual investment return of 8.8%, if you retire at 60 and didn’t pull any money from the account, your retirement account will have grown to over $880,000. Pretty good, right?

But say you start even earlier. Let's say you invest that same $250 per paycheck starting at age 20 (we’ll also assume the same annual rate of return and retirement plan asset allocation). By the time you retire at age 60, your retirement account will be over $2.2 million. Now that’s really good. 

Note: These examples represent an average rate of return of 8.8%, which is the historical annual return for 401(k) portfolios comprised of 60% stocks and 40% bonds and assumes semi-monthly pay periods. 

Finally, if you’re working for a company that offers a 401(k) match, you might consider contributing enough to take advantage of the full match amount. It’s essentially free money, and who wouldn’t want to make that a priority?

Pay off debt or save? 

You may also be hearing that you should try to both pay off debt and save at the same time. 

Here’s the reality: everyone’s financial circumstances are unique and the recommendation that you try to do both is a sweeping one that may or may not work for you. 

We’ve outlined some ways to think about how you might prioritize saving versus paying off debt, but realize that you have to do what’s in your best interest.

Remember: start with acknowledging that not all debt is equal, and that you should establish a solid emergency fund.

From there, look at your interest rates and do some math: you might consider making you saving and investing a priority if they earn you a higher rate of return than your debts will cost you.

There are different savings strategies and retirement savings strategies depending on your age, along with several approaches for how to get out of debt.

At the end of the day, doing something about the dilemma of saving versus paying off debt is a whole lot better than doing nothing. And that’s something everyone can agree on. 

In : Technical Analysis 

Tags: save money or pay off debt? 

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