If you’re in debt, you might be wondering: Should I pay off my debt first before saving and investing? Or, is ok to save and invest while I still have debt payments to make?
There is no one right answer. Being debt free and saving money are both important goals. But both compete for your financial resources. To make the choice that’s best for you, you’ll need to look at your own financial condition and prioritize your goals.
Here are some things to consider to help you make a plan.
Advantages to paying off your debt first
There are definite advantages to paying off your debt first. (Especially if you have large credit card balances with high interest rates.) A large debt burden drains your cashflow. The more debt you have, more of your income goes toward your monthly payments. The sooner you pay off your debt, more of your cashflow can be applied to other financial goals.
Another advantage is you will save on interest cost. Interest charges will accumulate as long as you have an outstanding balance. The faster you pay off your debt, the less you will pay in interest. And the savings can be significant.
Drawbacks to paying off your debt first
But there are drawbacks to this approach. Without having any savings, you risk not being prepared for unexpected expenses. Just when you make progress towards reducing your debt, you may suddenly find that you need to bring out the credit card or take out a loan to make ends meet.
Also, if you delay saving and investing too long, you may find yourself short of meeting important financial goals like having enough money for retirement.
Take a mixed approach: Pay off your debt and save/invest
Paying off debt should be a priority. But instead of putting all your financial resources towards debt reduction, it may be more advantageous to take a mixed approach:allocating a percentage towards your debt and a percentage towards savings goals. How much you allocate toward debt and savings depends on factors like how much debt you have, the type of debt, interest cost, you’re your income, and what you’re saving for.
If you’re considering a mixed approach, here are some factors to keep in mind.
Consider your cashflow
Before you make any plan you first need to look at your cashflow and determine your discretionary income — how much of your income is left over once you pay all your bills, both fixed and variable, and your required minimum payments towards your debt.
For example, let’s say your monthly net income after taxes is $4,000 per month. After you pay your rent or mortgage, utilities, car payment, student loan payment, minimum payment due in credit cards, food and household necessities, and any other bills, you have $500 left. That’s your discretionary income or what is available to put towards paying your debt and savings.
Pay off high interest debt ASAP
The interest rate varies depending on what type of debt you have. This makes some debt more manageable than others. For example, a mortgage on a primary residence tends to have a lower interest rate. Credit cards will have the highest. And student loans and car loans tend to fall somewhere in between.
Paying off your high interest debt such as credit cards should be a priority. If you have credit card debt, you should pay more than the minimum payment. The amount of interest you’ll pay over the long run can be significant. And that’s money taken away from other financial goals.
For example, let’s say you have a credit card balance of $3,000 and the annual percentage rate (APR) is 14.24%. If you only pay the minimum balance of $35 per month it will take you about 266 months (over 20 years) to pay it off. And you will pay about $6,293 in interest.
What would happen if you paid $50 per month instead of $35? The number of months to pay it off reduces to about 99. And the total interest paid reduces to about $1,942. By paying just an additional $15 a month saves you over $4,000 in interest and cuts the time to pay it off by more than half.
You can easily use an online financial calculator to see how much time and money you can save. Just enter your credit card information and just like that you can start to make a plan.
Prioritize these savings goals
When you have debt, some savings goals are out of reach and need to be out on hold. But some are too important to delay entirely.
You should have an emergency fund with five to six months of living expenses. This money is to be used only for emergencies such as job loss, a medical emergency, unexpected auto or home repairs, etc. Having an emergency fund is key to keeping you from getting deep in debt when something goes wrong. Being able to absorb unexpected expenses relieves the need to take out the credit card. Without an emergency fund, you may find yourself falling back in debt.
It can take time to build enough savings to cover five to six months of living expenses. But even contributing a little bit each month is beneficial.
Even if you decide that you want to put 100% of your discretionary income towards paying off your debt before you contribute to any savings, make sure you have at least a starter emergency fund in place. That’s having $1,000 to $2,000 in a savings account to help you in an emergency. It won’t be enough to get you through prolonged unemployment or cover major medical bills, but it will help with the unexpected expenses like auto repairs or plane tickets for a family emergency.
Saving for retirement is such an important financial goal. If you don’t have money now while you’re working, what are you going to do when you are retired and can no longer work? It takes time to accumulate enough money for retirement so it’s important to start saving early. You also get the advantage of compounding the sooner you start.
When you are in debt, you can still save for retirement, but you’ll need to prioritize how much to contribute to your retirement accounts versus your debt.
The interest rate on your debt is important when deciding how to prioritize. If the expected return on your retirement savings is greater than the interest rate on your debt, you can consider putting more money towards retirement. For example, let’s say your debt consists of student loans that have an interest rate of 5% and a mortgage with an interest rate of 3.5%. It is likely that the return on your retirement savings will be greater than the interest on your debt. Saving for retirement is a long term goal where you will most likely have a significant portion of your money invested in the stock market. Over the long term, the average annual return of the S&P 500 between 1928 and 2019 (including dividends) was positive: 11.57%.
But if you have high interest credit card debt, for example with an interest rate 18%, you need to prioritize paying off your debt which means limiting contributions to retirement.
If your employer offers a 401(k) plan, they may provide a matching contribution. If they do, that is free money. In this case, you should contribute at least the amount that qualifies for their matching contribution.
The bottom line
Even if you are debt free you may find that you do not have enough cashflow to meet all your desired savings goals such as a down payment for a new home, kid’s higher education, new car, vacation, etc.
You need to prioritize. This is especially true when you are in debt. Remember these points while you plan your savings goals.
• Your high interest debt such as credit cards should be paid off first
• Your emergency fund is fully funded
• You are contributing enough money for retirement
• You won’t put yourself at risk for falling back in deep debt
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