If you have debt, but also have a steady income, you’ll be faced with a decision: do you pay off your debt at the expense of your savings account, or save as much as you can, even if it means staying in debt a little longer.
This article takes a look at the effectiveness of each option in order to provide some perspective. While the advice provided may not be applicable to every scenario, it’s certainly worth your consideration.
Even if you’re eager to get out of debt, you know that having an emergency fund is important. If you were to suddenly lose your source of income, you’d be in trouble without any savings, even if your debt was fully paid off.
On the other hand, if you make smaller, steady payments while saving, you may still be able to weather those payments without an income, at least for a time.
On the other hand, the longer you stay in debt, the less money you end up in the long run. There is an exception to this rule, which will examine in a minute, but let’s first look at how debt ultimately impacts your bottom line.
Using some nice, round numbers, let’s say you owe $10,000 at an interest rate of 12% annually, with scheduled monthly payments of $500. Over the course of a year, you’d make 12 individual $500 payments, reducing the debt to $4,000. However, interest would be added to the principal sum throughout the year, bringing your total back to $4,990.
If, on the other hand, you could just pay the $10,000 outright, you’d put your debt to zero without paying a cent above the principal amount. In one year, you’ve saved about $1,000. Even if your savings account is now empty, you’re net worth is still higher for having pay your debt off first.
As this example illustrates, it’s typically better to pay off your debts before you start to save.
There are two scenarios you in which might choose the short-term benefits of saving over the long-term benefits of paying off debt as soon as possible.
The first is that you don’t have steady income. If, for example, you’re a contractor and don’t receive a regular pay cheque, it is always ideal to have some reserve funds. Since paying off your debt can leave you financially vulnerable, having no savings may force you to take out a second loan.
The second scenario is if you’re able to make an investment with higher interest/returns than your debt. For example, if you can generate savings interest at 3%, it makes sense to put as much money possible into that account if your debt charges a lower interest rate.
While the advice we’ve provided is applicable to most, your own situation will require consideration. Though in general paying down debt is more financially beneficial than saving, your approach should follow whatever will help you the most. Whether that means saving aggressively, paying off your debt in full, or taking a middle road, understanding the best course of action is half the battle.