Simple math suggests it’s likely better to get rid of debt before saving for retirement or adding to your emergency fund.
In general, if the interest you pay is higher than the interest you earn, you’re losing money.
But personal finance decisions are rarely so simple, and ditching debt first isn’t the right choice for everybody. For example, it can mean not having an emergency fund to fall back on, setting you up to take on more debt when an unexpected expense hits.
Here are scenarios for when each choice – paying down debt or saving – makes the most sense.
When to pay debt before saving
When you have high-interest consumer debt, paying it down first can help you solve ongoing problems with managing your money.
Identify your expendable income, create a budget based on that number and include paying down debt as a significant part of the equation. Consider opening a balance transfer credit card; these cards allow you to consolidate all of your credit debt onto one low-rate card, saving you money on finance charges.
Paying debt first also makes sense because you’re getting a guaranteed “return” by cutting your interest payments. It’s typically more than you’d earn in the stock market and definitely more than you’d earn in a savings account.
Kevin Smith, executive vice president of wealth management for Smith, Mayer & Liddle, says it generally makes sense to emphasize debt reduction. Building a sizable reserve in a savings account might offer comfort, but it comes at a low return and a high cost.
If your debt isn’t consumer debt, the decision changes somewhat, and not only because the loan may have a low rate and tax-deductible interest.
Making extra payments will save you money in the long run, but in the short term, it doesn’t cause your lender to recalculate and lower your monthly payments.
When deciding whether to pay off tax-deductible debt versus saving, don’t worry about losing a tax deduction if you pay off the debt. The deduction is probably worth less than the annual interest you would have paid on the loan.
When to save before paying debt
There are a number of good reasons to save first and pay later, but the top reason is to build your emergency fund.
If your debt has a very low interest rate, it may make sense to save first, says Melissa Joy, CFP professional, partner and director of wealth management at the Center for Financial Planning in Southfield, Michigan.
“If you don’t have any savings, focusing solely on paying debt can backfire when unexpected needs or costs come up. You might need to borrow again, and debt can become a revolving door,” she says.
Experts recommend building an emergency fund of three to six months’ worth of expenses and stashing it in a savings account. Compare savings accounts to find one that pays a decent return. But it makes sense to increase your debt payments once you have your mini emergency fund in place.
Another situation where it makes sense to save before paying debt is when you’re talking about retirement savings, especially if there’s an employer match available. If you have a workplace plan, try to contribute at least enough to get the maximum employer match.
Putting off saving for retirement until you are debt-free could cost you your most valuable asset: time. With compounding interest, even small contributions to your retirement plan can grow significantly.
Best of both worlds?
The best solution could be to strike a balance between saving and paying off debt.
You might be paying more interest than you need to, but having savings to cover sudden expenses like car repairs keeps you out of the debt cycle.
Additionally, having sufficient savings provides peace of mind. Some people are unlikely to feel at ease with any strategy, no matter how financially logical, that causes their savings to fall below a level that feels right to them. For these people, saving and paying down debt at the same time might be the best approach.