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Bankrate.com |
Building up savings vs. cutting down debt Dear Money Matters,
My husband and I have a substantial amount of debt. We do not have much in savings, however, we are now making more than enough money to just pay the monthly bills. My question is should we pay off our debt first, or should we save for a while and then pay off the debt?
Barbara Dear Barbara,
In many ways, the answer to your question depends on what's going to make you and your husband feel the best. Some people would get more satisfaction from first setting a chunk of money aside in savings, then aggressively going after their debt. Others feel right about starting a savings plan only after they've dug out from beneath their debt. Go with the option that jibes better with your personalities as well as your financial goals -- you're more likely to stick with it. However, from a numbers standpoint, it's a better idea to eliminate your debt as fast as possible for your first step. The reason is that you're likely paying out more in interest charges than you'll earn with most savings options. To illustrate: You didn't specify what form your debt takes, but I'll assume that a good share of it is credit card debt. In March 2002, the
going rate for a fixed-rate standard card is about 14 percent. By comparison, the interest on a
high-yield money market account is only a bit more than 2.6 percent.
If you look at both the debt and the savings as a form of return, you'll see that you're effectively "losing" more than 11 percent by putting your money into the money market rather than paying down the credit card with a much higher interest rate. Here's another way to look at it. Say you owe $5,000 on a 14 percent credit card. If you pay only the monthly minimum, it will take you 243 months to pay off the card and cost you a staggering $4,167 in interest charges. You can use Bankrate.com's "
The true cost of paying the minimum" calculator to see what applies in your case, but it's a powerful picture of just how much of a drain keeping to the monthly minimum can be.
Beyond the question of debt vs. savings, there's another important one to consider. Once you start paying down your debt, which debt should you tackle first? The answer: Tackle one debt at a time, applying every available extra dollar to the debt with the highest interest rate, while paying the minimum on the rest. To do that, create a "debt repayment schedule." Include columns for the name of the debt, balance due, interest rate, current payment and how long it will take to repay. Add a line under each debt to describe how you're going to fund the additional payments.
Click here to see how one looks using the "Payment Push" method advocated in Bankrate's "Money Makeovers."
Pay off the debt with the highest interest rate first, and then shift the effort to the next debt in line. This method gets you out of debt the fastest. |