Should you pay debts first or save? Use these guidelines to decide
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A common financial struggle for Americans is deciding how much money to devote to savings versus paying down debt. While the answer varies on a case-by-case basis, it’s often important to strike a balance between the two.
Wiping out high-interest debt on a timely basis will reduce the amount of total interest you’ll end up paying, and it’ll free up money in your budget for other purposes.
On the other hand, not having enough emergency savings can lead to even more credit card debt when you’re hit with an unplanned expense. One-quarter of people said they would accrue credit card debt to pay for a $1,000 emergency expense, according to Bankrate’s 2023 emergency savings report.
While there’s no right answer for everyone on how to juggle debt repayment and saving money, here are a few scenarios for when each choice makes more sense.
Key debt and savings plan statistics
- Common financial goals reported by Americans include building an emergency fund (46 percent) and paying off credit card debt (37 percent).
- Only 43 percent of Americans would be able to pay for an unexpected $1,000 expense from their savings.
- One-quarter would need to accrue credit card debt to pay for such a $1,000 expense.
- Millennials saved the most in 2022 out of all generational cohorts, putting away an average of $6,043 in 2022.
- Men saved an average of $7,007 in 2022, which was significantly more than the average $3,146 set aside by women.
- The personal savings rate in December 2022 was 3.4 percent, up from 2.9 percent one month prior.
- Overall credit card debt in the U.S. was $841 billion in 2022.
- The average credit card balance in the third quarter of Q3 2021 was $5,221.
Sources: New York Life Wealth Watch Survey, Bankrate’s 2023 emergency savings report, Bureau of Economic Analysis, Experian, Federal Reserve Bank of New York
When to make saving a priority
Here are some valid reasons for putting more of a focus on saving money than reducing debt:
Debt with a very low interest rate: More than a third of Americans carry credit card debt from month to month. If you carry a balance that happens to be at a very low interest rate, it may make sense to save first, says Melissa Joy, a certified financial planner and founder of Pearl Planning, a financial planning and wealth management practice in Dexter, Michigan.
Access to an employer 401(k) match program: More than half of Americans say they’re behind on their retirement savings. If you have a retirement savings plan through your job, it may come with an employer match. Try to contribute at least enough to get the maximum employer match. If you aren’t doing this, you’re effectively turning away free money.
And putting off saving for retirement until you’re debt-free could cost you some valuable time. With compound interest, even small contributions to your retirement plan can grow significantly.
No emergency savings: The top reason to make saving a higher priority than paying down debt is to build your emergency fund. The importance of having an emergency fund was highlighted in the age of COVID-19. Nearly one-fourth (23 percent) of Americans said their biggest financial regret during the pandemic was not having enough savings to weather the crisis, according to a Bankrate survey.
Without some money saved up, you could simply wind up adding to your credit card debt in order to pay for an unexpected car repair or a trip to the emergency room.
“If you don’t have any savings, focusing solely on paying debt can backfire when unexpected needs or costs come up,” Joy says. “You might need to borrow again, and debt can become a revolving door.”
How much should I save?
Experts recommend building an emergency fund of three to six months’ worth of expenses and stashing it in a high-yield savings account. Some even recommend putting enough cash in the bank to be able to pay your expenses for an entire year.
But you have to start somewhere. Aaron Graham, a tax planner with Holistiplan, suggests starting first with a goal to cover a single month’s expenses.
“There is no excuse for not saving for these emergencies,” Graham says. “It’s not a question of if they will happen, but when; plan accordingly.”
While you are at it, shop around with different banks to get the best possible rate on your savings.
Building up your emergency fund often goes hand in hand with creating and following a budget. In addition to incorporating line items into your budget for things like mortgage or rent, utilities, transportation and groceries, include line items for dollars you’ll devote to savings each month. Examples include an emergency fund, a down payment on a home or a car, or a vacation fund.
Preparing for economic challenges in 2023
A bit of advanced preparation can help you weather any difficulties you may experience this year when it comes to your income and expenses.
After a year of sky-high inflation and rapid interest rate hikes, economists predict slower hiring and more unemployment in 2023, according to a Bankrate poll. In fact, among workers who found better-paying jobs in recent years, more than half (56 percent) went on to report feeling worried about job security.
If you find yourself laid off from work, you can expect to spend around five to six months searching for a new job, according to some reports.
Another common enough reason for finding yourself with reduced income is switching to a new job that earns less money than your previous job brought in.
Continued high prices
Inflation rose 6.4 percent in January 2023 from a year prior, as measured by the Consumer Price Index (CPI). This reflects a decrease from 6.5 percent in December and a 9.1 percent peak in June.
Although inflation has cooled somewhat, prices remain uncomfortably high on everything from groceries and gas to furniture and vehicles. Americans are now spending a significantly higher amount than they did a few years ago to keep a roof over their heads and food on the table.
Adjusting to income reduction and price hikes
Getting your finances in order can help you stay afloat when faced with an increased cost of living or a reduction in income. With a healthy emergency fund, you’ll be able to weather such difficulties without the need to take on debt.
If you find yourself out of a job, being able to live off money in the bank means you won’t feel the need to take on the first job opportunity that comes your way. Having a savings cushion also comes in handy in the event you decide to switch to a new job that earns less money than your previous one.
A possible loss in income will be easier to handle if you work to bring down your expenses now. One step you can take is reaching out to lenders and providers to see about lowering your monthly bills.
“It can be easy to assume that whatever amount appears on your monthly bill is set in stone, and for some municipal utilities like water and electricity that may be the case,” says Tony Wahl, a credit and loan expert at Credit Sesame in Mountain View, California. “However, sometimes subscription services like telephone, cable and internet service can be negotiated. This can help prioritize your bills and free up some of your available cash to be added to your savings.”
When to prioritize debt repayment
When you have high-interest consumer debt, paying it down first can help you solve ongoing problems with managing your money. The more you reduce your principal and the amount of interest you owe, the more money you’ll have in your budget each month to devote to savings or other line items.
Get started with repaying your debt by following these four steps:
- Calculate your expendable income. This is what’s left over after you pay for housing, utilities, transportation, food, and so on.
- List your regular expenses. Include everything from monthly bills to things you pay for less than once a month. See if there’s anything you can reduce or eliminate.
- Create a budget based on your income and expenses. Include line items for any and all monthly debt repayments.
- Identify financial goals and add them to your budget. Create line items for anything from saving for a down payment on a house to saving for a vacation.
Tara Alderete, director of education and community at Money Management International, says it usually makes sense to prioritize debt reduction, but there are exceptions.
“If you already have adequate savings in your emergency fund, you may want to focus on quickly eliminating debt,” Alderete says. “However, if you find yourself making only minimum payments on debts with extremely high interest rates, those debts may be causing you to lose money and preventing you from achieving your overall financial goals, and you may want to focus on paying off that costly debt.”
As Alderete sees it, an important part of building a budget is focusing on your priority expenses first, so that you can free up money to put toward a debt reduction plan while hopefully still being able to contribute to an emergency fund.
Next steps to balance your savings and debt
The best solution could be to strike a balance between saving money and paying off debt. When it comes to debt repayment, choose a strategy that works best for you. Options include paying off your highest-interest debt first, paying off the smallest debt first or paying the debts first that most affect your credit score.
Debt consolidation may be a good idea if you have multiple high-interest debts. Combining them into one new loan can help you qualify for a lower interest rate, and it conveniently allows you to combine multiple payments into one.
Building up your savings each month as you pay down debt ensures you’ll have funds on hand to cover unplanned expenses that would otherwise put you deeper into debt. Additionally, having money in the bank provides peace of mind.
Having age-based savings goals can also help you stay on track with your emergency fund and retirement fund.
For many, saving and paying down debt at the same time might be the best approach.
“Every savings vs. debt situation is case by case,” says Aaron Clarke, a wealth manager at Heritage Financial in Gainesville, Virginia. “If a client has surplus cash flow, the best thing to do is ‘walk and chew gum’ — paying down debt and saving at the same time.”