You get depressed every time you look at the 25 percent interest rate on your credit card statement, yet you barely have a couple hundred dollars stashed away should your car die or your job go away.
Something needs to give. So, should you pay off the card and then start saving, or start socking away money then deal with the card?
Simple math suggests it’s probably better to pay off debt rather than adding to your emergency fund, or, for that matter, saving for other, more distant concerns, such as retirement.
If you’re paying more interest than you’re earning in interest, you’re losing money.
However, personal finance decisions are rarely so simple, and wiping out debt first isn’t the right choice for everyone.
For example, having no emergency savings to fall back on means you will be forced to whip out your credit card when an unexpected expense comes up, such as a medical bill or a pricey car or home repair.
Still, while there is no one right answer to the debt versus savings dilemma, there is one very wrong one, and that’s doing nothing.
“There are differing views on how you should prioritize your debt payoff, from starting with the highest interest rate to starting with the smallest balance, noted Aaron Graham, a CFP with Abacus Planning Group, Inc. in Columbia, S.C.
“The key though, is to actually start!” Graham said.
Here are scenarios for when each choice – paying down debt or saving – makes more sense.
Reasons to make saving your top priority
There are a number of good reasons to save first and pay down debt later.
If you have a credit card or other debt with 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, Mich.
Another situation where it makes sense to save before paying off debt is if you have access to a retirement savings plan through your job, especially if there’s an employer match available.
Try to contribute at least enough to get the maximum employer match. If you aren’t doing this, you are effectively turning away free money, a precious commodity in this world.
And putting off saving for retirement until you are debt-free could cost you your most valuable asset: time. With compound interest, even small contributions to your retirement plan can grow significantly.
However, the top reason to make saving a top priority over paying down debt is to build your emergency fund.
That is especially the case if you are like most Americans who, in a recent Bankrate survey, said they would be unable to cover an unexpected expense of even $1,000 out of their savings.
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.”
What could go wrong? Well lots of things. Saving first – and building up a decent emergency fund – could spell the difference between weathering tough times and winding up in bankruptcy court.
How much to save
Experts recommend building an emergency fund of three to six months’ worth of expenses and stashing it in a 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. Graham at Abacus suggests starting first with a goal to cover a single month’s expenses.
“There is no excuse for not saving for these emergencies,” Graham said. “It’s not a question of if they will happen, but when; plan accordingly.”
While you are at it, shop around with different banks in order to get the best possible rate on your savings.
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.
You’ll get 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.
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, which can allow you to consolidate all of your credit card debt onto one low-rate card and save you money on finance charges.
Kevin Smith, executive vice president of wealth management for Smith, Mayer & Liddle, says it usually makes sense to prioritize debt reduction, but there are exceptions.
Smith doesn’t see much gain in aggressively paying off a mortgage or a student loan that isn’t carrying an exorbitant interest rate.
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, he noted.
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.
The ideal approach
The best solution could be to strike a balance between saving and paying off debt.
You might be paying more interest than you should, but having savings to cover sudden expenses will keep 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 that causes their savings to fall below a certain level. For them, saving and paying down debt at the same time might be the best approach.
“Every savings vs. debt situation is case by case,” said Aaron Clarke, a wealth advisor at Halpern Financial in Ashburn, Va. “If client has surplus cash flow, the best thing to do is “walk and chew gum” – paying down debt and saving at the same time.”
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