With diploma in hand and a B.A. or B.S. added to your LinkedIn profile, you’ve graduated from late nights spent cramming at the library (right…) and hitting up the dining hall’s cereal bar for breakfast, lunch, and dinner. Now it’s time to start living IRL.
When it comes to your money, one of the biggest questions you might have (beyond how much you can afford in rent) is whether it makes more sense to pay off debt or save. The average student loan balance tops $37,000, which isn’t exactly chump change. And you might want to get that debt monkey off your back sooner, rather than later.
Then again, there are some real benefits to saving money right out of college. When it comes to reaching a savings goal — whether it’s building a rainy day fund, buying your first new car, or building a retirement account that will support around-the-world travel during your golden years — time really is on your side.
Not sure whether it’s better to pay off debt or save? This guide can help you decide.
The upsides of paying off debt first
There are several key benefits to paying off student loans, credit cards, or other debts you might have accumulated during college before making saving a priority.
The first is the potential to save money over the long run on interest costs. While federal student loans typically have low interest rates, private student loans can be a different story. Your interest rate for those loans may be two or three times the rate charged on your federal loans.
High-interest credit card debt can also be a real drain on your wallet, especially if you only pay the minimum due each month because you’re also juggling student loans or other debt. When you pay just the minimum on a credit card, you barely make a dent in what you owe.
Aside from saving money on interest charges, paying off debt first can give you more power to save later when student loan or credit card payments no longer take up room in your monthly budget.
In short, when you are debt-free, you can devote more effort to saving money.
Lastly, reducing the amount of debt you have can help improve your credit score because it lowers your debt-to-income ratio (that’s the amount of monthly debt payments you have divided by your gross income). The better your credit score, the more favorable lending terms you could qualify for when you apply for a loan.
The drawbacks of prioritizing debt over saving
On the flip side, putting debt repayment first can be problematic in some instances.
First, if you’re thousands of dollars in debt and earning an entry-level salary, it could take you a long time to pay it off. In this scenario, delaying saving could cost you.
That’s because if you’re not saving for retirement, you’re not taking advantage of compounding interest, which is basically interest you earn on your interest. That means you could be missing out on huge growth potential with your money.
The other downside? If an unexpected expense comes along, you may end up having to take on more debt to pay for it since you don’t have savings in a rainy day fund.
For example, if your car’s radiator goes kaput and you don’t have an emergency fund to fall back on, you might have to charge the repairs to a credit card. That puts you deeper into debt — and even further away from being able to pursue your savings goals.
Why it pays to get ahead by saving
Even if your rainy day fund only has $500 or $1,000, it could come in handy if you find yourself in a tight spot financially. At the very least, it could help you avoid taking on new debt.
More importantly, when you start to save money right out of college, you have the potential to grow more wealth over the long term. Regularly adding money to a savings account, your employer’s retirement plan, or an individual retirement account (IRA) is a way to harness the power of compound interest.
When it comes to compound interest, the most important rule to remember is that time is your friend. The more time you let interest accumulate on your savings and investments, the more it compounds. And that means a bigger balance in your bank or retirement account.
Here’s an example. Say you add $6,000 annually to a Roth IRA starting at age 25. You earn a 2% return each year. At age 65, your account would be worth approximately $369,660. If you wait a decade and don’t start saving until age 35, but achieve the same annual return, your retirement savings would be cut by a third, to approximately $248,277.
Bottom line? The sooner you start to save money, the more benefits you could reap.
Pay off debt or save money? Can you do both?
The short answer is yes, you can. Your level of success ultimately comes down to how you prioritize and manage your money.
Let’s start with paying down debt. There are several methods that prioritize debt reduction, including the debt snowball and debt avalanche, while still allowing you to set aside some savings. Both approaches advocate putting as much as you can towards one type of debt, while paying the minimum due on all the others. As you pay off the first debt, you roll that payment over to the next one on your list.
The difference between the debt snowball and debt avalanche is that snowball method has you paying off debts in order of smallest balance to largest, while the avalanche route has you start with the debt that has the highest interest rate.
Ultimately, the best debt repayment plan is the one that fits your budget and goals. (Looking for a budget plan? Try the 50/30/20 plan.) If you want a quick win, for instance, you may prefer the snowball method to clear a balance quickly. But if you want to save on interest, the avalanche route could be better.
Other options exist, too. If you have high interest credit cards, for instance, you could use a balance transfer promotion to shift your existing balance to a new card with a 0% APR. Or if you have private student loans or federal loans, you could refinance or consolidate them, potentially at a lower interest rate, making your debt more affordable.
As you pay down your debt, simultaneously prioritize your savings goals. Start with building a rainy day fund first. That way, you have some money tucked aside for unexpected expenses.
Even if you can only set aside $20 a month, do so and work to grow your savings balance to $1,000. Once you’ve achieved that goal, keep socking money away until you have enough to cover six to nine months’ worth of expenses.
Then focus on retirement. If your employer offers a retirement plan with matching contributions, save enough in it to at least get the full match. As your income grows, you can work to increase your contribution until you put 10 to 15% of your income in the account. Not taking advantage of these employer plans is just leaving money on the table.
Make your savings work for you.
Picking the right flavor of cereal used to be the most important decision of your day. Now, you need to decide what’s best for your finances: paying off debt, saving money, or a combo of both? Once you settle on a plan, you’ll be well on your way to an advanced degree in adulthood.