Should you pay off debt or save first?
- Feb. 3, 2021
- 5 min read
Ways to approach debt management
How to save for your goals
Pros and cons of prioritizing debt-repayment over saving
Whether you’ve recently graduated, lined up a new job, or just plain decided it’s time you got a handle on your debt management, you’ve probably got a few (or a thousand) questions.
One of the biggest questions you might have is how you can balance paying off debt and saving. Because, while you might want to get that debt monkey off your back ASAP, you also don’t want to forgo your emergency fund or retirement plan. Not sure how to walk that tightrope? This guide can help you with that.
The key to paying off debt while saving money is planning and prioritizing. Your level of success ultimately comes down to how you 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. Once you pay off the first debt, you roll that payment over to the next one on your list, and so on.
The difference between the debt snowball and debt avalanche is that the 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.
If you are working toward paying off debt and saving simultaneously, really think about which savings goals are your priorities. It helps if you can visualize them in some way, too — in fact, visualizing your goals can be a real motivator as you work toward them. Our Online Savings Account helps you do that by allowing you to separate your savings goals into different buckets, all within one account, (so you’re not losing out on that compound interest).
Once your emergency fund is well on its way, focus on other priorities, like retirement. Consider an individual retirement account (IRA) or, if your employer offers a retirement plan with matching contributions, take advantage of that by saving enough 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.
Say you decide to concentrate on paying off student loans, credit cards, or other debts you’ve accumulated before making saving a priority. What might some of the outcomes be? Let’s take a look.
1. You could potentially save money on interest costs over the long run.
While federal student loans typically have low interest rates, private 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.
2. Once you’re debt-free, you’ll have more saving power.
Paying off debt first can give you more power to save later when 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 developing a full-fledged savings plan.
3. Reducing your debt can help improve your credit score.
This is 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.
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 and start saving. In this scenario, delaying saving could cost you.
For example, 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.
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.
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.
Another downside to paying off debt before saving? 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.
While it might be tempting to tackle your debt and put off saving, finding a way to have a bit of both worlds might help you cover your bases. With careful planning, you can sock away a little money toward your goals and ease that debt monkey off your shoulders.
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