Thursday, 9 June 2011

Should I Save or Pay Off My Debt?

I’m often asked – “should I pay off my debt or start saving?”  This is a common question and my answer is generally universal.
While individually these are both very important goals, they are also only two pieces in the overall puzzle that is your financial plan.  For most people retiring debt-free is very important.  Those under that shadow of debt often want to focus solely on paying down debt first.  They appear to have ‘blinders’ on and don’t see the big picture.  Focusing on debt reduction could mean sacrificing retirement savings later.
The Problem Paying Debt Only
If you focus on debt reduction first and fail to put money aside, then you have nothing but your credit cards to fall back on in case of emergency.  For most of us, you can count on some type of expense coming when you least expect it and using credit to pay for it only makes it harder to get out of debt, and that’s assuming you have the available credit to begin with.
The longer you wait to start saving, the more you have to put aside each month later in life to meet your retirement goal. If you start saving earlier, you get the benefit of years and years of compound growth on your investments.
The Problem with Saving Only
On the other hand, if you save first and don’t focus on paying down your debt, you can end up wasting lots of money on credit card interest. Since credit card interest rates are often higher than savings interest rates, you end up spending more money on debt interest than you earn on your investment.
The other problem with saving first is that you risk entering retirement with debt. You may find that you can’t live comfortably enough on your retirement savings and because you have to keep paying your debt. So you’d have to either live uncomfortably or continue to work until you can pay off your debt.
When Saving Can Be More Important
If you don’t have an emergency fund, then take a few months to start one. The ideal emergency fund is three to six months of living expenses but it can take several years to build that type of savings. At first, focus on getting a quick $1,000 in a savings account. That money will cover many small emergencies like car repairs that would otherwise be charged to your credit card. Once you build your emergency fund, then you can focus on paying off your debt.
From a financial standpoint, if the interest rate on your debt is lower than the interest rate on your savings or investment, then you’d get a higher return by saving versus paying off debt. This is often the case with low-interest rate student loans. However, debt is debt and even low-interest rate debt lowers your net worth and makes you feel burdened.
The Winner Is - Both
Ultimately, you should find a balance between the amount you allocate to pay down debt and the amount you save each month. It isn’t wise to put off either of these in lieu of the other so come up with a way to split your money between the two. For example, if you have an extra $500 each month, you can put $250 toward your debt and $250 toward savings.

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