It’s a question plenty of Americans find themselves asking at one time or another: Should I save more money or focus on paying off my debt? In a perfect world, we could do it all, but from a practical standpoint, discretionary dollars — the money left after paying our living expenses —can be limited. That leaves us needing to make strategic decisions about how we allocate the funds we have.
If you’ve taken out student loans or a car loan, or if you’ve accumulated credit card debt, it may be tempting to make paying off those debts your No. 1 financial priority. While that is a great goal to aim for, you should also be doing your best to save, especially if you haven’t established an emergency fund yet. Your long-term financial health depends on developing good saving habits while also responsibly managing your debt.
The answer to the question “Should I save or pay off debt?” is yes. You need to do both, finding the balance that’s right for you. Maybe that means prioritizing paying off your debt, or maybe it means prioritizing saving. The following considerations may help you make that determination and put yourself in a better position in terms of both your finances and your peace of mind.
What to Consider in Balancing Savings and Debt Repayment
Here are some factors to consider as you decide how to allocate discretionary payments to saving versus paying down debt:
Your emergency fund. Do you have three to six months’ worth of living expenses tucked away in a savings account in case of an emergency? If not, prioritizing savings can help you get there. Don’t neglect making at least the minimum payments toward your debt, but commit a set amount to your emergency fund and then meet or exceed that goal every month or every paycheck.
Having an emergency fund is critical in the event you get hit with unexpected expenses — for example, you suddenly need to replace your computer, have your car repaired or pay for emergency medical care. Having cash on hand for unexpected circumstances may help you avoid having to borrow money and incurring potentially costly debt. You might also find that this financial safety net offers you peace of mind.
The cost of your debt. It’s important to make a list of all of your debt and make sure you understand what interest rate you are paying to carry that debt. While experts disagree as to what constitutes a “high” interest rate, if you look at your most recent statements, you can see how much your debt is costing you each month. If the amount you are paying to carry the debt exceeds the amount you could potentially earn by saving the money instead, then there is a practical case for prioritizing debt repayment.
You may want to target paying off the account(s) with the highest interest rate(s) first, to reduce the amount of interest you are paying. You make larger payments to that account while continuing to make the minimum payments on your other accounts and putting some money into savings. Once that account is paid, you can move to the account with the next-highest interest rate, and continue with this “avalanche” method of repayment until your debts are repaid.
Alternately, some people prefer to target their smallest balance first so they can feel a sense of achievement paying off a balance quickly and then moving on to the next smallest balance and so on. Like the avalanche method, this “snowball” method helps you gain momentum in paying off your debt.
Your employer’s 401(k) match program, if offered. If your employer offers a retirement plan that matches funds to a certain percentage (on average, 3% to 6% of your salary), that is essentially free money you can earn simply by contributing to your account. This is a case for prioritizing saving. As long as it will not prevent you from paying your living expenses or meeting other financial obligations, do your best to contribute at least enough to get the maximum employer match.
There’s another reason to make sure you are saving for retirement today. The compound interest earned in a retirement plan helps it grow over time. If you wait to contribute to your retirement plan until you are debt-free, you will have lost precious time during which your money could have grown.
Your short-term savings goals. Saving for emergencies and retirement are probably not your only savings needs. Maybe you are planning to buy a car in the next few years, or you want to do some traveling next summer. Figure out how much money you will need to have saved to achieve each of these goals and then dedicate some of your discretionary income to these short-term goals as well.
Tips for Saving and Paying Down Debt
Once you have determined the ideal balance of saving versus paying down your debt, keep these tips in mind for staying on track toward your goals:
Incorporate your debt repayment and savings goals into your monthly budget. Include your savings deposits and debt payments in your budget so that you commit to paying them each month just as you pay your rent, utility and other bills.
Choose the right savings account. Shop around for a savings account with an interest rate that will help your money grow faster.
Automate your deposits and payments. If you set up automatic deposits into your savings account from each paycheck, you will be “paying yourself first,” a strategy many financial experts swear by. If you never have the money in hand, you aren’t tempted to spend it; instead, it goes directly into your savings account. Setting automatic payments to your credit accounts is a smart strategy, too, since it helps ensure you never miss a payment.
Make at least the minimum payment to each of your accounts on time every month. Even if you choose to prioritize saving, you must make good on your commitment to repay loans and credit card debt by making on-time payments. Late or missed payments can result in fees and additional interest charges, as well as damage to your credit score and credit history.
