There are two schools of thought the argument of paying off debt first versus saving first and paying off debt slowly.
School of Thought #1: Some people believe that you should pay off all of your debt first before saving for the future or doing any kind of savings other than an emergency fund. The thought here is that you are effectively borrowing against your own money if you have $10k in the bank and $10k in debt. The logic is that the normal American wouldn’t go out and buy a loan in order to go invest it. This is more of an emotional approach to personal finance. I tend to lean towards the intangible and emotional side of making personal finance decisions, because this is life you are talking about, so you need to make decisions based on what is best for you and your family, and reducing financial risk in your life will put your family in a better decision. This approach reduces the financial risk in your life.
School of Thought #2: Other people believe that should save all you can as early as possible and just pay off your debt slowly, as long as your interest in savings is higher than the interest you pay in debt. So, if you are earning 12% in your investments, and you’re paying off a car loan at 7%, then you should just continue to pay your four or five year car loan off one payment at a time rather than paying it off early by temporarily haulting your savings. This approach is more of a mathematically logical approach to making a personal financial decision.
But, what if you could do a little bit of both? What if you could save aggressively AND pay off debt aggressively? Sure, in a perfect world, you might be thinking to yourself. But, for those of you who both work and have decent paying jobs, it may be possible for you to save for retirement, build an emergency fund, and pay off your debt more quickly than if you pay the regular monthly payment. If you and your spouse both work and contribute 6% of your salaries to a 401(k), you’ll be saving $4200 per year for retirement PLUS any matching contributions that you company gives you. That’s $2.25 million dollars if two 30 year olds retire when they are 65, assuming a 12% annual gain. That’s not too shabby for the average American. Inflation will eat some of the value of that money, but you’ll still retire nicely. Most families can sacrifice 6% of their household income without it being a major hit on their finances if both spouses work. Then, get on a strict budget to make sure you have a decent amount of cash to start paying off student loans, credit cards, and car loans. Don’t worry about the house, because your house is an appreciating asset and you can think about paying that off early once you’ve cleaned up the other debts, started funding college funds for kids, and your retirement contributions are rolling. You can make this happen, but it will take discipline. Again, this won’t work so well if you are supporting a family on one income. But, I’m speaking more to those that both work with full-time jobs of $35k or more.
Think about this plan and see if you can make it work. Are there any of you out there that aggressively save and pay off debt at the same time? What makes it work for you?
