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Should I Pay Off Debt or Save Money First?

By Valencia Higuera

will you save your money or pay off your debt?Living paycheck-to-paycheck greatly impacts your financial choices. You may face high credit card balances but have no way to pay down the debt, or you may wish to save for college or retirement but barely be able meet your monthly bills. However, if you land a new job that pays well or obtain an additional income source, the extra money could provide enough disposable income to pay off your debt or start saving. But which do you do first?

Opinions among financial experts vary, and there are benefits to both approaches. Consider the various reasons for both methods to figure out which would work best for you.

Reasons to Pay Off Debt First

Nobody likes debt, and without the proper level of income, high balances can follow you for years. But if you have the cash, here are three great reasons to pay off debt before saving your money.

1. To Eliminate Paying Interest
The majority of credit card holders pay interest on a monthly basis, which can be more than 20%. High rates make it difficult to pay down your credit card debt, especially if you fall into a rut of only paying your monthly minimum. This is because a large portion of your minimum payments are applied to the interest charges, and not the principal.

For example, say you have a credit card with a 22% interest rate. If your credit card balance is $5,000 and you pay the monthly minimum of $141 a month, it will take 281 months to pay off the balance. You will end up paying more than $8,000 in interest payments alone over nearly 24 years.

However, if you have an extra $500 each month and you apply this cash to your debt, you can eliminate the same balance in approximately one year and only pay about $541 in interest – a savings of nearly $7,500.

2. To Improve Your Credit Score
If you’re trying to improve your credit score in order to qualify for a mortgage or auto loan, paying off your debt first can jump-start your plans.

Credit card and loan balances factor into your FICO credit score – in fact, the amount that you owe accounts for a whopping 30% of your score. Your savings history with your bank doesn’t factor into credit scores, but if you want to prove your creditworthiness by adding points to your score in a relatively short amount of time, paying off your balance is the way to go. Once you improve your credit score, you’re eligible for lower interest rates on auto loans, mortgages, and other types of loans.

3. To Obtain Peace of Mind
If you owe hundreds or thousands of dollars in credit card debt, it’s likely that you know the anxiety it can bring. The thought of paying thousands of dollars in interest in addition to your debts can make your stomach turn. If you seek relief from this stress, paying off your credit card debts as soon as possible is the best course of action. Besides, while you may wish to save money, you can end up deeper in debt if your interest rates are high.

saving money

Reasons to Start Saving First

Wouldn’t it be nice to watch your savings or investment accounts grow month after month? If you focus on saving money before paying off debt, you can realize this dream sooner.

1. You Have a Low Interest Rate on Your Credit Card
If the rate of return on your savings account is more than what you’re paying in credit card interest each month, saving before eliminating debt makes good financial sense.

Let’s say you have little credit card debt and a low interest rate on your credit card. You can pay off your credit card account over time and put your extra cash toward savings. However, this approach doesn’t benefit everyone. It’s important to read the terms of your credit card agreement carefully.

For example, a 0% interest rate on a credit card is often limited to the first 6 to 12 months after you open an account. But after the introductory period passes, the interest rate on the card can jump to well in excess of 20%. If you decide to save before paying off debt while taking advantage of a 0% interest rate credit card, speak with the issuer and inquire about the average interest rate once the initial rate period ends. It is crucial to keep the rate low to avoid high-interest fees in the long run.

If you are unable to pay off the credit card balance before the 0% introductory period expires but have earned a high rate of return on your savings account, apply funds from your savings account to pay off your remaining balance, and then replenish your account.

2. To Create a Financial Cushion
While paying off debt first helps your credit score and offers peace of mind, it doesn’t help during a financial crisis. If you put all your cash toward debt repayment, you won’t have anything saved up for a rainy day. Create a six- to eight-month emergency fund, which can help you in the event of a job loss, divorce, or illness. It also prevents you from going deeper into debt while dealing with an emergency.

Final Word

Deciding whether to pay down debt or create a savings account first is entirely up to you. Evaluate your personal financial goals and decide which is more important.

If you can’t make a decision, why not enjoy the best of both worlds? Take your monthly disposable income and split the cash evenly between your debt and your savings. It will take longer to pay off your credit card balances, and your savings will grow at a slower rate. However, in the end, you achieve both of your financial goals – and once your debt’s gone, all of your extra income can go toward savings.

Which option – saving money or paying off debt first – do you think is best?

(photo credit: Bigstock)

Valencia Higuera
Valencia Higuera is a personal finance junkie who enjoys reading articles on budgeting, saving money, and credit cards. She has written personal finance articles and blogs for several online publications. She holds a B.A in English from Old Dominion University and currently lives in Chesapeake, Virginia.

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  • Adam

    Great Article! I appreciated how you took the pros from each personal finance strategy. If you’re earning lots of money from your savings then you should keep saving, but if you’re not, which, given the way money markets are behaving, seems more likely, you should try to eliminate as much debt as possible while keeping an emergency savings account open.

  • http://rodger-liverich.webs.com/transfermoneyabroad.htm Frollo Moran

    Paying down debt also might not be the best move if you are likely squander the cash surplus once the debt is paid. If you are getting the benefit of an interest write-off to help offset your income taxes, or if you have the ability to manage debt in the short term or long term.

  • http://www.cpastudyguides.com/ KDB

    If you can pay off the debt fast, then you should probably do that. If not, then doing both is not such a bad idea. Going strictly by the numbers it may not seem to make perfect sense, but at least if gets you into the mode of saving, and helps you build a little buffer when an unexpected expense comes up.

  • http://kenrikrobin.blinkweb.com/ Udell Tivis

    Paying debt and saving money are both very important goals. They are also steps you have to take to reach a bigger goal, living well during retirement.

  • http://kenrikrobin.blinkweb.com/ Udell Tivis

    Paying debt and saving money are both very important goals. They are also steps you have to take to reach a bigger goal, living well during retirement.

  • Lisa V.

    Do both. Even if savings is so minimal it’s a start. Plus if your debt is so large it might take a couple of years to pay off debt and you can’t afford to not start saving. There is a sense of security to having a cushion of savings in the bank, speaking from experience. I had a small amount auto deducted from my paycheck and before I knew it (only 2-3 months!), I had an emergency cushion. Not a lot, but enough to cover most unexpected expenses.

  • Elaine

    Do both. With compounding interest, the longer you save the better so even putting a little bit into a savings account every pay day can add up. Credit card debt is usually spread across several cards. Focus on one card at a time: pay as much as you can on that card and the minimum on the others. When it’s clear, move on to the next card and repeat. And pay on time to avoid charges.

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