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.
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.
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?