One night last week while getting the mail, my husband and I received a check for $360. We weren't expecting it, so the question arose what do we do with the money? Do we save it, pay down a bill, head to the mall? Do we select one option, all options, etc. It got me thinking about the question I get a lot about building a savings or paying off debt. What's the right financial answer? Well as with many financial questions, the answer is....it depends.
Pay, then Save When...
When you have high interest consumer debt (ex. credit cards), paying this off first will help you in the in the short term and long term because you will save on that ongoing interest. Remember, interest is the cost lenders charge a consumer for borrowing money. When you borrow money, you end up paying back more because not only do you owe what you borrowed, you owe interest. Paying debt first also makes sense because it’s typically more than you’d earn in the stock market, definitely more than you’d earn in a savings account (even the high yield savings accounts I recommend), and your payment is recalculated by the lender as the balance is reduced.
If your debt isn’t consumer debt (ex. mortgage), the decision may change because of the low rate, tax-deductible interest, and your financial goals. Making extra payments will save you money in the long run, but in the short term, it doesn’t cause your lender to recalculate and lower your monthly payments. When deciding whether to pay off tax-deductible debt versus saving, don’t worry about losing a tax deduction if you pay off the debt. The deduction is probably worth less than the annual interest you would have paid on the loan (again if you pay off the debt).
Save, then Pay When...
When you need to build an emergency fund. If your debt has a very low interest rate, it may make sense to save first, especially if you have no savings. Focusing only on debt payoff can backfire if you have no savings built up for unexpected expenses. You might need to borrow again, and debt can begin to build again. Experts recommend building an emergency fund of three to six months’ worth of expenses and stashing it in a savings account. Compare savings accounts to find one that pays a decent return. Then once you have your emergency fund built, it might make sense to increase your debt payments again. Another situation where it makes sense
to save before paying debt is when you’re talking about retirement savings, especially if there’s an employer match available. If you have a workplace plan, try to contribute at least enough to get the maximum employer match. Putting off saving for retirement until you are debt-free could cost you your most valuable asset: time. With compounding interest, even small contributions to your retirement plan can grow significantly.
Option 3: Pay AND Save
The best option could be to balance your saving and debt payoff. You might be paying more interest than you need to, but having savings to cover sudden expenses like car repairs keeps you out of the debt cycle. If the options above feel too one sided for you, it might make sense to do a little bit of both to put you at financial ease. So what did the hubby and I do with the $360? Well, see the breakdown below:
$120 - Bills
$120 - Savings
$120 - Fun