In the realm of personal finance, the age-old question arises: should you prioritize repaying debts or saving money? This decision requires careful consideration, balancing both mathematical calculations and emotional factors. This comprehensive guide presents two distinct approaches and a step-by-step plan to help you make an informed choice that aligns with your financial aspirations.
Is it better to repay debts or to save money? Two approaches
There are two different approaches to determining whether it’s more advisable to repay debts or save money, but they don’t necessarily exclude each other.
1.The mathematical approach to debt or savings
The mathematical answer to the question of whether to save or repay debts is that you should put your money where it will be most profitable for you.
If you’re wondering whether it’s better to repay a debt or put the extra money into a retirement savings account, consider the situation as follows: If the interest rate on the debt is lower than the return rate of the retirement account, pay the minimum on the debt each month and put the extra money into the retirement account.
Conversely, if you have a high-interest debt that costs you more than what you could earn by investing the extra money, you should strive to repay the debt before saving.
For instance, let’s assume your only debt comes with an interest rate of 4%. If you can reasonably expect a 6% return from your retirement account, the mathematical solution would be to pay the minimum on your debt and invest the rest.
On the other hand, if you have a credit card balance with a 19% interest rate, it is more sensible from a numerical standpoint to focus on repaying the high-interest debt.
2.The emotional approach to debt versus savings
Many individuals have a negative emotional reaction when it comes to debt. Therefore, when they contemplate whether to repay their debts or save, they opt to tackle their debts first, even if the numbers don’t necessarily support this decision.
Focusing on debt repayment before saving provides a greater peace of mind for some. In reality, money isn’t solely about budgeting or simple calculations.
A significant portion of emotion influences our day-to-day financial choices. If that weren’t the case, we would all spend less than we earn, no one would have debts, and there wouldn’t be money issues to speak of.
Do You Have to Choose Between Repaying Debts and Saving?
When considering whether to repay debts or save, do you have to choose one over the other? Of course not.
It’s possible to allocate a portion of your surplus income towards debt repayment and another portion towards saving for your future. This, of course, assumes that you have a significant amount of extra income to work with.
How do you calculate whether to save or repay debts?
Most of us believe that our money should be used where it can have the most positive impact on our overall finances. This might make you lean towards the mathematical approach.
However, if your debt is spread across multiple loans, such as a mortgage and a car loan, and your investment opportunities are diverse with varying return rates, the calculation becomes a bit more complex than simply comparing the interest rate of a loan to the interest you can earn from an investment account.
When you factor in compound interest, things become even trickier to calculate. Some accounts might not have the best returns this year, but their potential to earn you money over time through compound interest is unparalleled. You’ll miss out on this potential if you don’t contribute to compound interest accounts as early and as frequently as possible.
A step-by-step plan to compare debt and savings
If you’re feeling a bit lost right now, don’t worry. It’s because there’s no right or wrong answer to the question of whether you should pay off your debts or save. However, this step-by-step plan is what we recommend to individuals who have debts but want to start saving for the future.
1.Build an Emergency Savings Fund
If you’re wondering whether you should prioritize paying off your debts or start building your emergency fund, the answer is to establish an emergency fund. The last thing you want is to resort to credit cards and accumulate other high-interest debts in case of emergencies, such as medical bills, car repairs, or home maintenance.
The amount you want to start with depends on your situation, for instance, whether you own or rent a home, if you have children, and the job security in your field of work. The more financial responsibilities you have, the more you’ll want to set aside a significant amount just in case.
If you’re a renter and early in your career, you might be okay with a small emergency fund of $1,500 to $3,000. If you own a home or have children, you should aim for three to six months’ worth of income in your emergency fund. This way, you’ll be prepared for any unexpected situations, even if you were to lose your job.
2.Focus on Repaying High-Interest Debts
Now that you have a small emergency fund, direct your attention (and extra income) towards your debts. Any debts you have with risky interest rates, or rates higher than 9%, should be your top priority for elimination.
Such high-interest rates will likely cost you more money than you’d earn from most investments. By paying off these debts as soon as possible, you’ll pay less in interest.
If you have high-interest debts and anticipate needing time to repay them, you might consider refinancing through a personal loan. The idea is to replace a high-interest debt (like a credit card) with a lower-interest loan.
For instance, if you’re paying a 24% annual interest rate on a credit card and you get a personal loan at a 12% annual interest rate – and immediately use the loan amount to pay off your credit card – you’ll end up with a more manageable debt. In this example, 12% isn’t ideal, but it’s much better than 24%!
3.Determine Savings and Debt Priorities
At this stage, your finances are in reasonably good shape. You have an emergency fund, and you’ve cleared any high-interest debts. Should you pay off other debts or save more at this point? That’s up to you to decide.
If your debt’s interest rate is lower than the average stock market return rate (around 10%), it’s probably mathematically wiser to invest your money. Interest rates above 10% are considered high-interest debts, and it’s likely worth paying them off before starting to invest.
Having low-interest debts isn’t necessarily bad. You can start working on this debt or, if you have other financial priorities, start addressing those. It all depends on your tolerance for debt and your financial goals.
You might wonder whether it’s better to pay off your debts or save for a down payment on a house. If buying a house is one of your goals and you’ve cleared your high-interest debts, it might be time to start saving for that down payment.
On the other hand, if your priority is to become entirely debt-free, you can continue channeling your extra income into paying off the remaining debts.
4.Stick to Your Budget Plan and Keep Saving
The uniqueness of personal finance lies in its individuality. You’re not obligated to allocate all your extra income toward debt repayment or savings. You can do both.
Continue working toward being debt-free and keep contributing to your retirement savings. With the financial foundation you’ve built, you should be able to pay off your remaining debts while still planning for the future.
Paying off debt or saving money? It’s a personal choice.
Ultimately, the decision to pay off debt or save is one that each individual must make for themselves. Every situation is different. For some, it might make more sense mathematically to allocate the minimum payment to debt and the rest of the income to investments. However, the desire to be debt-free might lead them to do the opposite.
The key is to determine what’s mathematically logical in your situation and what aligns with your savings goals and values. From there, you can make an informed decision and create a plan that motivates you to take action.
Deciding between repaying debts or saving money is a pivotal choice that requires a blend of rational analysis and emotional consideration. The mathematical approach emphasizes interest rates, while the emotional approach focuses on peace of mind. Striking a balance between these approaches, guided by a step-by-step plan, empowers you to navigate this financial crossroad successfully.
Frequently Asked Questions (FAQs)
- Can I focus on saving without repaying debts? Absolutely, but managing high-interest debts is crucial to prevent long-term financial strain.
- Are all debts detrimental to financial health? Not all debts are equal; high-interest debts can be particularly detrimental.
- How do emotions influence financial decisions? Emotions influence our choices, impacting both short-term and long-term financial strategies.
- Is it possible to allocate funds for both goals? Yes, a well-structured financial plan can accommodate debt repayment and savings concurrently.
- Should I seek professional financial advice? Consulting a financial advisor can provide personalized insights aligned with your goals.
- Can I adjust my strategy over time? Yes, adapt your approach as your financial situation evolves, but remember to maintain a balance.