It is always good to save money, but what if you are in debt? Many people struggle with the dilemma of whether they should devote “extra” money to savings or use it to retire their debt. There is an easy answer if you look at the two options from a logical, mathematical standpoint. That said, humans are not robots, so a logical approach may not give you the best answer for your situation.
The other way to look at the problem is through an emotional lens. Retiring debt and saving money affect how people feel about themselves and their financial situations. The emotional approach can help you sleep better at night but it may not provide the optimal solution in terms of maximizing your net worth.
We cover both methods below; pick the process that most benefits you.
The logical approach for saving money versus retiring debt is a very straightforward calculation involving interest rates. The interest rate on the debt you want to pay off determines what your debt is costing you annually. You will also need to know what rate of return you could earn if you decide to invest in a way other than paying off debt. Some people would keep the money in a savings account and earn about one percent interest, while others would invest at what they expect would be a higher return in a different type of investment, such as a dividend-paying stock.
The logical solution is simple. If your returns from your alternate use of your money exceed your interest rate on your debt, then you should not pay down your debt. If your debt costs more than your expected return on the alternate use of your money, pay off the debt. "One of the greatest expenses we have in our life is the interest expense on debt," says Adam Carroll, Chief Education Officer at National Financial Educators. "Every single percentage point that you can decrease means massive amounts in your savings and investments later on."
The emotional approach for saving money versus retiring debt is nowhere near as straightforward as the logical approach. You must consider many variables. Then you must decide what helps you achieve your life goals while at the same time not allowing your debt to keep you awake at night.
Some people want to have a small emergency fund before paying off debt. While this may not make sense from a logical standpoint, it makes sense emotionally. Having $1,000 to $5,000 in the bank to cover small emergencies gives peace of mind to some, should something unexpected occur. They will not be getting the optimal benefit of that money, but peace of mind can be priceless.
Whatever you do, do not go overboard by funding anything larger than a small emergency fund while you have high interest rate debt. If you do, you will end up paying more in interest on your debt than you will earn on hoarding more cash.
Other people just cannot handle being a penny in debt. They may feel very stressed out and generally cannot sleep well whenever they owe any amount of money to anyone. For people like this, it may make sense to pay off your debt rather than save.
The unfortunate part is you may have to incur more debt should an emergency pop up. Just make sure you are not incurring more debt for anything other than a true emergency.
Life goals fit into the emotional approach as well. It may make sense to deviate from the logical path if you are saving for a house down payment or trying to pay off all of your debt before retirement. Just do not make foolish decisions based on unrealistic goals.
If you want to reduce your interest payments and lower your debt, try the free Debt Optimizer by MoneyTips.