If you're been struggling with a mound of debt for quite some time and are also working hard to create or preserve an emergency savings account, you may be wondering if you should switch gears and favor one goal over the other.
Prioritizing your debt payments is always a good idea, but you need to determine whether the consequences of paying down debt faster really are better than building up a savings fund.
See also: Emergency fund vs. Rainy day fund
I generally recommend that you try to accomplish both goals simultaneously, even if you can only pay some debt and build your savings little by little.
But for some people, focusing all their efforts on paying off high-interest debt and then shifting towards saving is the best way to get more control over their finances and stop worrying about debt. Also, for those individuals with absolutely no savings, it can be prudent to at least build some cash cushion before going all-out to knock out debts.
Here are some tips for handling the savings vs. debt payoff dilemma:
Reasons to Pay Off Debt First:
1. You want to lower your monthly payments quickly.
Paying off high-interest debts will reduce your overall monthly payments, which frees up more cash for savings and other expenditures. So, if your primary objective is to slash your monthly bills and more quickly free up cash, you'll want to pay off debt as soon as possible.
2. You need to boost your credit score.
If you're planning to buy or refinance a home in the near future or seek some form of credit, you'll need to have a good credit score. Accumulating savings won't do much for convincing lenders that you should get a low-interest loan (unless you're using the cash to reduce your loan amount).
In general, lenders will scrutinize your credit score because it's indicative of your payment track record and it also reflects how well you've handled credit card debt. That's because 30 percent of your FICO credit score is based on the amount of credit card debt you have outstanding. Shedding some of that debt to give your credit score a boost could make you eligible for much better interest rate on a long-term loan, potentially saving you thousands of dollars.
3. Avoid interest rate hikes.
If you're carrying a credit card balance that was initially offered with a promotional offer or zero-interest rate, you might want to pay it sooner rather than later, to avoid an interest rate hike. Going from a teaser rate of 0 percent to a 15 percent rate, which is the current average rate for credit cards, means you'll be subjected to finance charges on top of the charges you made for purchases. So paying off that debt quickly prevents you from having to pay extra, or potentially excessive, amounts of interest.
Reasons to Save First:
1. You can realistically save up enough money to wipe out debt within a year.
If you can see yourself paying off your entire debt load with a certain amount of savings within a year, focus all your efforts on saving up that money and make just the minimum payments for now. Depending on the debt load, one year's worth of interest might be a small price to pay for having all that debt cleared by year's end.
2. You want to preserve your emergency fund.
If you feel more comfortable knowing you have a stash of cash available for emergencies, you'll be better off saving before making big payments on debts. This is really more of an emotional decision rather than a financial one. But the truth is most financial choices are a simple matter of math or what "makes sense" economically. There's no shame in being realistic about your emotional comfort level when you evaluating different financial options.
3. You need access to cash.
If you want your money to be accessible at some point in the near future, such as relocating to a new state, traveling or starting a business, you may want to delay those big debt payments for a while. Instead, preserve your cash cushion and know that you have access to this cash when you'll need it. Remember that your savings account is still one of your assets.
Of course you could realistically do both and get ahead financially. This may seem tricky at first, but it's not really that complicated.
All you need to do is turn some of those debt payments into an expense and then allocate a portion of your income for a savings account. In this case, you won't be using your savings to pay down your debt, but using a percentage of your monthly disposable income instead. Both your savings contributions and your debt payments will be two separate "expenses" each month.