Paying Off Debt vs Saving: What to Choose
Summary: Deciding between paying off debt or saving is not a zero-sum game. For the average person, it is a balancing act and involves doing what’s best at any given time, for your financial well-being.
Managing personal finances often involves making tough choices, and one of the most common dilemmas is deciding whether to prioritize paying off debt over building your savings.
Let’s look at the advantages of paying off debt versus saving, the factors to consider when choosing between the two and practical strategies for achieving both goals.
Understanding the concept of paying off debt
Incurring a level of moderate debt (mortgage, credit card, student loan) is part of an average household’s financial journey. After all, debt is a risk you take on willingly, with the knowledge that it has to repaid within a timeframe. When debt exceeds a reasonable amount though, there can be financial disruption and even mental and emotional turmoil.
High inflation has led to a third of US adults leaning heavily on credit cards for survival. What’s more, nearly half of all credit card holders now carry debt from month to month.
Credit cards usually carry the highest interest rates, with some rates being as high as 30%. With high interest debt, a significant portion of your monthly payments goes to pay the interest rather than reducing the principal balance. In essence, you end up paying much more than the original cost of your purchases.
For example, if you are paying $212 monthly on a $5,000 credit card balance at 30% interest, by the time the card is paid off in 36 months, you would have spent a total of $7,641, of which $2,641 was for interest. It may also take a long time to pay off your credit card balance, especially if you are only able to make minimum payments on your credit cards.
Savings can act as a shock absorber for unplanned emergencies and expenses. Moreover, they can reduce the need to rely on high-interest debt.
The importance of saving
Saving can mean different things to different people. For some, it’s putting money in the bank while for others it’s buying equities. In economic terms though, it’s when you reduce consumption today to consume more in the future.
It’s a crucial decision that allows you to build a reserve that you can tap into for major purchases, emergencies or in retirement. By diligently putting away a portion of your income each month, you can create a safety net that reduces the need to rely on borrowing for unexpected expenses.
Many financial experts recommend you have an emergency savings fund to help pay your bills if you lose your job or encounter any other unexpected expenses like medical bills or car repairs. An emergency fund should have at least three to six months’ worth of living expenses. When unexpected events strike, you can dip into existing funds instead of having to rely on credit cards or other debt.
Saving money is also important for financial security in your retirement years. You can save for your retirement by contributing to a 401(k) or IRA retirement account, which can significantly grow your savings over time through the power of compound interest.
Is it better to pay off debt or save?
With economic uncertainties such as inflation, dictating our choices, the decision to save money or pay off debt can be complicated, Ideally, you should be able to do both, but if you are struggling financially, that may not be a viable option. For instance, higher credit card dependence, in the wake of higher cost of living, has been linked to diminished personal savings.
Since it’s not an either/or decision to save or reduce debt, it’s essential to weigh the pros and cons before developing an effective strategy.
Factors to consider when choosing between paying off debt and saving
1. Interest rates
Interest rates are probably the most crucial factor to consider when deciding whether to save or pay off debt. If you have a high interest rate on your credit card or payday loan, it negates any interest you may be earning on your savings. So, it makes sense to prioritize paying off your debts over saving.
2. Debt management
How are you at managing your debts? Do you remember to make your monthly payments on time? If you often miss payments and have difficulty managing your debt, your mismanagement could put you further in the red. Most credit card companies levy significant fees for late payments. Plus, late payments will also hurt your credit score, making it difficult to borrow money in the future if you want to buy a car or get a mortgage for a house. This is why it’s crucial to stay on top of your debt and make your payments on time. It’s not just about avoiding late fees; it’s about protecting your financial future.
3. Credit utilization
Credit utilization compares the total credit you have available to how much credit you are actually using. For example, if you have a credit card with a $5,000 credit limit and a balance of $3,000, your credit utilization is 60%. It’s recommended that credit utilization stays below 30% otherwise, it could hurt your credit score. Paying off your debt may be the right thing to do if you are using more than 30% of your credit limit.
4. Emergency savings
If you don’t have some money saved up for emergencies, saving your money may be wiser than paying off debt. Without an emergency fund, you may be forced to use a credit card when unexpected expenses arise, putting you in even more debt.
Best Ways to Pay Off Debt While Still Saving
It’s important to remember that balancing debt repayment with saving is difficult but not impossible. These methods offer a glimmer of hope, showing that it’s possible to achieve both financial goals.
1. Make a budget
The first step in paying off debt and building your savings is to create a budget to better understand where you are spending your money. A popular budgeting model is the 50-30-20 plan, where 50% of your income goes to your needs like rent, utilities and groceries, 30% is used for your ‘wants’ and 20% for your savings or debts.
However, if you are trying to pay off debt, you may try tweaking this formula a bit. For example, you could instead limit your discretionary expenses (the things you don’t need) to just 20% and then allocate 15% to savings and 15% to pay off debt. This way, you’re still prioritizing your expenditures while paying off debt and building emergency savings.
2. Choose a debt repayment method
There are various strategies available for paying off debt. Two of the most recommended are the debt snowball and debt avalanche methods. The debt snowball method prioritizes paying off smaller debts first while maintaining minimum payments on larger debts, fostering a sense of achievement as smaller balances are cleared. In contrast, the debt avalanche method targets debts with the highest interest rates initially, minimizing long-term interest costs significantly.
3. Set up automatic savings
Once you’ve created a budget and decided on how much of your income you can put into savings, set up your bank account so a percentage of each check you deposit is automatically transferred into savings. Even small, regular deposits can grow substantially over time.
4. Consider getting a balance transfer credit card
Getting another credit card might seem counterintuitive when paying off debt, but many companies offer 0% interest on balance transfers. This allows for all your payments to go toward the principal balance. However, it’s important that you pay off the balance within the promotional period (usually 12-21 months). This is to avoid being charged high interest on the remaining debt, an outcome that defeats the original purpose of the additional card.
5. Debt consolidation
If you have several high-interest credit cards, you may be able to consolidate them into one loan with a lower interest rate. This not only helps reduce the number of payments you must make each month but also enables you to pay your debt off quicker because more money is going to the principal balance.
Conclusion
Deciding whether you should be paying off debt or saving money is a decision that depends on various factors, including your financial goals. Factors such as interest rate, credit utilization, emergency reserves and your debt management skills are all essential things to consider when choosing between paying off debt and saving.
Ultimately, the best approach involves a combination of saving and debt repayment strategies that align with your financial situation and your long-term objectives. For personalized financial advice and comprehensive planning, contact Mutual of Omaha today to speak with one of our financial professionals who can help you develop a strategy tailored to your unique needs and goals.
FAQs
Q1: Is it better to save money towards a down payment on a house or pay off debt?
In most instances, you are better off paying off debt (especially high interest-debt) and hold off on buying than saving money towards down payment. Additionally, paying off your debt can help reduce your debt-to-income ratio and credit utilization, which can help raise your credit score. A higher credit score can impact a lender’s willingness to approve your mortgage and help reduce your interest rate. Depending on your situation, consider some of the tactics discussed above to pay down your debts and save simultaneously.
Q2: What is the 50-30-20 rule?
The 50-30-20 rule allocates 50% of income to needs, 30% to wants and 20% to saving and debt repayment. You can adjust this to fit your goals, such as using 30% for building savings and paying off debt, and 20% for wants.
Q3: Is living debt free worth it?
Living debt-free can bring a significant sense of financial security and peace of mind. Without the burden of monthly debt payments, you’ll likely have more disposable income to allocate towards savings, investments, or other financial goals. Being free from debt can also reduce stress and anxiety, as there is no looming obligation to repay borrowed money. This financial freedom can lead to a more stable and comfortable lifestyle.
On the other hand, living debt-free isn’t the only path to financial well-being, and it may not always be the most practical for everyone. Certain types of debt, such as a mortgage or student loans, can be considered ‘good debt’ because they often come with lower interest rates and can lead to long-term benefits like homeownership or increased earning potential. The key is to manage debt wisely, ensuring that it is used strategically and kept within manageable limits.
Disclosures:
Registered Representatives offer securities through Mutual of Omaha Investor Services, Inc., Member FINRA/SIPC. Investment Advisor Representatives offer advisory services through Mutual of Omaha Investor Services, Inc.
Mutual of Omaha and its representatives do not provide tax and/or legal advice, and the information provided herein is general in nature and should not be considered tax and/or legal advice.
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