Balancing Debt Repayment with Savings
- April 11, 2017
- by Emily
You may ask yourself, should I pay off debt or save the money? We've listed a few key things to consider as you are balancing how much to devote to each financial priority. Building your net worth is essentially about paying down debt and increasing your savings. How you go about maximizing your net worth is a personal question and greatly depends on your situation.
Budgeting guidelines recommend that you spend 20 percent of your income on “financial priorities” - savings and debt repayment, in other words. Unfortunately, they don’t specify exactly how much should go towards each goal. At Wealth Meta we believe that "one size fits all" advice is the first thing to ignore because it glosses over important details. You'll be much better off learning the financial landscape, understanding all your moves, and then picking the options that make the most sense to you.
You Lose More On Debt Interest Than You Gain From Savings
Almost any type of debt you have will come with a higher interest rate than you are likely to earn from a savings account or even from investments. This means that in terms of building your long-term net worth, prioritizing debt repayment is smart.
So I should put all my discretionary income towards paying off my car loan? Well, not so fast. First of all, it is still important to consider how much interest you pay on that particular debt. Car loans typically have low interest rates, so they should be a low priority in your debt repayment scheme. Credit cards, on the other hand, which often come with double digit interest rates should be the first thing you pay off.
Paying ahead on a loan is the surest “return” you’ll get on any of your investments, since you’ll pay significantly less interest over the life of the loan.
The Banks Make Money Off Your Debt - You Can Stop Them
Loans and credit cards are pushed by marketing teams, shiny advertisements, and sales people - just like all other major products. Except here, you and your future income are the 'product' being extracted. When you accrued the debt, you agreed to pay the interest over the life of the loan. When you pay ahead on the loan, assuming there are no prepayment penalties, you lock in that return. No matter what happens to the stock market, inflation, election cycles, etc, you have guaranteed yourself that return. Guaranteed returns are basically impossible to come by elsewhere.
When you pay ahead on your loan, you may find it a little sweeter that the bank doesn't really like it. The bank would rather see you pay them as much interest as possible! Just consider how much junk mail you get every month with low APRs on loans of every type. Credit card companies are even worse. They consider people who pay off their balance every month 'dead beats' since they don't make any money off them (except transaction fees which may not be enough to cover any miles or points programs involved with the card).
The Flexibility and Joy That Comes With Having Zero Payments Is Terribly Underrated
Paying off debt undeniably feels good. Paying off an entire debt makes your budget look amazing because it frees monthly cash flow. In other words, if you eliminated a $650 car payment you now have an extra $650 to deploy as you see fit towards your financial goals. It is also $650 less per month that you 'have to earn'. Less debt means more choices in life, which is a form of success.
You Need An Emergency Fund
Even if you’re working to pay off high-interest credit card debt, building an emergency fund is crucial. You should have enough savings to pay for 6 to 9 months of all of your expenses. Having this emergency fund in place can help you avoid going further into debt if something unexpected - a job loss or medical emergency - wrecks your financial plan.
If you don’t have this cushion in place yet, focus on building it before shifting more of your resources to debt repayment.
If your employer offers matching 401(k) contributions, not putting money into the company plan is like forgoing a part of your compensation. You lose the matching dollars if you don’t manage to contribute to the plan yourself.
For example, let's say your employer match is 3%. That means for the first 3% you contribute, your employer will kick in a matching 3%. By saving that 3%, you get a 3% raise! It’s like you are saving 6%. Plus when you save through your company’s 401(k) plan, that 6% is not taxed, which makes it even sweeter. Take full advantage of the employer match!
Buying a Home
If you’re currently renting and part of your savings plan is to save to buy a home, it makes sense to save more so that you can start building equity instead of paying rent every month. Prioritizing savings over debt repayment makes sense if you are able to buy a house sooner and get a head start on building equity.
Back to that issue of debt costing more than savings. If having a larger savings (which you use for a down payment) means that you qualify for a lower interest rate on your mortgage, you will be saving yourself a considerable amount of money in the long term.
The bottom line is that there is no magic ratio when it comes to paying off debt vs saving. It all depends on what your savings goals are, what type of debt you have, how high the interest rate is and how much savings you currently have.
Instead, think about breaking up your savings and debt repayment budget in terms of priorities. Your first priority should be establishing an emergency fund, followed by paying down any high-interest debt. Saving for retirement and paying off other debts are about equally important and come next in your financial priorities. The lowest priority, financially speaking, is saving for your next trip to Paris.