If you feel like you’re drowning in debt, you’re not alone. In 2021, household debt rose to More than 14 trillion dollars In the United States alone. This is a very large number, and we don’t even have a way to understand it. It’s no wonder people wonder whether they should prioritize saving money or paying off debt.
Being in debt is never a good feeling. Every time you spend money or dream of saving for something very special, debt is always in the back of your mind. With rising housing costs, stagnant wages, and an ongoing major student loan debt crisis, it can seem nearly impossible to pay off debt.
So, it makes sense that you would want to get it over with as quickly as possible! But is this always the best option? It may come as a surprise to you, but in some cases, it’s better to save than pay off debt.
Let’s break down how to decide whether you should personally save money or pay off debt based on your unique situation.
Understanding interest rates
Not all debt is the same, and this is the biggest factor in determining whether you should save money or pay off debt. Simply put, there is low-interest debt and high-interest debt.
When deciding which debt should take priority over saving, the first thing to look at is interest rates. A general guideline is that if the interest rate on the debt is more than 7%, you should pay that off before you start saving and investing. On the other hand, if your debt is less than 7% interest, you can start saving and investing while you work to pay it off.
I’ll go into more detail later about this, but basically you can make more money by investing the money you would put toward paying off debt. Cool, huh?
What are your priorities?
Before you know what to save and what to pay for, you need to understand what you need to survive! You need to determine how much money you need to cover all your living expenses. To do this, you should track spending for a month to see where your money is going. This will help you know which areas you spend the most on and what you can cut back on.
Next, you need to build a budget. If you’re new to this, I encourage you to check out all the budgeting resources on the blog or start at mine Free course on budgeting basics. Ideally, once you cover all of your living expenses, you can then use the extra money to create an emergency fund.
Build an emergency fund
Before you start paying off debt, you should have an emergency fund first. But why would you want to do that? You want to do this before paying off any debt so you don’t use credit cards in emergencies and rack up more debt when you try to pay them off.
Your emergency fund should cover between 3 and 6 months of expenses (aim for the higher end if you have family). It’s best to put this aside in a high-yield savings account so you can earn as much interest as possible while still having access to it in an emergency.
Remember, this is not a shopping account. Emergencies are for anything unexpected such as medical expenses or sudden job loss. By calling it an emergency fund, it encourages you to leave it untouched.
Once you’ve identified your emergency fund, it’s time to think about paying off debt or saving for your next financial goal.
Find out the best rates for savings accounts below:
How to evaluate your debt
Now is the time to prioritize your debt. This will help you determine the order in which you need to pay off debt as well as when you can start saving.
There are several methods you can use to pay off debt. Here’s one of my favorites!
- Create a list or spreadsheet listing all your debts, their interest rates, and the minimum payments for each.
- Then, add all of their minimum payments together to figure out each month’s baseline and what it will cost to pay them.
- Determine whether you want to pay off debt using the debt snowball method or the debt avalanche method.
The debt snowball method
- Look at which debt has the lowest balance and start from there. You will want to pay extra towards this debt each month. This is in addition to paying the minimum for all others.
- Once that debt is paid off, move on to the debt with the next lowest balance and keep moving forward until all of your debts are paid off!
- Continue this way until you are debt-free or until you free up additional money each month to save part of your income.
Debt collapse method
- Look at the debt with the highest interest rate and start from there. You will want to pay extra towards this debt each month. This is in addition to paying the minimum for all others.
- Once you pay off that high-interest debt, move on to the debt with the next highest rate and keep going until all your debts are paid off!
- When you reach interest rates below 7%, you can start using some extra money to invest and save as well as pay off debt.
How much should I save each month?
If you’re wondering how much you should save, you need to work backwards from your financial goals. Whether it’s saving for a vacation, a down payment, or an emergency fund, determine how much you want to save and the time frame to achieve that goal. Then work backwards! For example, if you want to build an emergency fund of $6,000 in six months, you’ll need to save $1,000 per month.
Each person’s savings plan will look different depending on your income and expenses. Whether it’s $20 a month or $2,000, the important thing to remember is that you’re saving.
Don’t be afraid to invest
While putting money in a savings account is great, it’s even better to invest that money. Money in a bank account hardly grows when it can earn you a lot through investing. If you wait to invest until you are completely debt-free, this will only prolong the time it will take to get out of your debt.
For example, student loans can take decades to pay off (unfortunately), so you don’t want to wait until you’re debt-free before you start thinking about investing for retirement or buying a home. The earlier you start investing, the better. Compound interest is when you earn interest each year in addition to the initial amount. It continues to grow every year at a higher rate.
Most student loans and mortgages fall under the 7% rule. Even the most conservative investments yield an annual return of 8-10%. If the interest is 7% or less, that means you can use that extra percentage to make money while also paying off your debt.
Find what works for you
In the end, we all want the same things. To buy a house one day, send our kids to college, retire at a reasonable age, and go on vacation every now and then. Most of the time, these things cost a significant amount of savings which can be difficult to achieve if you are constantly in debt.
If your debt is very high compared to your monthly income, it may take many years to reduce that debt to zero, especially if it is mostly at high interest. When that’s the case, you also want to try to save a little money each month on top of your debt payments, so your financial goals aren’t put right on hold.
Once you find a plan that works for you, stick with it. When you pay off your debt, you’ll be very good at putting money aside. You’ll be relieved when your savings start growing exponentially because you’ve put your entire previous debt payments into savings instead.
Final thoughts on saving money or paying off debt
As you can see, the answer will be very different given your current financial situation. The first thing you need to do is sit down and understand your debts so you can determine your priorities. Then you can put yourself in a position to pay off debt while also saving for the future!
If you’re just starting to deal with your debt and are feeling overwhelmed, be sure to check out my budgeting life planner. It’s a quick way to keep your finances organized so you can work on paying off that debt and saving!