Once you have established a budget and begin to save money, it can be confusing what exactly to do with those funds. On the one hand, you may be tempted to save and invest it to let the money grow over time. On the other hand, you may have some debt that still has not been paid in full.
Choosing how to allocate this money can be very difficult. After all, if you do not save enough money now, you may struggle when it comes time to retire. However, the prospect of entering retirement while still in debt can also cause a lot of anxiety.
For many people, the right approach is a blended one that allows them to save while also working on paying of debt. Here’s what you need to know to make that call:
What to Think about When It Comes to Paying off Debt
Paying off debt is a noble goal and should be a priority when it comes to personal finances. However, if you focus completely on paying off debt you will not have money to fall back on in case of an emergency.
If you do not have an emergency fund, you may end up taking out more debt to cover an emergency, which can make you feel like you are not making any progress. Unexpected expenses can creep up at any time, so it is important to have some amount of money set aside to help when this happens. Many experts recommend having $1,000 in a savings account to cover emergencies before focusing on paying off debt.
As you start to focus on paying off debt, make sure you make your high-interest debts a priority. By paying down the principal on these accounts, you reduce the amount of interest that you pay each month. This could ultimately have a bigger impact than you would make by investing the money.
For many people, it makes sense to focus on high-interest debt first and then make minimum payments on low-interest debt since they could actually come out on top by investing the money. Student loans and mortgages tend to carry fairly low interest, but it is important to keep track of each account on your own.
If you want to make extra payments on a fixed-payment loan, you will usually end up paying off the loan early as a result. The loan is not typically recalculated to lower your monthly payment. Importantly, if you make an extra payment, ensure that it is going toward the principal rather than being allocated toward a future payment, as that is the fastest way to reduce overall balance. You may need to request formally that the payment gets applied to the principal.
What to Think about When It Comes to Saving
Saving money is another important goal when it comes to personal finance and seeing the cash in those accounts grow can be very exciting. The primary issue that can arise when prioritizing saving over paying off debt is the fact that many debts have such high interest rates that you will pay more in interest charges than you gain by saving.
Also, if you prioritize saving, then you run the risk of carrying debt into retirement. Of course, many people have comfortable retirement lives while continuing to pay on debts. However, this can limit what you feel comfortable doing and place a significant strain on your monthly budget.
Some situations exist in which you should prioritize saving over paying off debt, such as any debt with a low interest rate. In this situation, you will likely see more growth in money saved in an investment account than you would avoid in interest payments.
If you find yourself with only low-interest debt, you should make sure you grow a significant emergency fund before you focus on paying off more debt. Ideally, an emergency fund covers between three and six months’ worth of living expenses.
However, if you do not focus on saving until your debt is completely gone, you will put yourself at a disadvantage in terms of retirement savings. Putting money away early gives you the benefit of compound interest. When money is invested for a long period of time, you will start to earn interest on the interest you already earned. These ultimately means you get exponential returns. This is the reason that it is so important to save for retirement as early as possible.
The Bottom Line in the Question of Saving Versus Paying Debt
In the end, it will probably be best to both save and pay back your debts simultaneously, but the balance of these actions will likely change over time. While you have high-interest debts, it is important to focus primarily on paying them off. If you can, however, you should also save a small amount in a traditional savings account to ensure you have money to cover unexpected expenses as well as invest a small amount in retirement savings to take full advantage of compound interest.
As your high-interest debts are eliminated, you can begin to focus more on saving since the benefits of paying off this sort of debt are more limited. The balance you strike between paying off debts and saving also depends on your own feelings. If you can only have peace of mind when you are free from debt, it could make sense to focus on that. On the other side of the coin, if not having anything saved gives you anxiety, prioritize that process.