What’s More Important: Paying Down Debt vs. Building Up Savings
For many households, it’s a personal finance dilemma: Should you try to pay down your debt first, or build up your savings?
Perhaps it’s due to the current economic environment, but opinions tend to have tipped toward the ditch-your-debt side. According to a recent poll by the National Foundation for Credit Counseling, Americans are choosing to deal with what they owe: nearly 90% of those surveyed said they value paying down debt over saving money.
At face value, paying down debt sounds like it’s always a good thing. But if it comes at the expense of saving, it’s a bit more complicated.
Reducing your debt makes sense if you’re someone who loses sleep over debt, or if you’re trying to improve your credit scores. And if you already have a savings plan established, paying down debt should be your top priority.
But when determining how you allocate your money, you should consider “opportunity cost.” For example, is the interest you’re paying on your debt greater or less than the return on an investment you could make with the funds?
If you have credit card debt at 14%, paying it off is like earning 14% on those funds — more money than you’d make if you put your money in a savings account. On the other hand, if you can refinance your mortgage to a low rate (say, 5%), keeping a low-interest loan active while putting money into other investments may garner you a profit, not to mention a possible tax deduction.
However, not everyone agrees on the idea of putting debt first. Some financial professionals suggest the cornerstone of any personal finance plan is to have an emergency fund in place and that developing a cash cushion should be the first order of business.
According to Cambridge Credit Counseling, consumers should be saving 10% of their income. And in an uncertain economy such as this one, you should be looking to have money to cover at least 10 months of expenses where you can readily put your hands on it.
In the best of worlds, you would split the difference: Pay down debt and contribute to a savings account at the same time. The end result would be a comfortable emergency fund, plus you’d be paying down debt which increases your credit score, reduces credit card usage, and improves your financial life.
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