Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
When you carry a substantial amount of debt but also need to grow your savings, it can be tough to figure out whether you should pay off debt or save money. Should you focus on shrinking your debt so that you pay as little interest as possible? Or, should you fund your savings so that you have enough liquid cash to deal with sudden expenses?
Experts believe that for most people, the answer to whether you should pay off debt or save is not cut and dried. It will depend largely on your individual circumstances and your tolerance for risk. Here’s what to consider as you navigate the important decision of when to save and when to pay down debt.
When you should save
If you haven’t set aside at least enough money to cover an emergency expense of between $400 and $1,000, then experts agree that you should focus on boosting those savings first.
“If you have no savings at all or very little savings, that’s an emergency,” said Bruce McClary, vice president of public relations at the National Foundation for Credit Counseling. Without the cushion of adequate savings, you could become overly dependent on credit as a safety net — which would make it harder for you to shed your debt for good.
You don’t necessarily need to save a huge amount, adds Thomas Nitzsche, head of communications for Money Management International. “If you want a rule of thumb, it’s a really good idea to at least get $1,000 saved up before you get really super aggressive with debt,” he said. The question of whether you should pay off debt or save money depends primarily on your personal circumstances and how much risk you can afford to take.
Stephen Newland, an accredited financial counselor and coach at Find Your Money Path, advises his clients to take a financial stress test before deciding where to focus their attention. For example, he recommends asking yourself how much misfortune you think you could withstand with the savings you have now. “If you lost your job and you subsequently lost your income for six months, could you make it?” asked Newland. If your answer is no, then you probably need to rethink your strategy.
Other risk factors could also tip the scale in favor of boosting your savings, Newland affirmed. For example, “If you have an old roof on your house, you need to keep a little more in reserve, or if you have an older car or questionable job prospects.”
You may find it tempting to put off emergency savings if you have a lot of debt. But unless you’re sure you’ll be able to pay off your credit card or other high interest loan balances quickly, you are taking a risk by putting off saving for years. “It’s inevitable that something’s going to happen, especially if you have a long debt road,” said Newland.
Experts typically advise that you save at least three to six months’ worth of living expenses; but, depending on where you live and whether you have a family to support, that amount could be more than you can handle. “You may find saving up a $3,000-to-$5,000 buffer more doable,” said Newland.
If most of your debt is relatively low interest, you may also want to consider focusing on your long-term savings, such as retirement. For example, paying off student loan and mortgage debt quickly isn’t usually as crucial as shedding high-interest credit card debt. But delaying your retirement savings for too long could make it tough to catch up later.
If your employer offers a generous 401(k) matching program, you’ll also leave a significant amount of money on the table if you don’t max out your contribution. If your debt is low enough that you can afford the interest on your loan(s), you may decide to be somewhat less aggressive with your payments.
When you should pay down debt
If you don’t have a lot of savings but have other resources that could help bail you out in a crisis, then you may have more flexibility with your get-out-of-debt strategy.
For example, Nitzsche recommends looking at your total financial picture, not just your savings, before deciding how much emergency cash you need. “Do you have a boat that’s paid for, or do you have a pretty healthy 401(k) that you have access to for a loan in a pinch?” he posed. If so, then you may not need as much cash on hand and can focus on reducing your debt instead of saving.
According to Nitzsche, you also may be able to risk saving less if you have a strong credit score — because that will give you access to interest-free credit cards and balance-transfer deals that you can use to finance unexpected purchases.
In addition, Newland points out, recent grads who are living at home or who still receive financial help from Mom and Dad may be able to afford a more aggressive debt strategy. The more resources you have available to you, the more risk you can afford.
The type of debt you are carrying also matters. For example, “If you’ve got a large amount of credit card debt and you’ve got a high annual percentage rate (APR), that should probably be your priority,” said Beverly Harzog, a personal finance and credit card expert for U.S. News and World Report.
Credit card interest is notoriously high compared with other loans. “Compound interest is really evil when you’ve got credit card debt,” said Harzog. If you don’t pay it down quickly enough — or worse, if you only pay the minimum amount due — you could wind up owing far more than you ever borrowed.
McClary recommends doing the math before deciding whether to pay off debt or save. The faster you pay off debt, the more money you’ll save overall. “Take your debt and look at it based on how much it is costing you to pay off,” he said. “I think what you’re going to find is that paying off your debt faster, clearing it out of your way — even if it gets in the way of growing your savings for a short amount of time — will help you in the long run.”
If you have enough money saved for emergencies, you may also want to consider paying off other loans, such as your mortgage, more aggressively. Just be aware that your lender may not readjust your required monthly payment unless you ask.
Best ways to save
If you decide to focus on your savings, it’s a good idea to be strategic. You’ll reach your goals more quickly if you take advantage of the many tools available to savers.
Choose the best online savings account
To get the best possible return, look for a savings account that offers an above-average amount of interest. You can use a customizable tool to compare savings accounts and get a feel for how much you can earn.
Take advantage of technology
Banks and credit unions are constantly developing new resources for savers, including savings calculators, colorful budgeting tools and automated money transfers. In addition, a number of apps have popped up in recent years that help savers to sock away extra change and automate their savings.
Upgrade when you’re ready
Once you have enough cash saved and you’re ready to take bigger risks with your money, research your other savings options. For example, if you can afford to let go of your cash for a longer period, you’ll earn more interest through a certificate of deposit. Or, if you’ve saved up a significant amount, you can invest your money instead.
Best ways to pay down debt
If you decide to focus on paying down debt, you also have a number of methods available to you.
Debt snowball vs. debt avalanche
Two of the best-known debt-clearing tactics are the debt snowball method and the debt avalanche method. The debt avalanche method is the most cost-effective: Pay off the balance with the highest interest rate first (while continuing to pay the minimum amount due on your other accounts) and then tackle the account with the next highest rate. But some research has shown that the debt snowball method — which advocates paying off the balance with the lowest interest rate first and then using that momentum to keep going — can be more motivating to certain borrowers. It can also be easier to stick with, believes Newland, because it is less overwhelming. Choose the method that best fits your personality.
Use a budget to help you carve out bigger payments
Look for opportunities to trim your expenses, recommends Harzog, and apply those savings to your balances. “Go through your budget with a fine-toothed comb,” she said.
Look for ways to reduce your interest payments
If your credit score is high enough to qualify, you’ll also save a substantial amount of interest by transferring your balance to a credit card with a low or 0% APR, or by consolidating your debts with a low interest rate personal loan. Alternatively, you may be able to lower your interest payments by talking with your creditor, advises McClary. “If you feel that your progress toward paying down debt is stymied by paying a higher rate than you [think] you deserve, it’s on you to make the first move,” he said.
Pay off debt or save: make the right choice
When deciding whether to pay off debt or save, there is no perfect answer. Before you commit to a strategy, think carefully about your finances and what resources are available. You may find that the choices you made years ago are no longer a good fit for today.