Pay Off Debt or Save? How to Make the Right Choice

It can be a tough decision: Should you pay down debt or save money? Is it more important to focus first on shrinking your debt to save on interest, or should you prioritize saving enough cash to weather unforeseen circumstances?

The answer depends on your situation, such as what kind of debt you have, how much interest you’re paying on it and how comfortable you are with risk. Here’s what you need to consider as you navigate the important decision of when to save and when to pay off debt.

When to focus on paying off debt

To decide whether you should save or pay off debt first, you’ll need to assess your personal situation. Is a significant portion of your income going toward debt payments? If so, paying down that debt could free up cash to put toward savings in the future.

Here are some other situations where it might make sense to focus on paying down debt:

• Your debt is high-interest. If you’re carrying high-interest balances on credit cards or loans, these costs can quickly spiral out of control. Paying down these debts first can save you a lot of money in the long run.
• Your debt causes stress. Do you feel stressed or anxious about your debt? If your debt is constantly weighing on you, paying it down may bring a sense of relief and improve your mental well-being.
• You have minimal living expenses. If you have low living costs — for example, you’re living with family and not paying rent — you have an opportunity to put extra money toward your debt. This can help you get out of debt faster than if you were living on your own and had to manage high expenses.

How to pay off debt

You’ve decided that tackling debt is your priority. Here’s how you can get started and make real progress toward your goals.

Understand your debt

Knowing exactly what you owe is the first step. Understanding your debt will make it easier to create a realistic plan for paying it off.

Review the types of debt you have. Which of your debts have the highest interest rates? Are you close to paying off any of your accounts; do any lenders have prepayment penalties?

Gather your statements to make a list of your debts. Note the minimum payment, interest rate and total amount due for each account. This will give you an idea of what you’re dealing with, allowing you to prioritize the debts that are affecting your financial situation the most.

For example, credit cards typically have compound interest — meaning interest is added to your balance daily, then charged monthly. This makes it expensive to carry a balance on a credit card. Therefore, you’ll want to prioritize paying off high-interest credit card debt as soon as possible.

Focus on one debt at a time

Always make at least the minimum monthly payment on all of your debts. Then, direct extra money toward one debt at a time to help you avoid feeling overwhelmed.

A common strategy for tackling debt is the avalanche method, which recommends paying off accounts with the highest interest rates first. Prioritizing high-interest debt, such as credit cards, will typically save you the most money in the long run.

Depending on your situation, you may also want to consider the snowball method, which involves paying off the account with the smallest balance first. Then you’ll work your way toward the biggest balance.

This might be the right choice if you have accounts that are close to being paid off. It can also provide a psychological boost when you see one of your balances go down to zero.

Ultimately, you’ll need to carefully consider your situation to choose the approach that makes the most sense for you.

Consider debt consolidation

If you’re struggling to manage your debt, you might want to consider debt consolidation. This involves combining multiple debts into a single loan, giving you one monthly payment. You may qualify for a lower interest rate than what you’re paying on your current debt if you have good to excellent credit.

If credit card debt is weighing you down, you can also consider consolidating with a balance transfer credit card. Similar to a consolidation loan, a balance transfer card allows you to shift high-interest debt to a new card with a potentially lower rate.

Many of these cards come with introductory offers as low as 0% annual percentage rate (APR) for a limited time, which can make it easier to save on interest.

Be aware that both balance transfer cards and debt consolidation loans can come with fees and may temporarily hurt your credit score. Debt consolidation is best suited for people with good credit who want to simplify their monthly finances.

When to make saving a priority

While tackling debt is important, there are times when prioritizing saving makes more sense. For example, if you’re earning more in interest from your savings accounts than you’re paying in interest on your debts, you may want to continue building your savings account.

In general, here’s when to focus on saving:

• You don’t have an emergency fund. If you don’t have enough saved to cover unexpected expenses, such as a sudden job loss or an expensive medical bill, building an emergency fund should be your top priority. This will prevent you from going further into debt if life throws you a curveball.
• Your employer offers 401(k) matching. If your employer offers a 401(k) match, this is essentially free money you don’t want to miss out on. Prioritize contributing enough money to your 401(k) to get the full match, as this can significantly boost your retirement savings.
• You’re going through a major life change. If you anticipate a major life event, such as starting a family, buying a home or changing careers, building your savings will help you meet your goals without increasing your debt load.
• Your debt is low-interest. If your debt has relatively low interest rates, there’s less urgency to pay it off. You might be better off focusing on saving, especially if the savings return will exceed the amount you’ll pay in interest on debts.

How to save money

Decided saving is your top priority? Turn that decision into action with these simple steps.

Assess your situation

Before you can start saving, you’ll need to take stock of your financial situation. Understanding your starting point is crucial for creating a savings plan.

Do you have a sufficient emergency fund to cover unexpected expenses? Are you on track with your retirement savings, or do you need to play catch-up?

To figure out how much you can realistically afford to save, you can first build a budget. Begin by tracking your monthly income and expenses. Then, subtract your monthly bills from your income to determine what you have left to spend or save.

Set savings goals

With your budget in mind, consider your short- and long-term financial goals. If you don’t have an emergency fund, you’ll want to focus on that first.

Experts recommend saving enough money to cover three to six months’ worth of living expenses. However, some people may want to save more, especially if they have fluctuating income or a lot of debt.

Once you feel confident about your emergency savings, you can begin to save for the future. This includes saving for retirement and paying off debt. To stay motivated along the way, break your long-term goals into smaller, more manageable steps.

Automate your savings

Once you know how much you can afford to save and what you’re saving for, make the process effortless by automating your contributions.

If you use direct deposit, you may be able to send a portion of your paychecks directly to your savings account. Alternatively, you could set up automatic transfers between your bank accounts.

Either way, automating your savings removes the temptation to spend extra money and ensures consistent progress toward your goals.

Frequently asked questions

Is it better to pay off debt or save?

The best choice depends on your circumstances. High-interest debt often takes priority, but an emergency fund is crucial for your financial stability. It’s all about finding a balance that works for your situation.

Is it better to pay off debt or save when buying a house?

If you’re planning to buy a house, you’ll need to save enough to cover your down payment, closing costs and other homeowner expenses. But if you have high-interest debt or you’re spending more than 50% of your income on debt payments, you may want to focus on paying down your debts before buying a home.

Should I get a personal loan to pay off credit card debt?

A personal loan may be beneficial if it offers a lower interest rate than your credit cards. Make sure you understand the loan terms and fees, and have a plan to avoid accumulating new credit card debt.