Banking 101: Pay Off Debt or Save - How to Make the Right Choice
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.
There are people who suffer because of an external hardship, but those things will happen and people should plan for them.
I know what another Mr. T would say, I pity the fool that lets a good website slide into oblivion and drive everybody somewhere else. Clicks are $$ Lending Tree, don’t fix what’s not broken just for the sake of change.
Your disclaimer at the end says it all.
1. Paying more interest
2. Taking longer to pay off the debt
I don't give the typical "cookie cutter" advice you can get that anywhere.
My point is that even with a balance transfer fee this is still the cheapest loan you will ever get from a bank.
I assume the young have google and a smartphone which is all that is required to look this up.
Two years old.
This is like the reward checking accounts with 10 debits per month.
Sure it is legitimate and might be worthwhile for a person with no other way to make an income. Open a new credit card, transfer the balance, every 2 months, for 2.5% interest after 6 transfers in a year.
I understand the world of high finance is more ****y, to some people.
All valid and legal since it is those banks/credit unions that offer it. One is just following their rules to earn some bonuses. It does take some labor and intelligence to find them. :-)
On a $100K balance transfer the monthly payments are significant and if you miss a payment, the whole thing is recalculated from day one with new interest and penalty added to it. It may become a disaster for someone who has lost the ability to pay in the middle of the cycle.
This business of "balance transfer arbitrage" is sometimes tricky. I have little doubt that when banks formulate their "0%, no-fee balance transfer" offers, some of them may be factoring in that a certain percentage of customers who take advantage of these may: 1) fail to make a minimum payment or two and therefore suffer much higher interest rates, or 2) become "addicted" to the "free cash", and not have a plan to repay in full the balance when the rate changes - and again the penalty is higher rates. To some degree, these higher rates will subsidize the lower rates (or zero rates) for those who pay on time.
To some that may be interested, my suggestion is (1) to keep an open mind (many do earn a lot from this method), (2) to try it for yourself prudently (keys: seek fastest way to get the money into your bank account, pay minimum balance monthly, pay in full when offer ends, etc.)
I would just say that this forum may not be the proper platform for such discussions. That is why the very few can still take full advantage of this tactic.
A better more advanced guide here:
Keep in mind that no guide is 100% complete. The most important thing to remember is do not under any circumstances make new charges on a balance transfer card. Use a cash back credit card like Citi double cash for purchases and a balance transfer card like Chase Slate for balance transfers. Trust me even if purchases are 0% as well don't do it as it makes things way too complicated. Feel free to ask me any questions as i have been doing this for decades.
All my cards sync up toward the last few days of the months on closing dates; for a better FICO (minimizing debt to income ratio).
And 10 votes... amazing, simply amazing :D
Save for it before you buy it, that way you teach the young to crave savings, because they can not have it unless they save for it, see how simple it is. Forget these credit methods and ways for handling debt, that is how the character of the young is changed the wrong way, tell them, you can not have it unless you can buy it after the saving equal the cost of the item(s).
Fourth, you can get credit card as a line of credit on any asset the bank find it acceptable.
I'm sure there are other methods to get a credit card, like asking your grand parents for their SS# and apply in their names, but you use it as your own and you posses the card and many more other schemes.
Ah, the problem was backin the day the parents weren’t making deposits into an account on my behalf. Clearly I am a member of the unlucky gene club. I am pretty sure the secured cards didn’t exist back them. My first credit card was obtained while I was at college as a targeted offer for students. I guess the acceptable asset was my education. I do wonder if it helped that I had no student loans as I worked full time and studied part time. Asking grandma and grandpa for their SS number?
If a person has the financial backbone of a jellyfish, they themselves have a problem that needs to get fixed. No amount of "blaming the messenger" (i.e., the credit card, or some other inanimate object) will get that done.
you werent suckered .
Because of that, I just set it aside in a savings account and then paid it all off at once.
I probably should have paid some and held back the rest but I was a paranoid about getting fired, quitting and then being unable to find another job and I did not want to lose the card or ruin my credit.
So I just sat the money aside and then when I had enough, paid it off in full. I think the final 17 payments all at once.
Probably should have paid some early and saved some.
I eventually lost that job but had the car paid off. Got another one that I didn't really like so only stuck with it about 8 months. Then I determined to start my own business and not work for anyone else. And I have not. I also swore off debt. And, other than a 2 month credit card cash advance when I was starting my business and later playing arbitrage by borrowing at 0% and sitting it in a savings account, I have never carried any debt. (waited & paid cash for a house. Probably should have bought sooner and borrowed to do it but I had my reasons for not doing it at the time)
I read something like this when I was young and it made a big difference in me retiring early versus always having a new car.
As for the cash back, the argument against credit cards says you and I spend more unconsciously because swiping a card does not "hurt" like cash does. And if I spend an extra $2.00 on a fast food meal, the 2% cash back dwarfs in comparison.
But, I think many young people and those in too much debt need to see the thing about cars, because that is how so many get in so much trouble.
(Even though I could pick at parts of the video)
OFF TOPIC, can you tell me how you can post without being a registered user? I tried logging out, Could not post. Created a new account, it forced me to pick a username so again, I have to have a username.
I have one or more stalkers who change usernames every other post.
If I were to be able to do that, my stalker would not be able to find me.
I don't like clearing any of that stuff so I may just have to come up with another username & then switch when he finds me.
I post on yahoo answers and there is a dozen people a month who want to get rid of a car they cant afford and are $2000+ upside down. Reality is you have to slowly chip away at that, No magic answer. Others are in the same boat but want a different car. SMH,
Most people would do well to stay out of car dealerships forever.
Speaking of fraud, here is something for you:
Read agenda 21 and you will find why.
Our society is addicted to debt and if all debts were suddenly paid in full the economy would collapse. Sad, but true. The danger for those without debt is that you will be asked (or ordered) to relieve the debt of those who can't or won't repay their debts. This is the insidious nature of large scale consumer debt. Someone defaults and we all end up paying more. Like retail theft, the cost is always passed on to the next guy with ready cash.
These debt strategies are boring at best. The best solution is to make more money AND spend less. When the next recession arrives be prepared, once again, to bail out the selfish who will demand "relief" from their oppressive debt loads. I believe in allowing people to fail. I'll buy you a meal but I'm not picking up your mortgage, student loan payment or cell phone contract.
These "balance transfer arbitrage" strategies, which I used heavily back in the day and still use somewhat today, do require some degree of thinking and planning - and good credit. They can of course be done in addition to "spending less" and "making more money". And ironically, it's actually the folks who go hog-wild with credit cards WITHOUT thinking and planning, who sometimes get themselves into trouble.
I'm here on this website mainly to look for good CD and liquid rates, just like yourself, but a question about these balance transfer strategies was posed several weeks ago in this forum, and I contributed an answer (as did others). I'm definitely not trying to "sell" anything. However, use of these strategies, together with other good financial practices, has allowed me to retire early and slightly increased our standard of living. For people who are using their balance transfer cash to speculate on penny stocks, or who are desperately looking for someplace else to transfer their balance because they didn't plan ahead for when it became due, it may be a different story.
That's a very different thing than using credit as a tool to make some spare cash. BY DEFINITION, to be done successfully the latter requires the balance transfer initiator to be knowledgeable about their credit and to plan well. I'd guess that 99% of the people who got themselves into trouble with credit from, say 2007 to 2012, were NOT doing the credit card arbitrage thing, but were instead trying to flip houses after the marker died, or were just clueless about credit cards in general.
I supported part of what you said with actual math to prove what you were saying. Trouble is I sent it and it was deleted (dead on arrival).