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When you’re in debt with rising interest costs, it can be easy to get tunnel vision. In many cases, paying off your debt should be your top priority. But being so focused on paying off debt can sometimes make it harder to achieve other important financial goals, like building an emergency savings fund to cover unexpected expenses.
Whether it is better to pay off debt or to save depends on your individual financial situation. Here’s a closer look at when to prioritize saving over paying off your debt.
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Paying off debt vs. saving: what should you prioritize?
Whether you should prioritize paying off debt or saving can depend on the type of debt you owe and the interest rates involved. As tempting as it may be to pour every extra dollar you have into paying off debt when you don’t have a reserve fund, it could hurt your financial goals. If an expensive emergency hits — like an unexpected doctor or car repair bill — and you don’t have an emergency fund, you may need to take on more debt to cover it unforeseen expenses.
In general, your first priority should be saving money for emergencies. If you already have money saved, you can focus on paying down debt until you are debt-free.
If you have very high-interest debt or some type of debt with difficult repayment terms (like a payday loan), you should pay off that debt first to avoid paying more interest than you need to.
If you’re still struggling to decide whether to pay down debt or build up your emergency reserves, look at how much it’s going to cost you each month. Notice how much it will cost you to pay off the debt and how quickly you can realistically pay it off.
HOW DO I SET UP AN EMERGENCY?
Reasons for debt settlement
In some situations, it may make sense to pay off debt before saving, including:
- You have a high interest rate. The quicker you pay off your debt, the less interest you pay. If you have high-interest debt, such as credit card debtyou can save a lot of money by focusing on paying off your debt before you start saving.
- You want to improve your credit rating. The less debt you have, the lower your credit utilization, which can improve your credit score.
- Debt causes you a lot of stress. As helpful as an emergency fund is, if the thought of debt is keeping you up at night and making your life extremely stressful, it may make sense to prioritize repayment over saving.
Here’s an example of why paying off debt as quickly as possible can be a sound decision.
Let’s say you owe $5,000 on a credit card with an APR of 17% or APR. If you only make a minimum monthly payment of $121, it will take five years to pay off the debt and you’ll pay a total of $2,573 in interest.
If you could double your monthly payments by paying $242 each month, you’d be paying off that credit card debt in two years and only paying $958 in interest. You can see how hectic it is to pay off your debt can make a huge difference financially.
If you have multiple high-interest debts weighing you down, you can combine those debts into one Debt Consolidation Loan, which is a type of unsecured personal loan. You pay off your existing debt and then only have one monthly debt payment to manage. If you can get a lower interest rate on the new remortgage loan, you can pay off the debt even sooner.
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reasons to save
As long as you’re still making minimum payments on your existing debt, prioritizing saving also has some benefits worth considering. Here are some circumstances where saving before paying off debt might make more sense:
- They have no emergency reserves. Getting into a costly emergency can leave you in debt, which can increase the amount of interest you have to pay and the time it takes to get out of debt.
- You are working toward a specific financial goal. If you have an upcoming expense, like a vacation or a car down payment, focus on setting money aside to help you reach your financial goal so you don’t have to borrow more to pay it.
- You have the opportunity to earn compound interest. Money you save can make more money for you. When you put money into a savings account, certificate of deposit, money market account, or investment account, you can earn interest that accumulates and increases over time. The earlier you start saving, the longer the interest will last and the more money you can make.
For example, let’s say you put $500 in a retirement account and invest $500 a month for five years with a 7.5% return. If that interest compounded annually, you would have $35,568 at the end of five years.
Establishment of an emergency fund
An emergency fund is an important safety net in case unexpected costs arise. How to build one:
- Add up your living expenses. A good rule of thumb for an emergency fund is to save six months of living expenses. This way you can afford essentials if you lose your job. If you’re employed and an emergency arises, this fund is likely large enough to cover unexpected expenses.
- Create a savings plan. Once you know how big you want your emergency fund to be, you can figure out how much you can afford to put into the fund each month. Add this amount to your monthly budget and stick to it as you would any necessary expenses.
- Open a high-interest savings account. Don’t leave your nest egg in your checking or regular savings account. Find a high-yield savings account to open and store your emergency fund in, so you can compound the interest and grow your savings for yourself.
Debt Repayment Strategies
There are many strategies to help you pay off debt. Here are some common ones to consider:
- Use a credit card or a debt consolidation loan. Combine your high-interest debt into one source like a Debt Consolidation Loanideally with a lower interest rate, can streamline your monthly payments and make it easier for you to focus on your debt-payment efforts.
- Work with a nonprofit credit counselor. You can book a free consultation through the National Foundation for Credit Advice and get personalized debt settlement advice.
- Consider debt snowball or debt avalanche repayment methods. With the debt avalanche method, you pay off your highest-interest debt first (while making the minimum payments on all your other debts), saving you the most money in interest. With the debt snowball method, you pay off your smallest balance first, which can be more motivating since your balances will do it disappear faster.
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If you want to focus on saving, these strategies can get you started:
- Create a budget. Creating a budget and sticking to it will help you stay accountable, avoid overspending, and develop better saving and spending habits.
- Reduce your biggest monthly expenses. While it may be difficult, try to cut down on your biggest monthly expenses. If it’s renting, you may be able to move to a cheaper apartment or find a roommate to help you split the expenses. If your car lease is sky high, consider buying a used car when it ends. See what’s eating up your budget and how you can make more room for savings.
- Negotiate your bills. Some bills, like cable and WiFi, are more negotiable than you might think. See if you can negotiate better deals on recurring monthly expenses so you can put more money to save.
It’s possible to work towards paying off debt and saving at the same time, but it’s important to plan and develop a strategy that will benefit you.
For example, you may be able to set a budget that includes both saving and paying off debt — such as As you pay off more debt, you can use more money to save and get closer to your financial goals.