Savings vs Paying Off Debt

We as Americans love to justify debt. Some arguments are more sound than others; for instance, it is easier to justify my student loan debt, which resulted from four years of excellent liberal arts education, than it is to claim that my frequent concert road trips warranted the many, many credit card charges. While I still proudly state that life experiences are priceless, it turns out that mine actually did cost money and I was responsible for paying it back. While trying to build an emergency fund, and save for a down payment, and pay off student loans, and invest for retirement. Sound familiar? So is it best to put the amount set aside for bettering your financial position towards paying off debt or increasing your savings?

 Many financial experts reduce the argument to simple math- if you are paying a higher interest percentage on your debt than you are receiving in your investments/savings, then use your cash flow to pay off debt. However, with today's tepid stock market performance and point-nothing returns on savings, a person following this "simple math" might be tempted to pay off his mortgage before saving a penny for retirement! This is not a healthy, sustainable plan, nor is the cookie-cutter "save for emergency fund > pay off debt > save for retirement". Everyone's plan will be slightly different based on goals, personality, and security requirements, however, there are some basic guidelines.

 Let's first distinguish between "good debt" and "bad debt." While the best debt is the one you've paid off, investment in an appreciating asset is typically considered "good debt"- a house, an education, or a business. "Bad debt" is acquired from anything that declines in value- car loans and credit cards (turns out the trips you've taken, the meals you've eaten, and the jeans you've worn are no longer worth the price you charged to American Express). The IRS actually recognizes the difference between the two, as they allow tax deductions for interest paid on home and student loans. Note that this is not a free pass to enter into a mortgage above your means or take out obscene amounts of student loans. Figure out how you'll afford the monthly payments in advance, and read the post "Indentured Servitude (or Student Loan Debt)" before taking on a big loan. Keep the total of ALL your monthly debt repayment amounts below 36% of your current monthly income (not the income you hope to make in 2 years).

DEBT- Start by listing all of your debts with the balance and interest rate. I personally do not worry about paying extra towards debt under 5% if it is a student loan or mortgage with tax-advantages. I also use 0% interest credit cards for large purchases (think fridge, computer, Home Depot supplies) and pay it over the time period to keep from putting a dent in my savings/ cash flow. I know that most personal finance bloggers are cringing right now, but come on. Free money for 6-12 months? One important caveat- if you cannot make all of the payments and pay it off during the 0% period, don't do it! You will get screwed in the end. Make sure you have the cash on hand to pay it off if necessary.

SAVINGS- Now make a list of your savings (even better, put your accounts in mint.com and have them show you the list). If you say "what savings?", there's a problem. Although I dispute the experts who say you should put six months of living expenses in a savings account before you touch your interest-accruing debt, I strongly encourage you to have at least the amount of one paycheck set aside in a savings account before you divert some of your cash flow to paying down high-interest debt. If your job is not secure, or you have a variable income, put aside a few month's worth of living expenses in the bank first. Base it off your own comfort level and employment situation. If you are saving for a down payment, wedding, or another big event you may need to pause your savings until your "bad" debt is paid off, but use your judgement. You don't have to put your home-owning dreams on hold just because you have a car loan.

RETIREMENT- I know that many people in their 30s do not believe in retirement. Maybe they don't think they will live that long, or perhaps they think that saving enough to actually retire on is impossible. Some think that they will save for it later, when they have more money to put away. Don't be one of them! The one point that all financial advisors agree upon is the power of compounding interest, and that the sooner you start saving the more you will have. Most working Americans save for retirement in either a 401(k) or an IRA, both of which offer tax incentives to save. If you have a 401(k) and your employer offers a match, always contribute up to the match, even if you have credit card debt. To not contribute up to the match is to turn down free money. The only exception is if you plan to leave your job within a year and will not meet your employer's vesting requirements. More about that in future posts.

 If your employer does not offer a match, I recommend that you still contribute a small amount to the 401(k). If you do not have a company plan, open an IRA and set up automatic deposits for each pay period. Do this even if you are paying off debt and can only contribute $20 at a time. You will create the habit of contributing to a retirement account, and it will be easier to increase your contributions as you pay off your debt. Also, the small but growing balance will (likely) encourage you to pay off debt so you can start stepping up your contributions.

PAYING IT OFF- Once you have established a small safety net, start tackling your "bad" debt. Pay the minimum on all of your debt except the one with the highest interest, and contribute all of your extra payment to that one card/loan. Once you pay that one off, apply those payments to the card with the next-highest rate, and continue until you have paid off all of your credit cards and lines of credit. This is called the "snowball method", because as you pay off one debt your payment to the next debt grows. Dave Ramsey coined this term and offers a free calculator on his site, as does mint.com. If you have higher interest student loans (I consider those to be over 6%), apply some extra payments to the principal, but you can also start directing some of your debt repayment money into savings.

After your "bad" debt is paid off, and you are making a dent in your high-interest student loans, you can go back to building a decent emergency fund. Again, the size of your fund will depend on your personal situation. I am currently a salaried employee with a stable job, so my goal is 4 months of "must have" living expenses. If you work on commission, or have a family to support, you may need up to 12 months of "must haves" for protection.

No "bad" debt, emergency fund in place, now it's time to up your retirement contributions. The goal is 12-15% of your gross income, and you can count employer contributions towards that total. As we discussed in "The B Word", your total savings goal is 20% of your income, so where does the other 5% go? The fun stuff! It may be a house, a wedding, or a fund to live off of while you start your own business, go back to school, or sail around the world. Maybe your idea of fun (or peace of mind) is not owing anyone money. In that case, put your "fun" savings towards extra principal payments on your mortgage or low-interest student loans.

Debt repayment and savings building can be a long road, so it's important not to get discouraged. Celebrate milestones- every card, or every large chunk. Acknowledge when you cut your debt in half, or double your savings. This is not a short-term goal, you are instilling a life-long habit. Put savings aside for your security and your goals, because you're worth it.

All posts on this blog are for informational purposes only and are not intended as recommendations as they may not fit your unique situation. Check with an advisor or financial planner for personalized advice.