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Save or Pay Off Debt?

Save or Pay Off Debt?

            If you suddenly had an extra $100 a week available to either save/invest or use for debt repayment, what would you do?  Set the money aside or increase your monthly debt payments? The question of which comes first - saving/investing or debt repayment - is one that financial advisors are often asked.  Is it better to save $100, add it to “regular” debt repayments, or even do a little of both?

            So what should you do? The best answer to this question is probably one that is used in many financial planning decisions...”it depends.” In other words, there is no automatic “right” answer that would apply to everyone all of the time. Choices need to be made based on personal circumstances and available saving/investing options.

            Many people would argue that debt repayment should take top priority. After all, interest rates charged for many types of debt (e.g., credit cards) are now in the double digits compared to relatively low rates of return earned on bank accounts and money market funds. It is often said that paying off high-interest credit cards is equivalent to earning whatever rate is charged on the card. 

            Another option for the extra $100 could be to use it to prepay the principal on your mortgage, saving both debt repayment time and future interest charges. Here, the key comparison is between the interest rate charged on the mortgage (after-taxes, if you itemize mortgage interest as part of your tax deductions) and the rate of return that could be earned elsewhere, such as on stocks or growth mutual funds. Of course, repayment of higher interest debt (e.g., credit cards) would almost always trump principal prepayment on a mortgage or home equity loan due to the much higher interest rates that are charged on credit cards.

            Let’s look at a specific savings designation for that extra $100.  What if it was stashed in an account designated for emergencies?  Perhaps, right now, you don’t have much (or any) money set aside for an unexpected expense or a financial crisis such as unemployment. In this situation, mathematical calculations and interest rate comparisons will not be the deciding factor between saving and debt repayment. The key point here is that you need a cash cushion, even if you will not be earning a high return on this money.

            Of course the third strategy is to do a little of both; i.e., use the extra $100 to both save and reduce debt. For example, since credit card interest is generally much higher than interest rates earned on cash assets (such as a money market fund), you might decide to spend $75 on debt repayment and save the remaining $25.

            By saving money and reducing debt at the same time, you’ll still be making a dent in your outstanding debt. You’ll also be building up some cash reserves and/or taking advantage of compound interest on long-term savings (e.g., 401(k) plan deductions from your paycheck). Perhaps even more importantly, though, you’ll get into a regular savings habit now instead of waiting until all of your debt is completely repaid, which could take years.

 

 

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