You must complete both, but prioritize as follows: It can be difficult to decide between paying off debt and setting aside money for emergencies. You're not the only one who finds it challenging to decide how to allocate money from a windfall or your budget. Separate from housing costs, household debt soared to its highest level in 16 years in 2020, but at the same time, household savings rates increased to levels not seen since 1975. Is paying off debt or saving money preferable? Most people must do both, but we'll look at some things to take into account when deciding which is more crucial.
Main Points
- Always make your minimum monthly debt payment as well as a small amount toward savings each month.
- When choosing between two options, specific circumstances can help determine priorities.
- Create habits around paying off debt and saving money at the same time for long-term financial stability.
What Is General Rule Regarding Emergency Savings Versus Debt Repayment?
Doing both is the general rule of thumb: Debt consolidation while increasing your emergency fund. "Ignoring the importance of commitment to do both now," he said, "saving at the expense of accelerating debt repayment." Todd Christensen, education manager at Money Fit by DRS, a nonprofit debt management company, said: "It should never be an all-or-nothing option." If you put off saving for emergencies or even retirement in order to pay off debt, but you never succeed in doing so, you might realize one day that it's time to retire and that you are unprepared—and, possibly, still in debt. Contributions could be prioritized toward your emergency fund—at least temporarily. If you don't already have anything set aside, Christensen advised building up a small nest egg—anywhere between $500 and the cost of one month's worth of living expenses. But keep paying more than the bare minimum toward your debts. Let's use an example where you have $100 extra per month that you can use to either pay down debt, put aside for emergencies, or both. In this situation, add an additional $5 or $10 to every debt account, and allocate the majority of the funds to savings. Note: The amount you can set aside each month above your living expenses is what is referred to as "discretionary" spending. Take discretionary money out of every paycheck right away rather than waiting until the end of the month to see how much is left. He said, "You never have money left over at the end of the month, so you've probably spent it all." He said that long-term benefits come from developing a savings mindset instead of purchasing whatever you want each month. When caught up on the account, you'll be more likely to transfer the last debt payment into savings. A variation on that idea was suggested by Samantha Gorelick, a certified financial planner (CFP) with Brunch & Budget, a financial planning company: Pay only the minimum balance on your credit cards until you've amassed a sizeable emergency fund. She advised starting with one month's worth of expenses and attempting to save enough money for several months. Starting small is acceptable; consider setting up an automatic deduction of $10 to $20 from your paycheck to go toward savings. Gorelick said, "While it won't build quickly, you're developing a saving habit—which makes you a saver. Increase the amount you transfer to savings as you become more adept at striking a balance between spending and saving. Your money should at least experience some growth and outpace inflation if you stay invested over the long term and continue making regular contributions. Up until 2018, the stock market had historically returned an average of 10% annually. Your money can grow even faster because it compounds in a tax-deferred investment account like a 401(k) or IRA. Missing out on one or two prosperous years might significantly impact your overall savings. You should be in a better position than you otherwise would be if you pay off the debt while also saving money.How to Choose Between Saving Money and Paying Off Debt as a Priority
There is no one solution that works best for everyone. But there are some inquiries you can make to help you choose whether to put saving money in a high-yield savings account ahead of paying off debt. Ask yourself these inquiries:How is the situation at work?
If your job security is in doubt, put emergency savings first. This is because, according to Gorelick, if you aggressively pay off debt and then lose your job, you still won't have any money, even if you don't have any debt. This encourages you to use more credit cards and accumulate more debt. Having savings can help stop you from using your credit card excessively in the event of a layoff or shutdown. Christensen concurred, adding that having some savings gives you a little more wiggle room when looking for work. When you lose your job and have no emergency funds, the worst thing that can happen is that you feel like you have to find something, anything, he said. "You land a lower-paying position. When future employers look at your resume and see that you're trying to get the same kind of job you had before, they wonder what happened. Being in this situation is difficult. On the other hand, saving might be a no-brainer if your employer matches all or a portion of the contributions you make to your 401(k) (k). You get an immediate return on your investment with a 401(k) match. Consider it a bonus or pay raise. Easy money is available. Therefore, save at least the amount your employer will match, which is typically between 3 percent and 6 percent of your salary. If you intend to leave your employer before gaining access to those matching contributions, there is an exception to the rule.How much do I currently have in emergency funds?
According to Christensen, a general rule of thumb is dividing your annual income by $10,000 to determine how much emergency savings you require. The answer tells you how many savings months' worth of expenses you'll need until you land your next job at a comparable salary. Save up three months' worth of living expenses, for instance, if your yearly income is $30,000. You need six months' worth if you make $60,000. Gorelick advised reviewing your budget if you discover that you are regularly withdrawing from savings rather than adding to them. Reduce your monthly contributions and concentrate on budgeting your spending so that it doesn't exceed your income.Do I require additional savings?
Christensen pointed out that sometimes "expected" expenses can be just as challenging as unanticipated ones. For instance, you'll likely have to purchase a car within the next five to ten years. However, you'll be at the mercy of the lender's interest rates if you don't start saving for that car right away. Other "expected" costs might cover home repairs or appliances. You could use a designated savings account for planned expenses rather than having to take money out of your home equity to obtain a loan for those things. Make your savings difficult to access, advised Christensen, to prevent you from succumbing to the temptation of "savings raiding." Put your cash in a bank that is not where you typically conduct your banking, such as one that is offline or online. In a genuine emergency, you need to have quick access to the money but shouldn't leave it open to whimsy spending.Which kind of debt do I owe?
Payday, car title, and pawnshop loans, for example, can have annual percentage rates (APR) well above 100%, which are shockingly high compared to other debts. Christensen noted that if you have any of these, you should pay as much as possible toward those types of debt. If it's just $1 or $2 per month, contribute to your emergency savings account. While it's still important to make regular payments on other debts with lower interest rates, such as your mortgage, car loan, and federal student loans, doing so may not be as urgent if you start saving for emergencies. Your advantage from paying off the balance quickly increases with the interest rate. Tip: You could use your monthly loan payment to fund emergency savings because federal student loan repayment was temporarily suspended during the pandemic, suggested Gorelick.Am I Anticipating a Possible Windfall?
Spend money wisely if you receive it unexpectedly from the government, a relative, or a job. If you already have some savings, Christensen suggests using the following formula as a general guideline:- Thirty percent should go toward needs, such as fixing your car or replacing any broken appliances, to avoid accruing debt in the future.
- 25% goes toward debt repayment.
- a savings rate of 20%
- 15% for investments over the long term
- 10% for recreational expenditures
- But if you don't have one, think about using this calculation:
- Thirty-five percent is set aside for emergencies.
- 30% is allocated to needs
- 25% goes toward debt repayment.
- 10% for amusement
A Salt Grain
The general principles are known as "rules of thumb" may not apply to everyone. In your circumstance, you might need to treat such laws with a grain of salt. For instance, pay off any outstanding debts from your credit cards, mortgage, or car before setting up an emergency fund. Christensen became tense. You might lose access to employment and other necessities of life if you don't pay back some loans, like a car note. However, even in that circumstance, "if you can contribute just a dollar to your emergency fund, you've saved something. Saving money is a lifetime commitment; until the current financial crisis is resolved, saving is not justified. If more people saved money, there would likely never be another payday lender. That is not the case. Important: For the best guidance tailored to your circumstances, consult a nonprofit credit counseling agency or a licensed financial professional if you have any questions.Questions and Answers (FAQs)
How can debt be repaid more quickly?
It takes strategic planning and focused effort to accelerate debt repayment. Both the debt snowball and the debt avalanche are frequently employed strategies. With the snowball method, you'll pay off your debt by applying as much as possible to the smallest debt and then rolling that extra money to each debt that grows progressively larger as you pay them off. You'll adopt a similar strategy when using the avalanche, but you'll start with the highest interest rate and work your way down. You'll gain momentum in both situations as you pay off each debt.What amount of money should I set aside each month?
One general rule of thumb is to start by saving 10% of your monthly income if you're just getting started saving. Establish a spending plan, and if you discover that you have extra money to save, do so. Saving money is a good place to start, and you can increase it as you find more room in your budget.