When it comes to paying off credit card debt versus building up savings, each option comes with its own set of advantages and drawbacks. On one hand, having substantial savings can provide a safety net during unexpected emergencies. On the other hand, focusing on paying off high-interest credit card debt can save you from accumulating more debt and incurring unnecessary interest charges.
While both paying off debt and saving money for emergencies are necessary for financial stability, you may have a limited budget and be wondering which one to tackle first. Understanding the benefits of both options will help you create a plan based on your financial goals.
- There is no one right answer when it comes to balancing paying down debt vs saving. It depends on your unique financial situation and what is important to you.
- Focusing on building emergency savings while at least making minimum payments on your credit card debt can give you a cushion during financial hardships. But, focusing on paying off your debt can make it more manageable over time.
- Saving and tackling debt is not a zero-sum game. The best strategy is to strike the right balance between saving and debt reduction through planning and budgeting.
The Argument For Saving First
While paying off your credit card accounts is crucial for achieving your long-term financial goals, so is building financial resilience and planning for your future. Before aggressively tackling any toxic debt, set aside an emergency fund and take advantage of employer 401(k) matches.
Start an Emergency Fund
While you may get tempted to pay off your debts as soon as possible, having an emergency savings fund that you can use during an unexpected crisis will go a long way to keeping your finances stable. Without designated savings for when things hit the fan, a sudden ER visit or a lost job can put you in a tough situation. You may feel tempted to rely on high-interest credit cards or personal loans to cover the emergency expense, which will only exacerbate your debt and worsen your financial situation.
If you have not created an emergency fund yet, most experts recommend setting aside 3-6 months’ worth of living expenses, though some suggest 6-12 months’ worth. If you find this difficult, start small. Even saving $20 a week could be a good start. Having some money set aside for an unexpected expense is better than nothing.
As you start stashing money away, open a high-yield savings account, such as Marcus by Goldman Sachs or Ally Bank, so your money can grow when you pivot to tackling your balance. While you build your fund, you should at least make the minimum payments on your debts to avoid paying late fees and damaging your credit scores.
Take Advantage of Your Employer Match
Retirement may be the last thing on your mind when you are struggling to pay off debt and save money. But, if your employer offers a match in a tax-advantaged retirement account such as a 401(k), you should at least contribute enough to meet the maximum match amount. For example, if your employer matches up to 5% of contributions, you should contribute at least 5% of your pre-tax income into your 401(k). Otherwise, you are missing out on free money.
While you will not be able to easily tap into your 401(k) to cover surprise expenses, taking advantage of your employer’s 401(k) match is crucial because you cannot get this money back retroactively. Additionally, the later you start planning for retirement, the more work you will need to put in down the line to make up for the lost time.
Pros of Prioritizing Savings
There are several advantages to prioritizing saving:
- The earlier you start, the more time you have to let compound interest do its magic.
- Rather than waiting until you repay all your loans, you can start working on your financial goals on your timeline.
- If an unexpected expense comes up, you will have easily accessible savings and not resort to accumulating more credit card debt.
The best reason to start saving earlier is to leverage the power of compound interest. Compound interest is the interest you earn on your interest, whether in a savings account, investment portfolio, CD, etc. In other words, the more time your money sits in the markets, the more time it has to compound and grow. If you are young, the more money you stash aside today, the greater the chance of it growing into something substantial down the line.
Waiting even 5 or 10 years to start saving can make a significant difference in how much money you have in the future. For example, if you set aside $1,000 today in an index fund like VOO or SPY toward your retirement savings, 20 years from now, that $1,000 would be worth ~$3,869.68. If you wait ten years before investing the $1,000, you would only have $1,967.15.
Saving early on can also help you achieve other medium-term or long-term goals, such as buying a house, traveling the world, starting your children’s college funds. Additionally, having some money set aside can provide a financial buffer for an unexpected car repair or medical bill.
The Argument For Paying Down Debt First
Debt can grow like compound interest as well, so it can increase over time and prevent you from getting other lines of credit or achieving your financial goals. If you have significant debt, you may want to aggressively whittle the balances down to make your debt more manageable.
Your debt repayment strategy will vary depending on the types of loans you have, such as student loans, auto loans, mortgage loans, etc. Start by focusing on the highest-interest debt first, such as personal loans or credit card loans, because their interest rates can cause your balance to spiral out of control.
2 Strategies to Reduce Debt
There are two common strategies for debt repayment: the snowball method and the avalanche method:
- With the snowball method, you would list out all your debts by their total amounts and pay off the smallest ones first. Then, work up to the most expensive ones. The goal is to focus on the psychological benefits of paying off your balances. By clearing small amounts first, you can give yourself some quick wins and lessen the emotional burden of carrying debt.
- For the avalanche method, you rank your loans based on their interest rates and focus on tackling the balances with the highest rates first while continuing to make the minimum payments on all the other loans. If you have lots of high-interest debt eating away at your take-home pay, this strategy can help clear the balances that impact you the most first.
Regardless of which strategy you choose, try to make the minimum payments each month at the very least. Additionally, keep any overdue debt at the top of your mind. If you do not pay your credit card balances on time, that could trigger late fees. Meanwhile, past-due mortgage payments could lead to foreclosure of your house. Missing even one payment can hurt your credit scores a lot.
If you are struggling to meet your minimum monthly payments or your total unsecured debt is more than half your gross income, you may qualify for debt relief. Talk to a financial advisor or credit counseling agency for assistance on a debt management plan.
Alternatively, you may want to consider lower- or no-interest options. For example, if you accumulated a lot of credit card debt, consider taking advantage of a 0% balance transfer offer. Or, if you have significant student loans, consider refinancing to lower the interest rate you are paying. The goal here is to reduce the interest you accrue over time and thus reduce your overall debt load.
Pros of Paying Off Debt
There are several benefits to bringing your debt down:
- You can reduce the amount of interest you pay over time, which will be crucial if you have a lot of high-interest debt.
- Your credit scores will improve.
- Once you repay your balances, you can focus on other financial goals.
- Tackling debt can remove an emotional or mental burden.
If you have $10,000 in credit card debt at 18% APR (annual percentage rate), and you only pay $200 a month towards your balance, you will spend much more than the principal to pay it off. In fact, throughout your repayment, you spend 7 years and 10 months to pay off the balance and accrue $8,622.21 in interest!
Credit utilization and payment history make up large chunks of your credit score calculations. If you consistently carry balances every month without making any payments, that can negatively impact your credit scores. Not to mention, carrying debt can take an emotional toll on your wellbeing and weigh you down in your day-to-day life.
Even Better – Balance Both
The best strategy is to balance saving money and paying off credit card debt. While every savings vs debt situation will vary depending on the person, it is possible to do both through planning and budgeting.
Learn to Budget
Calculate how much money you bring in every month and how much you are spending towards rent, groceries, utilities, entertainment, etc. Once you do the math, you can get a good sense of where all your money is going and ways to save money and pay off your balances more efficiently.
Next, categorize all your spending into needs and wants. Look for areas where you can cut back or eliminate certain expenses. For example, when I first started budgeting, I realized I was spending a lot of money on online shopping and buying things on sale even when I did not need them. After cutting those miscellaneous spending from my budget, I started allocating the extra money towards my emergency fund and investment accounts.
If you are a beginner at budgeting, use a simple budgeting system such as the 50/30/20 rule or 80/20 rule. With the 50/30/20 method, you would allocate half your income to needs, such as housing, transportation, groceries, etc. Then, 30% would go to wants, such as subscription services, traveling, or dining out, and 20% will go toward debt payments and savings. With the 80/20 rule, you would pay yourself first by automatically setting aside 20% toward paying off debt and saving when you get paid. Then, you can use the rest for whatever you want.
With the extra money you have from this exercise, decide how much to allocate towards tackling debt vs saving. It should not be an all-or-nothing situation where you only do one or the other. If you save at the expense of repaying your debt, you might never be able to zero in on your debt. Vice versa, if you sacrifice saving and never manage to pay off your balances, you could be completely unprepared when an unexpected expense pops up.
If you can afford to do both simultaneously, you should end up on stronger footing and be able to pave the way toward financial freedom and security.
The Bottom Line
Balancing savings and debt reduction can be difficult. On one hand, if you have long-term financial goals, such as purchasing a home, starting a family, or paying for college, that requires substantial savings. On the other hand, if you have significant amounts of credit card debt, it may seem like you will never be able to pay off everything you owe.
The key is to find the right balance for you given your financial circumstances, create a plan, and stick to it. In the end, it is up to each person to decide what is best for them. There is no one right answer – find what works best for your unique situation!