June 13, 2018
Unbiased Financial Information Provided by Financial Finesse
Most of us have long and short-term financial goals. We may want to buy a house, retire early, or start our own business some day. At the same time, most of us also have debt that we want to pay off within a few months or years.
Some people fear that if they commit to paying off their debts, they'll never get around to saving for the things they want. Others worry that if they put more in savings, their debts will continue to grow and eventually overwhelm them. It is an age old dilemma: Which should you tackle first?
Look at the Interest Rates
Typically, the interest rates that apply to credit cards are higher than what you would earn on a safe, conservative investment. Therefore, you'll probably get more bang for your buck by paying off high-interest debt than by putting money into a savings account that has a lower yield.
To illustrate, let's say you have a $1,000 balance on a credit card and your current interest rate on that card is 13%. If you commit to paying it off in one year, you will have to make payments of $89.32 per month for 12 months. To get your year off to a good start, your generous grandmother gives you a check for $1,000. You have two options:
- You could invest the $1,000 in a savings account that is currently paying a guaranteed rate of 1% and pay off the credit card with the monthly payments of $89.32.
- You could pay off your credit card right away with the $1,000 gift and then start putting the money you would have used for your credit card payments into the 1% savings account.
Let's compare the two scenarios:
|$1,000 put directly into savings yielding 1%||$1,000 used to pay off debt|
|Savings account balance at beginning of year...||$1,000.00||0|
|Monthly payments made to savings account...||$0||$89.32|
|Savings account at end of year...||$1,010.05*||$1,076.77*|
*based on 1% interest compounded monthly.
By paying the credit card off right away, you avoid paying the 13% interest on the debt you owed. Interest payments that would have gone to the credit card company can be put into your account and in this case, results in a net gain to you of $66.72.
Consider Other Kinds of Debts You Have
After you look at the interest rates on your debts, look at the type of debt you're carrying.
- Revolving debts, such as credit cards, generally are the debts to pay off first. Not only is the temptation there to add more to that debt, but the interest rate you pay can change and payments can go on indefinitely.
- Installment accounts, however, like most personal loans, have a fixed payment amount for a fixed length of time. Compare the interest rate you are being charged and pay them off from highest to lowest.
- Mortgages or student loans have certain advantages that other forms of debt do not.
- Mortgages typically come with lower interest rates and the interest you pay on these loans is generally tax deductible. Also, the home you buy with the mortgage will usually increase in value, meaning there is a corresponding return on the investment you make in the form of monthly payments.
- Student loans also have tax advantages. The interest you pay may be tax deductible. See IRS publication 970 for eligibility requirements. And of course, the education you receive can be viewed as an investment in your future earning potential.
Consider Investing Some Savings into Your Employer Sponsored Retirement Plans
Even if paying off debt is your main goal, if you have access to an employer-sponsored retirement savings plan (e.g. 401(k), 403(b)) you may still want to commit some dollars to it.
If your employer matches your contributions, you should try to contribute enough to get 100% of the company matching contributions. For example, if your employer matches 50% of your contributions up to the first 6% you contribute, then you should try to contribute at least 6%. If you don't, you're leaving money on the table.
Find the Right Balance For You
Like many financial dilemmas, there is no simple answer to the question of whether to save or pay off debt. It comes down to finding the right balance. Put special emphasis on paying off credit card debt, and use your company's retirement plan. If you do, then someday you'll find yourself in a position of not having to choose.