Should I save money or pay off debt? It is a common question to ask. The short answer is: It depends. The first thing to keep in mind when asking if you should save money or pay off debt, is that the absence of debt is not the same as having wealth.
To keep things easy to conceptualize, let’s create a hypothetical situation using small amounts of money. Pretend there is a person who makes $100 a week. This same person has expenses of $85 a week, of which $15 is for a student loan. This person also currently has $1,500 in savings, because they have been consistently saving $15 a week. The current principal on the student loan is $1,500. So, they are asking, “Should I save more money or pay off my debt?”
Option One: Keep everything the same
Option one is for the person to keep doing exactly what they are doing. Let’s assume the student loan was initially for $3,200, with a term of 5 years, and an interest rate of 5%. The person has been making all of the payments on time for almost three years, and will be paid off the loan in a little over two more years. He or she will pay $85 in interest over the remainder of the loan. The $85 isn’t a bad deal when you consider it is less than a week of this person’s pay, in exchange for having the time to make the payments on the debt while maintaining his or her savings.
Option Two: Pay off the loan completely
Option two is to pay off the loan completely. The remaining principal is $1,500, and they have $1,500 in savings, so the current savings can wipe out the debt in full. I would advise against this decision, even though it may seem tempting. Here is why: If this person suddenly loses his or her job, then he or she will have no savings to rely upon. Sure, he or she doesn’t owe money, but the absence of debt is not the same as having wealth.
With expenses of $85 a week, the $1,500 in savings could give him or her 17 weeks of being able to cover bills while looking for new employment. If he or she had paid the debt off in full, then they would now have less weekly expenses and no emergency fund to cover the $70 in expenses they still have. Everyone has expenses (even debt-free individuals) so being debt-free does not mean the same thing as financial independence.
The importance of maintaining savings
When you consider the importance of maintaining savings, particularly an emergency fund, you realize it is not always better to pay off debt rather than save. However, there are a few exceptions: High interest debt, like credit card debt, should be paid down as quickly as possible because the interest rates are so high. Structured long-term debt (such as a mortgage, auto loan, or student loan) should not be viewed in the same way as credit card debt. This is because these types of loans have a fixed monthly payment with lower interest rate levels.
This is not to say there isn’t a benefit to paying down debt sooner. In this example, this person may be well suited to put another $5 a week towards paying down the student loan, and only $10 towards savings, because savings accounts pay such low interest rates. If you have a fully funded emergency fund and are now funding investments, then the investments you have (based upon your asset allocation) may be generating higher returns than the interest you are paying on your long-term debts. Why pay down a mortgage with a 3.75% annual interest rate when you can instead use that money to receive a 6-8.5% return in an investment portfolio?
This post has highlighted the advantages of balancing paying off debt with saving more money. It is almost always beneficial to pay off high interest obligations such as credit cards as soon as is possible. It is sometimes beneficial to pay off long-term debts a little sooner, but not at the expense of your emergency fund.
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