Whether it is better to save or pay off debt does not have a simple answer. In some cases, it is better to increase your savings, and in other cases, you should reduce your debt first. Your case depends on whether you:
- Have an emergency fund
- Invest in a retirement account
- Have credit card balances
Different circumstances will affect what is the best strategy to implement. In general, you will need to concentrate on paying off obligations until you only have low-interest installment loans, and then begin to increase your savings.
When to save before paying off debt
While it is important to reduce liabilities as soon as possible, there are cases when it is important to save first.
Emergency Fund First
Everyone should build an emergency fund first before paying off debt. Unforeseen situations can destroy any financial plans that you have. When you are paying high interest on loans it is difficult to think about savings but remember that if you must spend money then you will have even worse terms on the next loan you take out. Rainy day funds will:
- keep you from having to take bad loans
- Discipline your spending habits
Any responsible financial plan starts with building an emergency fund to keep you from getting into worse debt if something bad happens.
In some cases, you should invest in retirement savings before you start paying down your liabilities. If you have high interest revolving credit accounts, like credit cards, you should pay them off or consolidate them into lower-interest loans before you save in retirement accounts. However, if you only have installment loans, such as a mortgage, then you should consider retirement investing first.
401Ks and 403Bs
401Ks and 403Bs are tax-advantaged retirement accounts before paying down installment liabilities. In other words, the government and your employer give you incentives to contribute to these types of accounts. The basic benefits of investing in these accounts are:
- You either pay taxes on the money you invest in the beginning but not when you withdraw your money, or you defer taxes and pay them when you retire
- In most cases, your employer will match your contributions up to a certain amount
Private companies generally offer 401Ks to their employees, and the government and nonprofit organizations usually offer 403Bs to their workers. Also, the government sets limits on how much you can contribute to these accounts. Therefore, you should put in the maximum amount you can as soon as you are able.1
IRAs (Individual Retirement Accounts) are also tax advantaged retirement accounts. However, you should invest in your 401K or 403B first because:
- Employers do not contribute to these accounts
- The tax advantages are the same
If you have very high interest, revolving credit accounts you need to consolidate or pay them off as soon as you can. After that, put in the maximum amount you can for your 401K or 403B you should contribute the most you can in your IRA. Only then, should start to eliminate lower interest installment loans.
When to Pay Off Debt Before Saving
When is it best to eliminate balances before saving? That depends on if you have an emergency fund, high interest obligations, and/or a retirement account. As we talked about before, your strategy will depend on your financial situation. However, if you have an emergency fund then your next step probably depends on the type of debt that you have.
Revolving Credit Accounts
Revolving credit accounts are accounts that you can borrow on at any time, and the balance goes up and down depending on how much you use it. The most common type of revolving loan is a credit card. Do you have high interest credit cards? Do you have a rainy-day fund? If your answers are yes to the first and no to the second you need to:
- Immediately try to consolidate credit cards into an installment loan
- Immediately start saving in a rainy-day fund
If you already have a savings plan for emergencies, then your focus should be on paying off high interest revolving credit accounts as fast as you can. Credit card interest is crazy high so never carry a balance on these accounts. Pay them off as soon as you can! If you can’t pay them off in a timely way, then try to consolidate them into an installment loan.2
Installment accounts start with a fixed loan amount that you
- You can consolidate revolving credit loans into installment loans and save money
- Installment loans may have prepayment penalties
- It may be better to save than pay down these loans
When is it better to save than to pay down your debt? When you can get a higher interest on your investments than you are paying on your debt. However, this is rare. Another case is retirement investing. The tax advantages with tax
There are times when you need to reduce your debt before saving. There are also times when you should save before paying off your obligations. Finally, sometimes you should balance paying off debts and saving at the same time.
- If you don’t have an emergency fund and you make credit card payments, you should build a rainy-day fund and consolidate your obligations
- If you have an emergency fund, then eliminate your revolving credit accounts as fast as you can
- If you don’t have any credit card debt you should max out tax-advantaged retirement accounts before paying down installment loans
- If your retirement funds are maxed out, then balance saving and paying down installment debt at the same time
No matter what your situation is the most important thing you should do is make a budget. Discipline yourself to live within your means. If you can’t do this on your own find a financial planner, like Crown Financial, to help you.