If you have outstanding debts and find yourself with disposable income, you might be conflicted about whether to save that amount or allocate it towards paying off your debt. Giving careful consideration to the pros and cons of both options can help you to make a practical decision.
Saving allows you to generate a nest egg while paying off your debt helps you save money on the interest you pay. In this article, we lay out some of the key considerations for doing both that you can include in your decision-making process.
Key Takeaways
- If you have outstanding debts and find yourself with disposable income, you might be conflicted about whether to pay off debt or save the extra money.
- In many cases, the objective is to determine the net financial results of the savings plus interest versus the reduced interest on the debt from credit card to student loans.
- One option is to split your extra income in half toward debt and savings.
Understand Your Situation
One of the main things to consider as you mull over whether to pay off your debts or save is to understand your financial situation. You won't be able to get a good grasp of what to do until you're firm in where you stand at the moment.
Review some of the key financial metrics that apply to you, namely your:
- Monthly income from all sources
- Spending habits
- Household expenses, such as rent, food, utility bills
- Any savings you already have
Once you determine these, make a list of all the debts you have. Be sure to include creditor names, balances, interest rates, payment due dates, and whether you're making the minimum monthly payment or going above by making a larger lump-sum payment each month.
There are a few things you'll have to prioritize, including the potential earnings generated from putting your money into a savings account versus the cost of holding your debt, and whether you have an emergency fund in case things get tough.
Should You Save Your Money?
When you save your money, you commit to putting aside any additional money you have at the end of the month with the hope that it will generate a return. You may consider putting your money into a savings account, certificate of deposit (CD), government security like a Treasury bill (T-bill), or a money market account.
Saving your money requires a great deal of discipline and focus. It can be very disheartening when you consider the rate of return on many savings vehicles, which is typically lower than the interest on any debt you have. According to the Federal Deposit Insurance Corporation (FDIC), the national average rate for a savings account was 0.46% while a 60-month CD was 1.39% as of Nov. 20, 2023. Keep in mind, though, that many of these vehicles rely on compounding, which means you earn interest on the money you deposit as well as the interest you earn.
As noted above, you'll have to ask yourself some important questions before you decide to save your money. How much money are you making each month? Can you make any sacrifices to set aside some money for savings? Can you even afford to save some money as you factor in your debt situation?
Let's assume that you have an extra $250 at the end of each month after you factor in your monthly expenses. If you add this amount to a savings account (and make the minimum monthly payments on your debts), the interest you receive would be determined by the type of asset in which the amount is invested. Assuming a conservative rate of 2% compounded daily, your total savings after nine years would be about $29,580.
Be sure to ask yourself whether the money you may earn in a savings vehicle would be more than the cost of holding a debt.
Paying Off Your Debt Before Saving
Like saving, debt management and repayment can seem overwhelming. But it doesn't have to be, especially if you can put aside your emotions and focus on the end goal. You may even have to tighten up on that extra spending (like that daily coffee and donut) to eliminate your balance.
One factor that may sway you into paying off your debt first is the cost of debt or the interest you pay. Your credit card's interest rate is likely much higher than what you would earn on a savings account, especially if you have multiple balances owing and aren't putting a dent in them. Consider the national average of 21.19% across all credit cards and 22.77% on accounts that have been assessed interest as of August 2023, according to the Federal Reserve.
Assume you have a credit card balance of $6,500 with an annual percentage rate (APR) of 19.5%, and you make the minimum monthly payment of $130. It would take you 101 months to pay off the balance and will cost you over $6,600 of interest.
Let's assume again that you have disposable income of $250 each month. If you add this amount to your credit card payments, it would reduce your payoff period to about 20 months and cost you about $1,000 in interest. This results in a saving of about $5,600.
If you're the type of person who pays off your credit card balance(s) each month, you may want to consider putting more of your disposable income into a savings vehicle.
Can You Save and Pay Off Your Debt?
The short answer is yes. But again, it depends on your financial situation and your resolve. For instance, if you have a lot of debt and you're scraping by with just the minimum payments, it may be a good idea to focus only on your debts and put the thought of saving aside until you get a better grasp of your liabilities. If you're focused, have the discipline, and aren't overburdened with debt, you may be able to do both.
Once you've determined your monthly financial situation, your options include the following:
- Making the minimum monthly payment on the credit card and adding your disposable income to a savings account
- Adding your disposable income to your credit card payments and start saving after the credit card has been paid off
- Splitting your disposable income between the credit card and your savings
Here are a few options that you have available that allow you to save while you pay off your debts.
Emergency Fund
An emergency or rainy day fund is generally used to cover unexpected expenses and can be invaluable in the event of a job loss or other emergency. This is something you should have even if you have balances owing. If you don't already have one set aside, it might be more beneficial to add your disposable income to such an account.
Keep in mind that paying off your debt, such as a credit card balance, and freeing up your credit limit is not a practical substitute for a rainy day fund. It is not the soundest financial strategy to rely on credit in an emergency. It should be a last resort. By using savings instead of credit, you avoid falling into debt and paying hefty interest charges. Furthermore, if you have been using credit cards in a manner deemed irresponsible by the issuer, your credit limit may be reduced after paying off debt. Thus, reducing your ability to turn to credit in a rainy day situation. And remember, a rainy day fund is for emergencies—not for that luxury good that you've had your eyes on for the last six months.
Save Through Your Employer
Consider enrolling in an employer-sponsored plan, such as a 401(k). The best time to start saving for retirement is always right away. Saving through your employer's 401(k) plan offers a number a of benefits including tax-deferred growth and the deduction of your contributions from that year's taxable income. Be aware, in most cases, the money cannot be withdrawn until you reach age 59 and a half without paying tax penalties on top of normal taxes. Once you reach age 59 and a half, distributions are taxed as normal income.
Saving with a 401(k) takes the guesswork out of saving because it relies on automatic payroll deductions so you don't have to do anything—your employer does it for you. This option is even better if your employer matches your contribution because it gives you free money that goes toward your retirement savings.
Spend and Save
Some banks allow you to save automatically every time you spend. You'll have to open a savings account and use your debit card to take advantage of this feature. Whenever you use your debit card, your purchase will be rounded up to the next dollar with the extra change swept over to your sales account.
So if you buy something for $18.37, your bank will round it up to $19, with the additional 63 cents moved over to your savings account. This allows you to save smaller amounts while concentrating more money on your monthly bills.
Pay More Than the Minimum
Paying just the minimum balance on your credit card(s) and/or loan(s) means it will take longer to pay off the balance. That's because more of your payment goes toward interest rather than the principal balance.
If you make a little more than the minimum payment, you'll cut down the balance as well as the time it takes to eliminate the debt. Any extra money (even a few dollars) can go into your savings account.
Use Credit Card Points
Some credit cards offer you points on the purchases you make. These points translate to money. For instance, some card issuers offer you 1% cash back on all of your purchases. Others may give you a higher percentage on different categories, such as gas, groceries, and restaurants.
So if you have a rewards card, consider using this sum to get a statement credit that pays down your balance. If you're able to, you may also use it to deposit into a savings account.
Consolidate Your Debt
If you have good credit, you may be able to get a debt consolidation loan. This allows you to pay off all your debts and make one larger monthly payment to one creditor rather than to multiple lenders.
Pooling your debts into a consolidation loan lets you make one monthly payment, which may give you some additional money at the end of the month so you can stash some money aside into a savings account. One thing to remember: Don't rack up those credit cards again once they're all paid off.
Can I Save Money and Pay Off My Debts at the Same Time?
Yes, you can save money and pay off your debts at the same time. How much you put to both depends entirely on your financial situation (notably, how much disposable income you have) and end goals. If you intend to be debt-free sooner, you'll likely want to focus more of your disposable income on your financial obligations. If you carry fewer balances, consider putting a little extra toward saving. Keep in mind that you should consider the pros and cons of the cost of carrying debt versus the interest you'll earn from saving before making a decision.
What Are Some Debt Repayment Strategies?
There are several key ways to pay off your debt. They include the following:
- Using the debt avalanche strategy involves paying off the debt with the highest interest rate first, then moving on to the next highest until you reach the one with the lowest rate. While you put more money on the one with the highest rate, you should always make the monthly minimum on the others.
- A debt snowball occurs when you focus on paying off the debt with the lowest balance first and move your way up to the one with the highest balance. Like the avalanche, you must keep paying the minimum payment on your other debts.
- Paying more than the minimum. Even putting a few extra dollars toward each debt can lower the amount of interest you pay overall.
- Debt consolidation lets you make one payment to a single creditor provided you qualify for a debt consolidation loan.
What Are Some of the Options I Have to Save Money?
If you have some extra money each month, you may want to consider one of the many options available to help you save.
The most basic is a savings account. Some financial institutions offer high-yield savings accounts, which yield higher than traditional accounts. Money market accounts offer higher yields while giving you some of the benefits of a checking account.
If you can afford depositing a large sum and don't need the money right away, consider a CD, which locks in your money for a specific period of time, usually at a higher rate than a savings account.
If you're saving for a rainy day, though, make sure you put your money into a highly liquid account (like a savings account) so you can easily access it when the need arises.
The Bottom Line
Consider your full financial picture when you decide whether you'll save or pay off your debts. This can include whether you have someone else you can rely on in the event you are unable to cover unplanned expenses. If you are unsure of which solution is most suitable for you, splitting your disposable income between the two options may allow you to benefit from both. Working with a financial planner may help to provide a comprehensive solution.
