Work on Debt Reduction or Build Savings?

There is huge amount of personal finance tips on the web, in books, on the radio, and on the television. The problem for most people is what to do first. Should we start by investing? Should we pay off our credit cards? Should we have 6 months of savings in the bank before we do anything else?

The answer can be difficult because each one of us have different financial circumstances. Some are single, some are married, some have kids, some don’t. Some work full time and go part time to school, some are the reverse, and some are fresh out of college looking for answers.

Today we’re going to look at two goals that most people have first:

  • Build an emergency fund of 3 months
  • Pay off all credit card debt

They’re both great goals to have and are necessary if you want to get ahead.

Which Makes Financial Sense?

Let’s run a scenario and see if a decision comes out of it. Say you have $1000(tax refund, scholarship, etc) and you also have $1000 credit card debt. You can put th money into a savings account and earn 4% a year or you pay off your $1000 debt which is on a card with 23.99% interest.

Here’s how your net worth would change if you decided to put it into savings:

Initial1 Year3 Years5 Years
Savings Account$1,000.00$1,040.00$1,124.86$1,216.65
Credit Card Debt($1,000.00)($1,239.90)($1,906.16)($2,930.44)
Net Worth$0.00($199.90)($781.30)($1,713.79)

How Life Affects Savings and Debt Reduction

If life were purely financial, then paying off the debt immediately would be the way to go. You come out better. The problem is bad stuff happens. If you’re pouring every last spare penny into paying down your debt with no savings whatsoever, then you’re leaving yourself vulnerable.  If something like your car dies, then you could end up dipping back into your credit card to bail you out.

Bad events keep you in this cycle. How do you solve this? Create a bare bones emergency fund.  For how much? That depends on your circumstances.

Basically think a possible misfortune that could set your debt repayment back and use that as your bare bones goal. Some pick an arbitrary number like $1000 or something like one month’s expenses.

From there, pay your debts down while saving a small percentage into your savings. You’ll build your cushion up, but still pay your debts faster.

Why Should You Do?

Personal finance is not a one size fits all, so please let me you how you’ve tackled the problem or  what you’re doing now.

Photo Credit: Pikaluk