One of the age-old battles in the personal finance realm is this: Should I reduce debt or save money? Which is the best path? Build up a ton of savings and then focus on debt reduction? Or should you eliminate debt, and then concentrate on saving money? Both of these are noble and necessary budget goals. Even during good economic times, it is a tough decision to make. During an economic recession, the choice is one that many are agonizing over. The battle is on.
Corner #1: Pay Debt Off
One of the most compelling arguments for paying off debt is the interest. Interest charges on consumer (mainly credit card debt) debt are huge. If you have the household average of $8,100 in credit card debt, and you are paying 19.99% interest, you will pay around $1,600 in interest charges on top of what you pay toward the principal. Different credit cards have different interest rates, of course, and the minimum payments are meant to stretch out your repayment term by years. Which means your interest charges add up even further. And, if you have paid late or gone over the limit, you have those fees added on to your total and you are paying a default rate in excess of 27.99%. And that doesn’t even include other debt you might have. Imagine if you decided to forgo savings for 8-12 months while you really concentrated on debt reduction. Besides, your savings efforts are only going to yield between 2% and 6% (if you’re really lucky), which isn’t much when compared to the interest you are paying to creditors. Eliminating debt, and then focusing on savings, can be really tempting at this point.
Corner #2: Bank It
While the argument for paying off debt first is a good one, it doesn’t account for peace of mind. Financial problems can cause stress, and that stress can start affecting other areas of your life. Whether or not you think it is a good thing, emotion plays a big role in personal finances. This means that if you are emotionally concerned about your finances, things may not be going well. Besides, what happens if you knock down most of your debt and an unexpected emergency comes up. With no savings to draw on, you are forced to pull out the credit cards and charge the car repairs or most of the medical expenses. You have worked so hard, and now you are right back in the debt hole. If you had just muddled through the minimum payments, saving money, before starting to reduce debt, this situation wouldn’t be so bad.
Can’t we all just get along?
It is easy to see both sides of the fight. But maybe it doesn’t have to be an either-or proposition. What if you can do both? The first step is to look at your household budget. Figure up your income and expenses, and look for ways to cut waste. Some studies and experts are of the opinion that between 10% and 15% of the average household’s monthly income is wasted on unnecessary expenses. For a household that earns $4,000 a month, that’s between $400 and $600 that goes to waste. Let’s be extra conservative, and say only 7% of that income, or $280, is going to waste. Make a plan to stop wasting that money and use it in a more constructive manner to improve your personal finance situation.
Next, consider your position. Is your job relatively stable? Do you already have some savings set aside? How much? With any other decision-making partner in your household, figure out a division of savings and debt payment that you are comfortable with. If you have a relatively stable job, and some savings, maybe you could put 15% — $42 — of your (formerly) wasted income toward savings each month. The other 85% could go toward debt reduction. $42 isn’t a lot, but if you are in a reasonably good place (excepting your debt) the important thing is to keep saving money. When you get a windfall or a bonus, divide that “extra” money up according to your plan, and use it for debt/savings.
If you have no savings, and you are concerned about your job, your wasted money should perhaps go mostly to building up a safety net, using higher yield options, such as a rewards checking account, CD ladder, money market investment or even short-term bond funds. And, if you are indecisive about the whole thing, go 50-50 on debt reduction and building up savings. The important thing is to make a plan and stick to it, developing better personal finance habits. Once you have paid off your debt, put the money you were using to make debt payments into savings.
Obviously, you should try to squeeze more than just 7% of your income out for savings and/or debt reduction. If you can find 15% — or even 20% — that would be much better. You will build your savings and pay down your debt faster.
Miranda is freelance journalist. She specializes in topics related to money, especially personal finance, small business, and investing. You can read more of my writing at Planting Money Seeds.