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What goes up must come down. Unfortunately, the law of gravity doesn’t apply to debt.
According to Northwestern Mutual’s 2018 study, the average person took in more debt and carried $38,000 in personal debt (excluding mortgages). This debt includes student loans, car loans, and credit card bills.
With this mountain of debt, we spend about the same amount of our income on debt repayment and discretionary spending. Little, if any, is left for savings.
Reducing debt is a top priority for many of us, but so is savings… the main question is should we pay off debt or save?
Both methods will get you out of debt, especially if you’re willing to put in a little bit of effort to earn extra money on the side. But whether or not you choose to save or pay off debt first, you should go with the one that fits your personality the best.
We’ll present both cases so you can decide for yourself.
Before we look at both scenarios, let’s be clear that you should be paying the required debt payments on all your debt before you even decide whether to pay off debt or save. Failing to pay your bills on time will hurt your credit score.
Why you should pay off debt first before saving money
Logically speaking, you should tackle debt before you save or invest your money.
Why?
The interest rates that you pay on your debt is often higher than the interest rates you can earn from a high-interest savings account or even the stock market.
According to CreditCards.com, the average interest rate credit card companies charge on outstanding balances is 17.71%.
By paying down your credit card debt, you’re guaranteed to save 17.71% in interest fees. Even professional stock traders won’t be able to beat this return on a consistent basis.
Reducing your debt may boost your credit score
One of the credit factors that make up your credit score is credit utilization. This number is a ratio of how much you borrowed to your available credit limit and shows lenders how much credit limit you’ve used up.
Lenders look at this number to see how responsible you are with debt.
Maxing your credit cards, overspending or carrying high balances often will result in a high credit utilization ratio and can hurt your overall credit score.
By focusing your efforts on debt repayment, you’ll be lowering your credit utilization and improving your creditworthiness.
It is recommended that we should keep our credit utilization rate below 30%. The lower the credit utilization rate, the better.
Psychological reasons why you should pay off debt first
Following logic makes perfect sense, but humans are not robots. We have feelings and tend to act on emotions so we need to consider psychological effects when making our decisions.
Resist the temptation of buying things
It’s great that you’re able to put cash aside and save money in your bank account.
But if you’re itching to touch that money or constantly thinking about ways to reward yourself, you’re better off putting those savings towards your debt.
This way, you won’t be tempted to spend your hard-earned savings on unnecessary things and wind up in debt again.
Being in debt is stressful
We all know that debt negatively impacts our well-being – mentally, physically, and emotionally. If you’re the type of person that can’t sleep well at night knowing the fact that you owe people money, then you should focus on paying down your debt first.
Learn how to be debt-free and reclaim your freedom and life.
Before you decide to go with savings first, remember that taking a longer time to pay off your debt means you’ll end up paying more in interest in the end.
Reasons why you should save first before paying off debt
People get into debt for many reasons and one of the main reasons is because they didn’t have enough savings or emergency funds to cover for unexpected expenses.
It’s not uncommon that many people rely on their credit credits to pay for unexpected travel or a big car repair bill when most are living paycheck to paycheck and will have to borrow to pay for $1,000 in unexpected expenses.
The power of an emergency fund
Having an emergency fund can save you from falling back into the vicious cycle of borrowing.
How much should you save?
Financial experts recommend that we should have an emergency fund that can cover our living expenses for 3 to 6 months. This is just a suggestion – you may need more if it’s more difficult to find jobs in your industry or you have medical bills to look after.
If you want more tips on how you can start saving money fast, check out these top 50 ways to save money today.
Take advantage of free money
After the required repayments on your debt are taken care of, you need to take advantage of your company’s benefits packages.
Most companies will match their employees’ contribution to their 401(k) retirement account, usually up to 3% to 6% of your salary, and offer the employee the option to buy company stocks at a discount with their employee stock ownership plans (ESOP).
You’re essentially getting free money from your company by participating in these programs. You can’t afford to miss out on these perks.
Wrap up on should I pay off debt or invest?
What is the best approach when it comes to deciding whether we should be paying off debt or investing?
Some people choose to pay off the highest interest rate loans before they even think about saving or investing.
Whereas some like to have a safety net or save to buy their first home before they tackle their debt. You can also adopt a hybrid approach by allocating 50% of your extra cash to debt repayment and 50% to savings or an 80/20 mix.
There’s no right or wrong answer to this question.
What works for other people might not work for you. Your situation and how you feel towards debt is unique to you. What’s important is finding the approach that you can live with to kill off that debt.
You may not realize, but finding the answer to whether you should pay off debt or save first is a huge step towards your financial goals. When you ask this question, it shows that you’re serious about reducing and getting rid of your debt for good.
Hi Ling, I’m curious how you feel freelancers should balance the question of paying down debt vs. building savings. On the one hand, paying down (and eventually paying off) debt will save money in the long-term, but with the unsteady income structure of freelancing, it seems like it could be more important to set aside a healthy amount of savings to fall back on in “famine” times. But then also paying off debt means they won’t need to worry about paying down debt in the “famine” times. Thoughts?
Hey Kate,
I agree that it’s more difficult for freelancers to budget or plan for the future due to volatile income. That’s why it’s important to consider saving for an emergency fund vs. trying to pay off all debts immediately.
However, everyone will likely have different thoughts, strategies and ways to saving vs. paying down debt.
I know some people who don’t want any debt at all, so they tend to focus on paying that off ASAP because they can sleep better at night.
On the other hand, I also know people that can tolerate a little bit of debt but also want to save for retirement while paying off the debt, so they balance between the two.
At the end of the day, it it depends on the individual and their values; what makes them feel more comfortable. 🙂
Great post, Ling, I have a small emergency fund that I would like to grow a little but I always end up putting the little extra I could save onto my credit card. Probably the smartest choice really.
We tend to put holidays on a credit card so that they are covered in case anything goes wrong like the Thomas Cook debacle going on at the moment. We then pay it off once we return.
Hopefully, I will be able to add to my emergency fund soon.
Good post, Ling, Keep up the good work.
Thank you, Lee!
You are doing so well with saving money and creating wealth based on what I read on your blog. 🙂
Thank you for dropping by to leave a comment! It’s always nice to hear from you.
the good one…over a long period of time…i am waiting for your post over a period of month….i think this the post take large gap between old post – groceries…..anyway nice one ling…please try to give next post as your income stream…..we love that series…try to give update about that….
Hey Azar
Thanks for dropping by as always. I always appreciate hearing from you. 🙂
As much as I’d love to write more about those, I’ve put them on a hold for now because they take a long time to prepare and I’ve been focusing on creating content about different money topics like saving, budgeting and other ways to earn extra money. Plus, I want beginners or new blogggers to be able to relate to my smaller income reports.
For now, I’m focusing on other areas my blog. 🙂