There are three key factors to financial health: 1.) having a budget, 2.) having money in savings, 3.) and being debt-free. In calculating your budget, how should you allocate your money when it comes to savings and debt? Having money in savings is important to provide the resources you need for emergency expenses, to avoid financing large expenses, and to reach other financial goals. However, eliminating debt is important to building your credit, saving you money by eliminating accruing interest obligations, and keeping more money in your pocket. But is it more important to pay down debt or to build up savings?
Here, we discuss the pros and cons of prioritizing each to help you determine which strategy is best for your finances.
Paying down debt
Nobody wants to be in debt. Debt is a mounting burden as even after you reap the benefit of the borrowed money, the amount you owe will continue to increase thanks to accruing interest until sufficient payments are made to eliminate the balance. Therefore, many consumers prioritize debt repayment to save money that would otherwise be spent on interest. Prioritizing debt repayment will yield automatic savings by reducing the amount of interest paid overtime on your outstanding balances.
Your strategy for managing and repaying debt will vary based on the kind of debt you have, such as student loans or credit cards, and your financial obligations. For student loans or mortgages, you may be able to enter a forbearance or deferment period while you focus on paying down more costly debt obligations. However, credit card debt and personal loans should be repaid as quickly as possible due to often high interest rates and unforgiving repayment terms.
There are two popular methods for repaying debt: the snowball method and the avalanche method. Through the snowball method, repayment efforts are focused on the account with the smallest balance first. This allows you to stay motivated because you quickly see progress as debt after debt is eradicated. Alternatively, the avalanche method prioritizes payments toward accounts bearing the highest interest rates. The results through this method vary as the highest balance could have one of the lower interest rates, which means you could continue to accrue substantial interest while focusing on paying down the account with the higher interest rates.
Unfortunately, the average balance of consumer debt is quite high across America compared to average income levels. This means for individuals who choose to prioritize debt payments, it could be a long time before they can shift their focus to building up savings which could result in a vicious cycle of incurring large amounts of debt as financial emergencies come up and there are no savings available to cover the unforeseen expense.
Building up savings
Having a funded savings account is crucial to support your family through a financial crisis, such as a medical emergency, job loss, or other costly hardship. With money safely tucked away in savings, you can avoid incurring substantial future debt from these unforeseen expenses. However, it is also important to save for other financial goals, such as purchasing a car or home, paying for your child’s college, or funding family vacations. The general recommendation is to have at least six months’ worth of expenses in savings.
Prioritizing your savings will cost you if you have outstanding debt because every dollar you put into savings is a dollar that you are taking away from repaying your debt. While the money in your savings will grow as it accrues interest, unfortunately, the same is true for your debt. Therefore, if building your savings is your priority, not only will you be paying less toward your debt but the accruing interest on your outstanding balances will continue to increase your debt.
However, saving money now in a high-interest savings account can help your money grow quickly even after you shift your focus to paying down debt. So, the benefit of prioritizing your savings first is establishing the funds you need to take care of your family in an emergency, rather than incurring more debt by relying on high-interest credit cards or personal loans. Plus, once you build up some savings, you will be accruing interest which will allow your money to passively increase even if or when you stop contributing to the account to focus on other financial obligations.
If your debt has low-interest rates, if you have access to a 401(k) match program through your employer, or if you do not currently have a funded emergency savings account, prioritizing saving is in your best interest until you reach a balance that can support your family for a few months in the event of an emergency. Once you fund your savings account, you should prioritize debt payments. However, if at any time you need to take money from your savings account and the balance dips below what is needed to cover a few months of living expenses for your family, you should return your focus to rebuilding your savings account back up, shifting your priority back to debt repayment only after your savings account is funded.
Finding balance
So, should you prioritize paying down debt or building up your savings? While it is important to find the strategy that works best for your individual financial goals and outstanding obligations, for many people the most effective strategy is going to be one of balance, where debt and savings are managed simultaneously. Having money in savings is so important, not only for your overall financial well-being but to spare you further stress and money when unexpected expenses come up. Likewise, being debt-free is a goal for many Americans and is essential to your financial health. Therefore, finding the balance that allows you to pay down your debt while ensuring you have the money you need in savings to reach your financial goals and cover you in an emergency is the best plan.
