You have a regular source of income, youâ€™re paying your bills on time and you have some extra dollars left over each month. What should you do with that extra cash?
If you donâ€™t have debt (lucky you!), then the choice is simple â€” save or invest as much as possible. If you have debt, however, the choice can be a bit murkier: Should you pay off your debt first or save? Here are some things to consider when asking yourself that question.
Just when youâ€™re cruising along, life can throw some unexpected and expensive curves your way. A sudden job loss, medical bills or car repairs can pop up out of the blue, and if you donâ€™t have the funds to pay for them, you can end up seriously in the red. To cover unexpected costs, some may resort to high-interest credit cards and loans. Those kinds of moves can dig you into a financial hole that can take years to pay your way out of.
Saving up a healthy emergency fund can protect you in instances like these. How much should you save? Experts generally suggest that you should save an amount equal to between three and six months of living expenses. Depending on your individual circumstances, however, you may need more than that. (Check out this article to figure out how much to save and where to keep it.)
If youâ€™re fortunate enough to work for a company that offers a retirement plan with matching contributions, then consider making that method of saving a priority.
For example, if your employer offers to match your contributions dollar-for-dollar up to 6% of your salary in a 401(k) plan, then contribute at least that much, if possible. The money can then grow in a tax-free or tax-deferred 401(k) until you withdraw it in retirement â€” all that compound interest can really add up over the years. If you donâ€™t contribute up to that amount, youâ€™re leaving free money on the table.
Note, however, that If you need to withdraw these funds early (before the age of 59 and a half and before the account is five years old) there will be penalties to pay. That makes this a better tool for long-term savings rather than for the short-term or as an emergency savings fund.
Debt gets a bad rap â€” often for good reason â€” but in some cases, carrying your low-interest debt and investing or saving your funds instead may be more beneficial. For example, the current fixed interest rate for direct subsidized and unsubsidized student loans is 5.05%, and the average 30-year fixed mortgage rate is about 4.3%. The stock market, on the other hand, has gone up an average of 10% a year since 1926.
Beyond comparing interest rates, however, you also need to assess how much risk youâ€™re willing to take and how much access to your savings that youâ€™ll need. Of course, there are no guarantees that your investments will perform well, and paying down debt comes with zero risk. Savings accounts are a less risky saving option, but the average interest rate is often less than 1 or 2%. Other options, such as individual retirement accounts (IRAs), have restrictions on how the funds can be used outside of retirement.
Itâ€™s hard to get ahead of high-interest debt, because compound interest is working against you. Credit card interest rates, for example, average between 15 and 20% â€” an amount which adds up quickly. If you make the minimum payment, you may not even be making a dent in the principal amount owed, and you can spend years just paying interest. Calculators like this one can help you figure out just how much interest youâ€™ll pay and how long it will take to pay off.
If you have high-interest debt, make sure you explore all the options for paying it down, including consolidating your debt and researching balance transfer cards.
Though your debt is costing you in interest, you might find that some loans may offer useful perks. For example, federal student loans may offer tax benefits and even loan forgiveness programs for eligible borrowers. Similarly, there are tax write-offs for mortgages and in many cases, the money you invest in a home will pay off down the line when you sell your property.
On the other hand, the debt on the credit card you maxed out to pay for that trip to Cabo comes with no benefits â€” just a bunch of interest. High-interest debt with no benefits should be at the top of your pay-off priority list.
While there are many factors that go into determining your credit score, the amount of debt you carry is an important component. If you plan to buy a home or secure a loan in the near future, take a look at your debt-to-income ratio (DTI), which many lenders consider before approving you for a loan. If your DTI is high, you may want to consider paying off some debt before applying for that new loan, which may result in lower interest rates for you later.
Debt can take an emotional and physical toll on people, ranging from depression to insomnia and more. When it feels like a black cloud hanging over your head and itâ€™s affecting your life in negative ways, it may be in your best interest to prioritize paying debt off first.
Of course, saving vs. paying off debt early doesnâ€™t have to be an either/or situation â€” ideally, you can do both at the same time. If, however, a choice must be made between the two, there are many factors to consider. As with most financial moves, there are no cut-and-dry rules, and the best one for you will depend on your individual circumstances.