It’s a question we hear a lot: should I save first or pay off debts?
Though there is no one-size-fits-all solution, in general the best way to get to financial freedom faster is to put most of your money towards paying off your debts, while also still putting a small amount towards savings and an emergency fund. This is especially true if you have lots of high-interest debt (such as debt from credit cards). Prioritizing debt management will help ensure your outstanding debts don’t get out of control, because when you’re drowning in debt, it becomes nearly impossible to build up some emergency savings.
That being said, there are times when it may actually be wiser to focus on putting money aside for things like retirement and an emergency fund (especially if you are nearing retirement age). Here’s some important things to consider when deciding whether to prioritize paying down your debts or boosting your savings account.
Here are some examples of when it's better to pay your debts first rather than save money.
The type of debt you have matters significantly. High-interest debts (like credit card debt and personal loans with high interest rates) can be the most financially debilitating and take the longest to pay off. If you have a lot of high-interest outstanding debts, it’s wise to focus on paying them off rather than growing your savings.
It’s not just the type of debt that matters — the amount of debt you have is also a consideration. For many people, having a large amount of outstanding debt can be an incredibly stressful situation and dramatically affect their quality of life. If your debts constantly weigh on you, paying off your creditors should be a priority. That’s because if you feel overwhelmed and don’t get a handle on your debts soon, the risk is that you could start to feel that the situation is hopeless and just give up on paying off your amounts owing entirely.
Aside from enhancing your mental wellbeing, there are several other benefits to paying off debt.
If you’re looking to buy a home and get a mortgage (or want to apply for any kind of loan or new credit cards, for that matter) in the next few years, you’ll want to make sure you have the highest possible credit score. A high credit score not only improves your chances of getting a mortgage, it also makes it more likely that you’ll get the most favourable rates. Having lots of debt can negatively affect your credit utilization ratio (because you’re using up too much of your available credit). Furthermore, if you’re often making late or irregular payments on your debt, your score will drop — especially if your account is sent to collections. Paying down your debts will help keep your credit score and credit file healthy.
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When you’re no longer paying high interest rates on a variety of different debts, you’ll have more money to put towards important things like saving up for a house, an emergency fund, a retirement nest egg and your children’s educational future.
There are times when it may be better to forgo paying down debts in order to save money.
If you are in a field of work where there’s lots of turnover or the economy is heading towards a recession and you are uncertain about your job security, you should prioritize saving money. If you lose your job and have no savings, you won’t have a financial safety net and will have to start taking on more debt.
If you’re nearing retirement age then saving money should be a priority as your capacity to earn income will become more limited.
There are numerous benefits to saving money.
Saving money means that you’ll have an emergency fund and always be prepared to handle any unexpected expenses, including things like job loss, a medical emergency or an urgent home repair.
An unexpected emergency isn’t the only reason it’s good to have a pot of savings at the ready. Having access to backup funds can give you the freedom to pursue opportunities like travel, quit your job to look for a new one, or even go back to school.
There are numerous ways to tackle debt. When developing a debt management plan, consider these options.
This method focuses on prioritizing paying off the debts with the highest interest rate first. So, you would rank your debts based on which ones have the highest interest rate and then put all your debt payments toward the single costliest debt first. Once you paid off that creditor, you would then move on to the debt with the second highest interest rate and so on and so on. It’s a highly directed and efficient way to tackle debt.
Instead of focusing on what creditor charges the most interest, with the snowball method you pay off the account that has the smallest balance first, while still making the minimum payments on your other debts. Once the smallest debt is paid off, you move on to the next smallest debt and so on. The idea behind this method is that you’ll gain momentum and a sense of accomplishment by actually closing several debts, which will then encourage you to finish paying off all your creditors.
Another popular way to pay off debts faster is by getting a debt consolidation loan. You would get a loan with a reasonable interest rate and then use the funds from the loan to pay off multiple creditors like credit card companies and utilities. Many people find that it’s much easier to tackle debt with a single loan payment than to keep track of multiple payments with numerous creditors. When a debt is easier to manage, chances are that you’ll be more successful at paying it off.
Financial experts tend to advise that people should aim to have an emergency fund that could cover three to six months worth of expenses. Another good rule of thumb when it comes to saving is the 50-20-30 approach to budgeting. With this money management technique, you divide your net monthly income into three main categories: you put 50% of your money towards your needs (that would be anything essential like housing and groceries); 30% for wants (like restaurants or entertainment); and the remaining 20% should go towards savings.
In general, while everyone’s situation is unique, debt payment should be prioritized over building up your savings because paying off debts makes it much easier to grow your savings in the long run. To decide whether focusing on debt or prioritizing saving money makes sense for your circumstances, it’s very helpful to consider things like the interest rate on your debts, the number of outstanding creditors you have and whether you may need access to retirement or emergency savings in the near future.
Sandra MacGregor is a professional writer who specializes in topics such as finance, travel, health, and lifestyle. Her work has been featured in the Toronto Star, the Montreal Gazette, and the New York Times. She is a regular contributor to the Borrowell blog.
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