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When it comes to the question “is it best to pay off debt or save?”, the answer is, it depends on your situation. However, there are some guidelines you can follow to determine whether paying off debt or saving your hard-earned cash is the right choice for your situation.

When to Pay Off Debt Before Saving

I find it’s best to think of debt as a guaranteed return on your money when comparing it to saving and investment returns.

If you don’t focus on paying down the debt, you will continue to pay for both principal and interest for the life of the loan. Assuming a consistent interest rate, the payment for interest will continue to be that same rate for the life of the loan (why I like to consider it a guaranteed return on your money).

For most loans, if you do decide to focus on paying off debt as you pay down the principal, your interest rate (and payment) will decrease.

Over time you get more and more money to put toward the debt. Before long you pay it off well before the anticipated pay off date. Once it’s paid off, it’s like you’ve gotten a raise. More of your money each month has been freed up for saving and investing (and even having a little fun!).

If your debt interest rate that you are paying is higher than the saving rate of interest you’re earning, you are better off paying down the debt.

Example

As an example, let’s say you have a 60-month car loan for $20,000 at a 4% yearly interest rate. On the flip side, your savings account provides an interest rate of 1%, compounded monthly. You have an extra $300 per month to either put toward the car debt or add to your savings account.

Scenario A – Paying Off Debt First

If you put the $300 towards debt you’ll end up paying off the loan in 32 months and save 995.22 in interest charges. At month 33, you can start saving $668.33 (previous car payment plus $300 additional each month) and have $18,925.29 in savings by month 60.

Scenario A – Table

Scenario B – Saving First

If you put the $300 towards savings and left the savings in the account over the 60-month period for the car loan, you would have $18,449.71, but would have paid the full amount of interest on the car loan.

Scenario B – Tables

Scenario B – No Additional Principal Applied to Debt

Scenario B – Additional Principal Applied to Savings

Conclusion

When you compare the two scenarios, scenario A ends up with a net gain of $19,920.51 (total savings + savings from paying off the car loan early) and scenario B ends up with a net gain of $18,449.71.

By choosing to save your money and pay the full amount of the loan versus committing the extra money to pay off the car loan, you’ve missed out on $1,470.80 over the 5 year period.

When to Save Before Paying Debt

Emergency Fund

The primary reason you would save first is to create an emergency fund. An emergency fund is savings that are meant to be used for financial emergencies. Examples include job loss, a car wreck, major house damage insurance deductible, etc. You set these funds up to ensure you don’t take a step backwards at the first sign on financial distress.

Most experts recommend 3-6 months of savings for your emergency fund, but it all depends on your situation. If you and your spouse are both real estate agents or sales agents (commissioned based income) you may want to save 6 months. If you are both salaried employees, with great companies, with no sign of uncertainty, you may feel comfortable only having 2 or less months saved.

Ultimately, it is your decision and you should have enough saved to feel comfortable. If you stay awake at night worrying about what you would do if a financial problem arises, you probably don’t have enough in your emergency fund.

Save Before Paying Debt When the Savings Interest Rate is Higher than the Debt Interest Rate

You also might consider saving first if your debt has a very low interest rate. For example, my wife and I currently have a car loan with a 0.9% interest rate. If you can find a savings account that has a higher interest rate (higher than 0.9%), it would generate more earnings than you would make in cost savings from paying off the loan and saving later.

When Your Employer Offers a Match on Your Retirement Account

Another reason you might consider saving first is if your employer offers a match on your retirement. If your employer offers a 50% or 100% match up to a certain amount, it makes sense to focus on paying up to the match first before paying off debt as you’re getting a guaranteed 50% to 100% return on your savings.

Conclusion

The answer to, “is it best to pay off debt or save?” is, it depends on your situation. For most people, what will work best is a balance between paying off debt and saving.

The financial guidelines mentioned above are meant to help you determine if it is better to pay off debt or save. However, you are ultimately in charge and will make the final decision.

If you ever feel uncomfortable handling this alone or need affirmation that you’re making the right decision, please reach out to a financial advisor (preferably a fiduciary). It does cost a little money, but they’ll help you sort out your situation and you should make that fee and more back in savings and piece of mind.

What approach do you use for your situation? Any pointers or tips to help readers make the most informed decision?

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