Banking 101: Should You Save or Pay Down Debt?
If you have debt such as credit cards, store charge accounts, auto loan payments, and/or a mortgage, you may have wondered if it is better for you to pay extra to reduce or pay off the debt or to put money into a savings account to build a cash cushion. Saving money and paying down debt are both important personal financial moves. Having an emergency fund might mean not having to use a credit card or borrow money in an emergency. Eliminating debt can help to improve overall monthly cash flow.
With planning, it might be possible to build savings and pay down debt at the same time, but for a lot of people, budget constraints and priorities may force a choice to do one or the other. Carefully considering your financial situation and priorities can help you decide what to do.
There are benefits and drawbacks to consider for each option, which can change over time as your situation changes. There may be instances when prioritizing either saving or paying down debt has a clear advantage.
Paying Debt First
Not all debt is created equal and understanding the types of debt you have is important. Revolving debt such as a credit card continues to roll over and accumulates interest until it is paid off. Credit card debt has the potential to last forever, especially if you are paying only the minimum monthly payment shown on the statement. Paying more than the minimum monthly payment (and not making any new charges on the account) will help to pay the balance off faster.
Term loans (also called installment loans) such as a car loan or a home mortgage have a set end date which is established when the loan is taken. The payments and loan term are designed so that when installment loan payments are made on time according to the payment schedule, the debt obligation eventually ends. Paying extra money with each regular payment, even a small amount, can shorten the amount of time needed to pay off the loan.
There are two philosophies when focusing on paying off debt, commonly referred to as the “snowball method” and the “avalanche method.” One focuses on the balances owed on various debts, while the other focuses on the interest rate being charged on each account.
With the snowball method, after paying the minimum monthly payments on all your debts each month, extra money is added to the payment of the debt with the lowest balance every month until it’s paid off. Once the lowest balance debt is paid off, the amount that used to go towards that debt is added to the payment with the next lowest balance each month until it is paid off. This process is repeated until all balances are paid off. Benefits to this method include the satisfaction of a “win” each time a debt is systematically eliminated, and the measurable reduction in the number of payments made each month.
The avalanche method determines which debt to pay down first by ranking the debt obligations based on the interest rate charged. The debt with the highest interest rate would receive higher payments until it’s paid off. After the first high interest rate debt is paid off, the remaining debts are ranked and the remaining debt with highest rate would receive additional payments, and so on. Paying off the higher-interest debt more quickly can reduce the total amount of interest you’ll end up paying over time and can free up money in the budget for other uses.
For most people, their home represents both their largest asset and largest debt. Paying off the mortgage can be a form of long-term security and provide a sense of accomplishment but depending upon your age and the interest rate on your mortgage, you may benefit more from building savings than paying off the mortgage. Depositing any extra funds into a savings account, money market account, or high yield savings account can help you build (or increase) a cash reserve or emergency fund.
Focus on Savings
The top reason to make savings a higher priority than paying down debt is to have an emergency fund to handle unexpected life events such as a vehicle or appliance breakdown or a medical situation. Even with insurance, you may be required to pay a deductible or co-pay amount.
When you have accumulated savings, you may not have to borrow money or use a credit card in an emergency. Without an emergency savings cushion, you could end up with even more credit card debt when faced with an unplanned expense.
Experts recommend building an emergency fund equal to three to six months of expenses and depositing it in a high-yield savings account. If you are just getting started, the initial goal might be to build a balance of a single month’s expenses. The important key to knowing what the emergency fund target amount should be is following a budget.
If you have debt at a very low interest rate and can earn a higher rate in a savings account, it might make more sense to focus on saving money first. Instead of paying extra on the low-rate debt, continue to make the scheduled payment amount and deposit any extra money into the higher-rate savings account.
The information contained in this article should not be construed as financial, legal, or tax advice, and may not be reflective of terms and features currently offered by Enterprise Bank. Please contact us for details on current product offerings and rates.
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