Paying off debt vs. saving, which one should you prioritize? On the one hand, paying off debt comes with invaluable emotional relief. But it may drain your accounts. On the other hand, saving providesfunds for emergencies and investments. But is it worth it if it involves carrying debt? In this blog, we'll cover whether it’s better to save or pay off debt.
Should I pay off debt or save? Which comes first?
While saving refers to keeping money for future use, paying off debt is the process of settling all the debts you owe. Both are important. When you save, you’re able to set aside money for emergencies, short-term and long-term goals. Savings may cushion you against a sudden and unexpected job loss. You can also save to prepare for big life events — like vacations or purchasing your first car.
Paying off debt offers emotional relief, which in turn can lead toless stress and improved health. It can free up funds for pursuing other life goals such as investments or further studies. And when done properly, paying off debt can improve your credit score and help you manage funds in a better way going forward.
With that in mind, is it better to save or pay off debt? There’s no one-size-fits-all strategy. Whether you should prioritize saving or paying off debt will come down to your financial situation and goals. For example, you can prioritize short-term saving over paying off debt. This would mean putting more money away in the near future so that you enjoy the financial security that comes with having extra money in the bank. Similarly, you can focus on paying debts so that you attain the financial freedom that comes with being debt-free.
Ideally, you should create a good strategy that can help you deal with both sides rather than just one side. That way, you will be able to save while also reducing your debt burden. The amount to allocate to each can depend on what’s weighing you down more between debt and saving.
Types of debt
There are severaltypes of debt. The most common ones for individuals and households are the following.
Credit card debt
This is debt that you accrue from using your credit card. It’s usually carried over from month to month and typically carries a high interest rate. In 2022, the average interest rate on credit cards was19.07%, which was considerably higher than the average lending rate (for all loans) of3.25%. Because of this high APR, it’s always a good idea to pay down orpay off your credit card debt before it slips out of control. The upshot of using credit cards is that it can help you build your credit score and improve your credit profile. But this is only true if you manage the debt properly.
Payday loans
These are short-term, high-interest loans that you typically have to pay with your next available paycheck. Just like credit card debts, interest on payday loans can quickly accumulate and push the total amount out of control. In fact, the high APR— which averages391%— is the reason payday loans are called predatory loans. For this reason, they are best paid as soon as possible. The lender will typically require you to sign documentation committing to repaying the debt. If you default, they may put your account in collection.
Personal loans
These are loans you take for the purpose of covering personal expenses. They may be your own individual expenses or family expenses. Whatever the case, the loan is typically unsecured — meaning that you can get it without offering collateral. While this is good news for you as a borrower, it makes personal loans harder to qualify for. Many lenders only approve applicants with a good credit profile. Average interest rates on personal loans start from6% but may go up to 36% if you have a bad credit profile.
Car loans
A car loan is a debt that you take in order to purchase a vehicle for personal or business use. Car loans are typically self-secured, which means that the vehicle itself acts as collateral. If you default on the loan, the lender may repossess it. Car loans typically have lower interest rates. The average APR in 2022 was4.9%.
Student loans
These are loans that you take in order to pay for education. It may be your own education or your child’s. Whilestudent loans help you afford an education, they can eat into your income and savings. For this reason, you want to be fully aware of the amount you’re borrowing and how you intend to pay it back.
There are two main types of student loans: federal and private. While federal student loans are funded by the government, private student loans are offered by private lenders like banks and credit unions. The average APR on student loans is5.8%.
Mortgages
A mortgage is a loan that you take out to purchase or refinance a property. Mortgage loans are typically secured, with the property acting as collateral. If you default, the lender may sell the property to recover their funds. Depending on your credit profile, a lender may require a down payment before they approve your mortgage loan application. Additionally, the exact interest rate that you qualify for typically depends on a variety of factors, including your income, debt-to-income ratio, and credit score. Currently, the average APR on a 30-year fixed mortgage loan is6.49%.
Business loans
If you want to start or grow a business, you can apply for a business loan and use it as initial or working capital. Many lenders have specific lending terms for business loans, including minimum annual revenue and a minimum time in business. Some lenders have specialized loans for specific purposes. For example, you can obtain an equipment loan for purchasing business equipment. The biggest advantage of business loans is that they carry relatively low interest rates - as low as2.82% for SMEs and 3.25% for large firms.
So, you have debt and want to save?
The challenge of having debt, particularly too much high-interest debt, is that a huge chunk of your money will go to servicing the interest. This may limit or flat-out prevent you from saving. But it doesn’t mean you absolutely can’t manage to save and pay off debt simultaneously. There are a few strategies you can use to maximize your financial freedom, depending on your personal finances.
Strategies
Pay off high-interest debt first without saving: In this case, focus on paying offhigh-interest debts like credit cards and payday loans and forego saving. This will free up cash as soon as you finish paying off the debts. It also prevents interest from going through the roof. The downside is that you won’t have savings to depend on if there’s an emergency.
Pay off high-interest debt heavily while saving small: Rather than ignoring savings altogether in favor of paying off high-interest debts, you can spare a little income and channel it into your savings account. Your savings will grow slowly but your high-interest debts will disappear faster. This will leave you with low and medium-interest loans that won’t have as much interest accumulating.
Make minimum payments on high-interest debts while saving aggressively:This is a good strategy if you can score a higher APY than the average APR on your debts— say, 5% APY and 2.5% APR. That would mean your savings are growing faster than your interest is accruing. However, most high-interest debts have APRs that are generally higher than APYs, so you risk losing money even if you save aggressively.
Pay off low-medium interest debt while saving small: If you don’t have any high-interest debt, but have low-medium interest debt — this one’s for you. Some loans, like auto loans, have manageable interest rates. You can aggressively pay them off while saving small. And – if you get a higher APY on your savings, the earnings may grow faster than interest on debts.
Make minimum payments on low- and medium-interest debt while saving aggressively: Low- and medium-interest debts like personal loans typically have long repayment periods. You can make minimum payments on them and save a bigger percentage of your income. This can help you earn more with APY from accumulated savings compared to what you’re losing with APR from accrued interest, particularly if the total amount of savings is considerably more than your total debt. Whenever possible, make one extra monthly payment per year. That extra payment may not affect your savings by much but it can help you save on interest and pay off the debt faster.
Align your financial goals to your debt-payoff and saving strategies
Ultimately, everyone’s financial situation and goals are different. Some people may find it easier to pay off debt at the expense of saving while others may prefer the other way around. There’s no right or wrong way of doing it considering the goal is the same — to pay off debt and save. The only difference will be the portion of income that goes to savings and the portion that goes into paying off debt. If your immediate goal is saving, you may be more inclined to save more and live with debt. On the other hand, if your debts are weighing you down too much and having negative financial impact, you may find it best to concentrate on paying off debt first.
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