To Pay Off Debt or Save? That is the Question

In uncertain financial times like these, we all tend to focus more sharply on money matters. This is actually good news, because this new focus can help us educate ourselves and develop healthier financial habits for the future. One question that comes up frequently in analyzing personal finances is, should I pay off debt or save money?

We hear a lot about how Americans don’t save enough for the future, and how important it is to have an emergency fund for a rainy day. But we also hear a lot about the importance of getting out from under crushing credit card debt. So it’s only natural to wonder which is more important.

At first glance, you might think the answer is always “pay off debt first.” But there are a few things that you should consider before taking this advice.

1. Know Thy Enemy. Sometimes consumers do the wrong thing, for the right reasons. For example, given all the hair-raising news about eroding home equity and foreclosures, many consumers are pumping extra cash into paying off their home mortgage, rather than directing that money towards other more potentially dangerous debt like credit cards.

It is unwise to pay down your relatively low-interest, tax-deductible home mortgage, student loans, or business loans if you carry other more volatile forms of debt.

2. Break the Piggy Bank. As painful as it sounds, many times cashing in your low-interest savings account to pay off a high-interest credit card is the right choice.

Interest accruing in most savings accounts can’t keep pace with the interest accruing on a credit card account, so it is generally a wise move to raid the savings account to help get out of debt.

3. Divide and Conquer. When analyzing debt, carefully consider what motivates you the most towards repayment. Does paying interest drive you nuts? Perhaps paying off your highest interest rate card first make sense. Do you need some quick wins? Maybe you should pay off a couple low-balance cards early in your plan. However you decide to do it, figure out a way to single out one debt and make it your top priority.

Pay the minimums on your other cards until you slay the beast with the highest interest level, the highest emotional involvement (a personal loan to in-laws, for example), or the lowest balance (following the debt snowball method). Then move to the next worst offending debt and so on.

4. Know Thyself. There are two schools of thought regarding saving vs. paying off debt. One school of thought is that you should pay off the debt entirely before beginning a savings regimen. This works well until the bottom of your hot water heater gives way unexpectedly and you wind up with a hefty cleanup charge, which might lead to a credit card tailspin.

If you are the type of person who can stick with a payment plan, regardless of occasional setbacks, you should pay of your credit card debt first. If you are more likely to be derailed and disheartened by an unexpected expense, it might be wiser to focus on creating a rainy day fun, while committing to a cash-only plan for new purchases.

Once a small nest egg is built, then the attack on debt can be renewed with more confidence.

5. Hands off the Cookie Jar. In the rush to get out of debt, some people consider tapping into or liquidating their 401(k) or IRA funds. This is a poor personal finance move, since not only will you be gouged by Uncle Sam upon withdrawing the funds prematurely, you will also be losing the long-term impact of those funds on your overall financial well-being.

Some folks might stop short of cashing in their retirement funds, but instead decide to take a loan out against their 401(k). This can be a viable option for a disciplined borrower, but beware that failure to payback the loan from your 401(k) in a timely manner can result in weighty tax consequences and stiff penalties. Also keep in mind if you are laid off, or you decide to switch jobs, the loan may be due in full immediately.

For those tackling debt, how have you decided to go about it? Save first, pay off debt, or a little of both?

Comments

  1. I have had the fortune of being able to be more or less debt free for the past few years, but I agree with the points about taking things out of the cookie jar (retirement accounts). Some people will blindly max out their different retirement accounts because they are tax-advantaged each year, but don’t worry about the fact that their month to month spending is more than what they now have left over. Sometimes each month, just to be safe, I’ll pay down my credit card mid month so that I can see my cash balance go down, rather than just assuming I’ll have enough to cover it each month. Helps with budgeting for sure.

    • We did the same thing for a while. When we were planning to get a mortgage we paid our card off around the 13th, because the statement closed on the 15th, and that was the balance reported to the credit bureaus. Even though we pay the card off every month, to the bureau, it looked like we owed several hundred dollars (mostly utiilties) every month.

  2. Unless the choice is clearcut, a “diversification” approach works best.

    Put 50% of your savings into your Frugal Dad 3-tier emergency fund, and use 50% of your saving to pay off credit card debt.

    There are two strategies to pay off credit card debt: a) The “cash flow” method (pay off the lowest balance first), and b) The “minimize total cost” method (pay off the highest interest rate first).

    If you don’t have an adequate ememrgency fund, use the cash flow method.

  3. Unless the choice is clear-cut, a “diversification” approach works best.

    Put 50% of your savings into your Frugal Dad 3-tier emergency fund, and use 50% of your saving to pay off credit card debt.

    There are two strategies to pay off credit card debt: a) The “cash flow” method (pay off the lowest balance first), and b) The “minimize total cost” method (pay off the highest interest rate first).

    If you don’t have an adequate emergency fund, use the cash flow method.

    If you have an adequate emergency fund, use the minimize total cost method.

  4. I have been thinking about this a lot lately. I think it is a very personal decision.
    If I had consumer debt, I would not be worrying about the mortgage at all. I would be paying off those credit cards ASAP. However, since I have no consumer debt, my focus is my mortgage, at the expense of extra savings.

    We do have money in different investment vehicles, and continue to invest. However, the bulk of our spare money goes toward paying down the mortgage, even though the interest rate is low. I just want the piece of mind that comes with being debt-free, and that is worth more to me than getting a couple percentage points extra of investment income.

  5. I’m fortunate to not have any consumer debt. After I max out my tax advantaged retirement accounts, most of the excess has been going to the mortgage.

    If interest rates were higher or the economy was booming again, I might do more in stocks or CD’s, but right now there is so much uncertainty that I feel more comfortable with the sure thing approach which is paying down debt.

    • Wise move. And as you say, it’s tough to lock in a guaranteed return of 5 or 6% (or higher, depending on your actual mortgage rate) that you “lock in” when clearing some mortgage balance. The only risk is neglecting required retirement savings, but it sounds like you have that well-covered.

  6. My husband and I just took a 401k loan out to pay off our CC debt. We went from paying 20% interest to Citi and Chase to paying 5.25% to ourselves. In 5 months, 10% of the loan has already been paid off :)

    Reasons why we went against the conventional wisdom:
    1. Our 401k was high enough that we only needed half. Based on our ages, we still have a good amount in there.
    2. Contributions are still allowed while paying the loan.
    3. My job is fairly secure.
    4. The loan allows pre-payment. Once our savings goals are met, we can start sending in extra payments to snowball these if we need to (but with a loan that low we might just put the repayment amount into savings instead.

  7. My family is taking the 50/50 approach hitting our credit card first. We have a small emergency fund but would like to have more. I recently decreased my 401K contributions in order to use that money to save/credit card. I don’t know how long I’ll do this. I don’t want to do it for very long but we have to get the credit card paid off!

    • Always contribute enough to a retirement program to get the employer match. For example, if an employer matches 50% on the first 6% of salary, then your return on that 6% is 50%, which is much higher than credit card interest.

      Once you hit the employer match (or if there is no employer match), use the diversification approach.
      If you don’t have an adequate emergency fund, pay 33% to building your retirement fund, 33% to building your emergency fund, and 34% to reducing credit card debt.

      Once you hit the employer match (or if there is no employer match), if you have an adequate emergency fund, pay 50% to building your retirement fund and 50% to reducing credit card debt.

  8. The method that I’m taking is to concentrate primarily on debt, with some savings here and there. I was fortunate enough to have a job through college, and so have a decent amount of savings already started. I also don’t have any credit card debt, just a decent sized loan. I’m currently in ‘hyper aggressive pay down mode’, making bi monthly payments each month.

    To be perfectly honest though, I’m not sure I’ll start maxing out my retirement accounts once it’s paid off. The payments I’m making on my loan will be going into savings for a house, so I won’t have much extra anyway. The way things have gone, I really don’t put much trust in the market anymore. It just depends on what I see. I’ve been doing some investing in some gold funds, which are giving me great returns though. :)

    • Always contribute enough to a retirement program to get the employer match. For example, if an employer matches 50% on the first 6% of salary, then your return on that 6% is 50%, which is much higher than credit card interest.

      Once you hit the employer match (or if there is no employer match), use the diversification approach.
      If you don’t have an adequate emergency fund, pay 33% to building your retirement fund, 33% to building your emergency fund, and 34% to reducing credit card debt.

      Once you hit the employer match (or if there is no employer match), if you have an adequate emergency fund, pay 50% to building your retirement fund and 50% to reducing credit card debt.

  9. I’m doing a little bit of both. I’m focused on paying more than the minimum when it comes to debt, and have already consolidated. Now I’m also using extra money towards savings. It’s possible to accomplish them both.

  10. I mixed things up a little. First I tackled high-interest debt (credit cards) while committing NOT to add to them unless someone was bleeding. That meant that I paused debt reduction when an unexpected expense came up, and them went back to debt reduction. Next, I built up a hefty emergency fund, because I could see the writing on the wall regarding an upcoming job loss. During the period while I was unemployed and bringing in very little income, I paused everything but eating and shelter. Once I got a job, I tackled low interest debt (my student loan), then rebuilt my emergency fund. Now we’re paying off our mortgage.

    • I believe that if you don’t have an adequate emergency fund, you should live as if you had no job.

      Once you have an adequate emergency fund, you can live “normally”. That still means saving enough in your retirement plan and paying off credit card debt.

  11. I have a very low interest rate on my mortgage and my second, so those are not a worry to me. My focus is to pay off the credit cards. However, it is important to have a rainy day fund set up, because if you have a tire blow out or the fridge breaks, you need to be able to repair or replace without pulling out the cards again. Once you have a rainy day fund (whatever amount feels best to you $1000 maybe?) then hit those cards with a vengeance!
    Bernice
    http://livingthebalancedlife.com/2010/waiting-for-perfect/

    • A Frugal Dad 3-tier Emergency fund is fulled funded with at least 6 months of expenses. As Frugal Dad pointed out, when his mother became disabled and lost her job, it took her 6 months to qualify for disability payments.

      With the job market being as poor as it is, if you only have a single income from (a) job(s), then a 12 month emergency fund is better.

  12. While paying one more house instalment when the currency exchange price is good it’s much better to get rid of something that can give us faster result. There will be a lot of next payments for house and we won’t see affects for years, but still many people would do that thinking, that if that’s their biggest debt, than that’s what they suppose to do. And it’s not quite like that.

    I was surprised to read about paying first the highest emotional involvement debt but if that will make us sleep better and make us more concentrated then it actually may be a good idea too. Thanks for the tip ;)

    Andrzej

  13. I say go for the largest return. There is no advantage to putting money towards a retirement fund giving you 5% return. When you have a credit card or other loan out charging 25%. It is good to have an emergency fund say $2,000 to help cover if your car breaks down or something. After a small emergency fund like that get that debt paid off. (If your company matches your retirement payments, put enough in to get the full match and that is all)

    • Don’t forget about the income tax benefits.

      For example, an Illinois resident in a 25% Federal income tax bracket with a 401(k) plan gets 25 cents “matching” (income tax reductions) from Uncle Sam and 3 cents “matching” (income tax reductions) for every 72 cents he contributes himself (he must contribute a dollar: 1.00 – .25 – .03 = .72).

      That’s a 39% return in a 25% bracket.

      And don’t forget about the Federal “retirement plan credit” for those in the very low tax brackets.

  14. We’ve taken the Dave Ramsey approach in regards to saving and paying off debt. First we established our $1,000 emergency fund (we already had it actually…just haven’t added to it this year) and have been paying off debt like mad. The credit card debt was gone a year ago so now the focus is on our first car loan. It should be paid off by March!

  15. How about a little of both? Saving puts you in a position to not need to get into further debt. At least a token amount, just to get into the habit.

  16. FD,
    I’ve been battling with the ‘cashflow’ side of paying off my debt for a while.
    I currently owe $130K on my house with payments of $1250/month. I have enough in my non-retirement brokerage accounts to pay off the mortgage.
    I can’t invest that $130K (with reasonable risk) to return the $1250/month to make the mortgage payment.
    So, I’m thinking that paying off the mortgage will free up the $1250/month, which I can use to ramp my non-retirement investments back up. Giving me absolutely no debt going forward.
    Thoughts?

    • I like that plan, assuming you can clear the mortgage with enough emergency fund (minimum six months or so) left over. I’d hate to see you pay off the house and the next month get hit by something requiring an outlay of cash (layoff, illness, etc – stuff happens). That’s my only reservation.

      Going forward, you’ll be putting that $1,250 and then some back into savings/investments, and will soon have $130k built back up. As you say, all the while being debt free, house and all.

      • FD,
        You make a good point about the emergency fund. Not having the $1250/month payment really lowers the amount of the ’6 months emergency’ fund requirement as it is by far my largest expense.
        While I may not have 6 months of liquid emergency fund available immediately, I will have a lower requirement.
        I would also keep the re-advanceable HELOC in place for opportunities/emergency at least until I get the funds built back up.

        • Maybe thinking about the reverse situation can help you decide. If you already had a paid off house would you take out a HELOC to invest in stocks? If the answer is no, then I think you’re ready to make the plunge and move the money over…just my opinion.

          • I love looking at things like that – Dave Ramsey often asks people the same question when considering a mortgage payoff. Thanks for bringing that up.

  17. I agree each person should evaluate their situation before deciding to pay off debt or save. But once you dig yourself out from all that debt wouldn’t it be nice to be better trained to borrow responsibly the next time? There are people out there that know how to wisely borrow money. Get their advice. Learn from them. Copy their actions. Read my recent post about preventing borrowing indigestion at http://wp.me/pZTwu-aq

  18. A penny borrowed is a penny earned and a penny repaid is gone forever. The bank charges you interest based on the likelihood you’ll pay them back. If you prepay a fixed rate loan, you’re giving the lender extra loan profit. I cover this and more at my proborrower blog.

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