August 5, 2021

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Saving Vs. Paying Down Debt – Forbes Advisor

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Saving or reducing debt – that is a balancing act that many of us face. But how do you find this balance in your own situation? The answer depends, in part, on whether you already have enough cash to save and how much high-yield debt you have on you. In some cases, you may want to save and pay off debt at the same time.

“It really comes down to calculating the opportunity cost of putting one thing above the other,” says Dan Mathews, a CFP in the Kansas City area. “Sometimes a balanced approach can be best.”

Here is an example of this opportunity cost. If you are likely to be making 6% annual retirement income, but have accumulated credit card debt at an annual percentage rate (APR) of around 18%, it is probably best to pay off the debt first. Why? Because paying 18% credit card interest more than offsets the 6% you make on your savings.

Jeremy Shipp, CFP in the Richmond, Virginia area says saving rather than paying off debt should be a “coordinated and efficient” strategy that emphasizes the ability to access cash quickly. If every dollar left after paying daily expenses is going to be used to reduce debt, don’t put money aside in case emergency costs arise, he says. That could then lead to you running into even more debt.

Establishment of an emergency fund

If you haven’t created one yet Emergency fundExperts generally recommend focusing on this before focusing on reducing debt.

Bruce McClary, a spokesman for the National Foundation for Credit Counseling, says an emergency fund should include at least three months of your take-away pay. (Some experts suggest an emergency fund will cover the cost of living for six to nine months or more.) If your total monthly takeaway salary is $ 5,000, the amount in your emergency fund should be at least $ 15,000 based on that Three month equation. This money should be used to cover emergency expenses such as unexpected car repairs or medical bills.

What if you have to pay less than three months to take away in an emergency fund – or no money at all? If so, McClary believes that building an emergency fund should be a priority over deleveraging. It is best to avoid using your emergency savings to pay off debts as you could run into more debt in an emergency.

Part of your decision about emergency savings should include how much access you have to your money, according to Shipp.

For example, on the debt side, consider the difference between a mortgage and a line of credit, he says. If you wipe out the balance on your line of credit and unexpected costs arise, you can easily go back to borrowing against the line of credit. However, if you use extra cash on your normal monthly mortgage payment, you will lose access to that money until you refinance the mortgage or sell the property, Shipp says.

On the savings side, consider the difference between a 401 (k) company retirement account and a savings account. When you add funds to your savings account, you can quickly access this pool of funds to cover the surprise costs. However, it can be costly to withdraw money that you contributed to your 401 (k). Under normal circumstances, you will be required to pay income tax plus a 10% penalty for every 401 (k) withdrawal made before the age of 59 1/2.

to pay off a debt

McClary says that if you are able to pay off debts, the “golden rule” is to look out for high-priced debts with no collateral, such as debts, and debts first. B. High interest credit card debt or high interest personal loan. If you are fortunate enough to be free of high-interest debt, consider reducing any remaining debt balances while still working out cash for savings, he says.

Paying off overdue debts should be your top concern, says McClary. Overdue credit card debt can result in late fees, while overdue mortgage payments can put you on the path to foreclosure. In addition, past due debts can affect your creditworthiness.

Mathews offers a few scenarios to help you find out whether you should be saving money or reducing debt.

If you have a pile of money in a savings account that earns very little, if any, interest, Mathews suggests withdrawing that money and paying off debts. That way, you can lower the interest you pay on the debt and pay off the debt faster. In this case, according to Mathews, paying off debts “makes a lot of sense”.

“Not doing anything and sitting on too much savings is the worst thing you can do,” he says.

However, there is one more factor that needs to be weighed in this scenario. When you move money from a low-interest or interest-free savings account into a retirement plan or investment account, you can potentially enjoy investment returns that outweigh what you would make from the savings account, says Mathew. There is a wrinkle in this plan, however. The amount of interest calculated over time if you just made the minimum payments on your existing debt could negate your investment gains, he says.

Mathews says he generally encourages younger people to put money into retirement savings rather than using it to reduce debt. But, he adds, if someone is burdened with high-yield debt like a stack of credit card bills, it might be wise to invest more money in paying off the debt.

“However, I expect someone will be much better off in the long run if they save money today in a retirement plan or other tax-deferred account that is built based on your long-term goals and needs,” says Mathews. “It has the chance to grow into something essential and accessible than putting it in for home equity or even student loans.”

For someone on or near retirement, the conversation between saving and paying off debt is different, says Mathews. People at this stage of life tend to run into debts and debts want to pay everything they owe, even their mortgage, he says. This frees up money for future living expenses, vacation, and other retirement expenses.

Mathews believes it’s okay to take out a mortgage when you retire, given today’s historically low mortgage rates. Remember that you want to take advantage of these low prices now Refinancing a Higher Interest Mortgage.

Saving strategies

Let’s say you decide to spend a lot of your financial energy saving money – for emergencies, retirement, and other purposes. How you do that? Here are three suggestions:

1. Start small if you have to. Even if you can only save $ 25 a week initially, that’s better than saving nothing at all. At the beginning of your savings journey, this money should be paid into an emergency fund. Consider opening a savings account for your emergency fund only so that you can separate it from other money pools, such as B. a checking account for paying household expenses.

2. Put money aside for retirement. Once you have a sufficient amount of money in your emergency fund, your next goal may be to build your retirement assets through a 401 (k) or individual retirement account (IRA). A popular rule of thumb is that you need to cut out at least 15% of your annual pre-tax income for retirement. This goal includes any money your employer pays into a retirement account.

3. Don’t overlook the appropriate pension contributions. If your employer matches the contributions you make to a company retirement plan, such as For example, a 401 (k), you might be throwing away thousands of dollars if you don’t add money to your account. When this happens, instead of putting the money elsewhere, you may want to make sure that you are making at least enough contributions to earn the Employer Match.

Debt Reduction Strategies

What if your debt problems override your savings problems? Follow these three tips:

1. Go over your budget. How much money do you take in each month and how much is it going to spend? Once you do the math, you can get a good idea of ​​how much money you can afford to pay off debt. If you find that you can get $ 400 a month out of your budget, you can allocate $ 250 of that to get rid of high-interest credit card debt and $ 150 to save for emergencies.

2. Look at your expenses. As you browse your budget, check to see if you can cut expenses or delete them. For example, do you really need to subscribe to four streaming services when just one subscription is enough? You may be able to move this found money to your debt reduction column.

3. Consider options with lower or no interest. To get out of debt, you can consider steps such as: For example, take advantage of a 0% credit transfer offer for high-yield credit card debt or refinance your student loan to get a lower interest rate. With student loans, it is advisable to weigh refinancing if a loan has an interest rate of at least 8%. The goal is to reduce the amount of interest you pay on this debt over the long term.

Bottom line

Balancing savings and deleveraging can be difficult. However, if you carefully think about your long-term financial goals and needs, you can ensure that your financial life is not out of whack.