Should I Pay Off Debt or Save?

Goal-setting is a crucial first step for taking ownership of your finances and getting closer to financial security.

But what if your financial goals seem to be at odds with one another?

That often seems to be the case when you’re faced with debt and the need to build up your savings, either personal or retirement.

So which do you pick? How do you prioritize between paying off your debt and saving for your other financial goals?

The Case for Paying Off Debt First

According to Howard Dvorkin, a CPA, two-time author, and chairman at Debt.com, “It’s always better to pay off debt—because you’re paying yourself. Every dollar you erase from your credit card balance means more pennies in your pocket.”

How so? Dvorkin explains:

“When you have large credit card debts, you’re generally paying around 18 to 20 percent—some people pay a little less, some more—just for the privilege of carrying those balances. That literally means you’re paying about 20 cents on the dollar of your money to someone else, and you’re getting nothing in return.”

While Dvorkin refers specifically to outstanding credit card debts, this can be said of any high-interest debt you owe. The average interest rate on a personal loan ranges from 10% to 28%, after all, though for those with average or poor credit, this rate could be closer to 18% to 36%.

Why Savings Should be Your First Priority

Others argue that you shouldn’t neglect saving for the future, particularly retirement. Their reasoning is as follows:

• Thanks to compounding interest, the earlier you save, the better. This financial concept describes how interest on your initial principal and its accumulated interest builds up and makes for exponential gains. This can mean a world of difference depending on what age you actually start saving. For instance, assuming an average gain of 7%, depositing $3,000 in your retirement account annually for 40 years will translate into well over $600,000. However, if you begin saving the same amount at the same rate but 10 years later, your balance will be closer to $300,000.
• From a practical standpoint, you need to have a healthy amount of savings to safeguard against life’s unexpected challenges. Funneling all your “extra” income into debt puts you at great financial risk in the event of a car accident, natural disaster, or some other unexpected event.

Guidelines to Consider

Of course, it’s not a straightforward decision because there’s no one-size-fits-all answer to whether you should pay off debt or build your savings first. With that in mind, here are some general guidelines that financial experts say you should consider.

It really depends on your situation

Ashley Patrick, Ramsey Solutions Master Financial Coach and owner of Budgets Made Easy, advises asking yourself several questions to determine whether to prioritize debt or savings:

• Am I at risk of losing my job in the next 2-3 years?
• Will I be moving anytime soon?
• Am I pregnant or planning to have any children soon?
• Do I have major medical issues that I need to save for?
• Do I expect any major house or vehicle repairs in the near future?

According to Patrick, “If the answer to all of those is no, then save a small amount before prioritizing debt. If the answer to any of those is yes, then prioritize saving money until the anticipated event has passed.”

Look at your interest rate

“The best way to determine which goal should be prioritized between paying off debt and saving is to look at interest,” Allan Liwanag, the financial blogger behind The Practical Saver, says. “If you are earning more interest when saving money than when you’re paying interest on debt, then it’s best to save money. If the interest rate is low, it makes sense to save on things that are of most importance, such as emergency funds.”

For instance:

Your online savings account has an annual percentage yield of 2.2%—certainly better than a traditional brick-and-mortar account—but still much smaller than credit card debt with a 20% interest rate. In this case, your debt deserves more attention, as your “return on investment” for money going towards that debt is significantly better than your savings’ interest rate.

“On the other hand, if it’s the reverse,” Liwanag says, “then paying off debt should be prioritized over saving money. Interest rates on debts are typically higher than the interest rates on saving or even the return you get from the stock market—in which case, paying off debt makes more financial sense.”

Consider whether your employer matches your retirement contributions

R.J. Weiss, a certified financial planner and founder of The Ways to Wealth, agrees that deciding which financial goal to prioritize can be determined by looking at your interest rate in your savings account and your debt.

However, he points out that your employer may play a role in this equation, specifically when it comes to retirement contributions.

“Keep in mind, if your employer matches part of your retirement contribution, this will significantly increase your rate of return and that match should be factored in your decision,” says Weiss.

“That being said, I wouldn’t recommend this strategy for everyone, especially when debt keeps someone awake at night. When that’s the case, one can consider a hybrid approach. An example would be to invest in their 401(k) up to their employer match, and then focus on paying off debt with the remaining available funds.”

Choose the middle ground

That is, you can make more than your minimum payment toward debt while also simultaneously contributing to your savings.

Sound a little too far-fetched?

Make no mistake: this path is definitely possible.

Although it can feel like a balancing act, try these tips to attack your debt and set aside money for savings at the same time:

• Develop a budget. Find out your monthly fixed costs and set limits on discretionary expenses so that you have room to both save and make larger payments toward your debt.
• Better yet, treat your debt and savings as fixed costs. And then automate debt payments and savings contributions so that you have no choice but to work with what’s left over for the rest of the month.
• Start small. You have to make that minimum payment toward your debt no matter what, and finding room to save can be exasperating on an already tight budget. There may be plenty of frugal habits you can introduce to your lifestyle, but don’t expect to go from 0 to 100 at once. It’s okay to begin by only saving $10 or $20 a month—just try making it a goal to gradually increase this amount over time.
• If you have the time and means, pick up a side hustle. If your normal monthly budget already has you putting more than the minimum payment toward your debt, then this extra income can go directly into your savings.

At least build a financial cushion first

Others suggest that before you target your debt, you should first establish a solid emergency fund. This way, you’ll protect yourself from any unforeseen major expenses.

“You need enough savings so that if something happens, like you need new tires on your car, you can pay for it without adding on more debt,” Val Breit, blogger at The Common Cents Club, advises.

For Breit, that was “a few thousand dollars”—but it’ll vary depending on your regular monthly expenses. Cities and communities with a high cost of living generally warrant saving up even more than if you live in a small town. Whatever the case, set an appropriate benchmark to save for your emergency fund.

Conclusion

For many, finding a balance in simultaneously paying off your debt and reaching your target savings may be the best route for obtaining peace of mind while also whittling away at your debt—even if you pay a little more in interest. Though the two goals may seem like competing priorities, they’re ultimately both important pieces of your overall financial health.