Many financial advisors talk about the value of having some savings to avoid debt. But what about people who already have debt? It’s a challenging situation for someone to be in, especially if their income barely outpaces their expenses.
How can someone know if they should pay off debt or save?
The truth is, people can do both at once — but one must take priority. This will depend on the person’s financial situation and life circumstances.
Here’s how to evaluate whether to prioritize debt or saving.
Create a Budget and Cut Expenses
When someone wants to improve their financial standing, they have to create a budget to know exactly where each of their dollars goes.
After documenting their expenses, they should scan carefully through and slash expenses where they can.
Unused subscriptions, dining out, and entertainment are often prime candidates for budget cuts.
Now, that doesn’t mean that people have to avoid all fun if they want to escape debt. Rather, they should reprioritize the bulk of their funds towards financial improvement at this stage. When their money situation stabilizes, they can add back more discretionary expenses.
Pay Off Debt or Save?
Now that the budget is in place, it’s time to decide: pay off debt, or save?
The answer lies in each person’s financial situation, life circumstances, and remaining income after expenses.
Paying Off Debt First
People should focus on debt first if their loans have high interest rates (such as credit card debt) and/or if they have plenty of extra cash after expenses.
Paying interest is essentially throwing money into the fire. Taking care of debt first can save someone thousands of dollars on high-interest debt like credit card bills. Other debt, like student loans and some mortgages and auto loans, may have more reasonable rates where it makes financial sense to continue paying the minimum. It’s also important to be aware of prepayment penalties before tackling debt aggressively — it may not be worth paying a loan early depending on those fees.
For people who have no savings at all, it’s good to start putting away at least a small amount of money in an emergency fund. Setting a goal of even $500 can cushion a lot of financial blows.
Otherwise, put savings on hold and throw everything at debt. Once debt levels are low, it’s fine to redirect more towards savings.
There are two methods of paying off debt:
- Debt snowball: Pay off debts in order of principal balance, starting with the smallest debt, while paying the minimum on other debts.
- Debt avalanche: Pay off debts in order of interest rate, starting with the highest rate, while paying the minimum on other debts.
People should focus on savings first if their financial situation is less stable, their debt is in the form of lower interest loans and/or only have a little extra cash after expenses.
After all, if someone tries to attack debt with no savings, then something bad happens, they’ll have to take on a lot more debt to get out. That will put them right back where they started — or worse.
For example, someone trying to pay down student loans with a 4% interest rate is great. However, without an emergency fund they could need to tap into credit card debt in an emergency, with an interest rate of 30%.
When someone is in a rocky financial situation, they should set debt payments to the minimum and bank the rest until they have adequate savings. After building up a nice emergency fund, they can start tackling debt with either the snowball or avalanche method.
Notice: Information provided in this article is for informational purposes only. Consult your financial advisor about your financial circumstances.
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Original Source: Advance America: How to Balance Paying Off Debt and Building Savings