Debts can seem especially overwhelming when you need to build up a nest egg. In such a situation, you ask yourself which to choose to pay off your debts or save money. Your goal should be to strike the right balance in which you can become both debt-free and have little money saved. Be sure it is possible to pay off debt and save money at the same time, but you need to create a strategic plan and simplify your spending habits. Create an emergency fund of at least $500, to begin with, then expand your savings from there. Even a small emergency fund can keep you from going further into debt when an unexpected expense arises.
Create an Emergency Fund or a Savings Account
Experts generally advise prioritizing the creation of an emergency fund over debt reduction. Having some money set aside for savings can serve as a financial safety net. Besides, as you start saving for an emergency fund, open a high-interest savings account so your money can grow when you shift your focus to debt repayment. Not only will you build a reserve to cover unexpected expenses, but you'll also be establishing better saving and spending habits.
Use 50/30/20 Rule Budget
The 50/30/20 rule budget requires tracking and categorizing your expenses into three categories: needs, wants, and savings or debt. Needs are must-include expenses in your budget. Wants are expenses on which you choose to spend your money but are not urgent to live your life. Finally, the savings or debt category includes money set aside for the future. Depending on your total debt and earnings, you may want to cut back on your wants while increasing your debt payments and savings.
Pay off Harmful Debts
Once you've set up your essential savings, start paying off your harmful debts, such as payday loans, credit cards with interest rates higher than 15%, car title loans, and rent-to-own payments. You will ask “Why?” The answer is simple: high-interest debts can deplete your budget and lead to a debt spiral.
Create a Debt Repayment Strategy
Your personal debt repayment strategy will differ depending on the type of debt you own. If you have loans, for example, you may be able to inquire with your loan provider about the delay, forbearance, or loan forgiveness.
In general, there are two common debt repayment strategies: the snowball method and the avalanche method.
The snowball is a debt repayment method in which a person outlines all of his\her debts from smallest to largest (excluding the mortgage), then starts to pay off the smallest debt first, while only making minimum monthly payments on the other debts.
The avalanche method entails focusing on paying off the debt with the highest interest rate first, followed by the debt with the next highest interest rate, and so on. This method may assist you in escaping a debt avalanche and reducing large interest charges.
Whatever strategy you choose, consider paying more than the minimum each month. One simple trick is to set aside any additional money for debt payments, such as a bonus or a surprise gift from a close relative.
Pros and Cons
Now let’s dig into the advantages and disadvantages of both creating a nest egg or a savings account and paying off the debt.
There are several significant reasons to pay off debt as soon as possible:
- It may assist in the improvement of your credit score.
- Once your debt is paid off, you can devote your full attention to saving and other financial goals.
- Debt relief can alleviate an emotional and mental strain.
On the contrary, there are three main benefits to getting a good start on saving:
- The sooner you start, the more time you have to gain from interest charges.
- You can work toward your financial goals on your own timetable.
- If an unexpected expense arises, you can avoid accumulating new debt.
However, paying off your debts first can lead to
- Penalties. If you're stuck in debt and paying it off bears a penalty, as with some loans or mortgages, put the money in a savings account until the penalty is tiny enough and won’t ruin your financial stability.
- Losses. If the interest rate on your debt is less than the amount your savings receive, you can profit from saving. Every quarter, the bank will pay you interest on the amount in your savings account. This allows you to profit from the "lazy" funds in your account.
On the other hand, creating a savings account first, can have small but significant disadvantages.
- Interest charges can add up on your debts and ruin your financial stability.
- Making payments on your debts not only maintains your credit scores, but also strengthens your creditworthiness. If you save for an emergency fund first, your credit score may suffer as a result. Consequently, continuing to make minimum debt payments helps to maintain a strong credit score.
- If you're struggling to make the required minimum payment toward debt, or if paying for housing or utilities is a strain, you're not ready to create a savings account or an emergency fund.
Carrying debt for an extended period of time isn't preferred because it can cost more in interest and prevent your progress to your goals. But you can't afford to put off saving as well. Thus, when choosing between paying off debt or saving money, a balanced strategy that includes both may be the best solution.