Build Up Savings or Pay Down Debt?
January 8, 2009 by Miranda Marquit
Filed under Credit, Debt Management, Economy, Family finances, Money advice, Personal Finance, Saving Money
Yesterday, I wrote a post about 5 steps on the journey to financial freedom. I got this comment from Flipsem:
I understand that we all need cash reserves for emergencies but, can being a saver and being in debt be a good strategy? With interest on debt being higher than savings would it be better to pay off your debts first? What are your thoughts?
What a great point.
To some degree, this question is similar the post regarding whether or not to pay off a credit card with a CD. If you have debt that is eating away at your finances through interest payments, conventional wisdom says that it might be a good idea to pay it off quickly and then start saving. However, I still maintain that you can work toward both goals at the same time. Getting in the habit of saving is almost as important as saving itself.
In this economy, having some sort of savings is important. But it is also important to get rid of debt. Here is what I suggest if you are trying to figure out whether to build up savings or pay down debt:
- Figure out how much extra you have each month.
- Take 75% to 80% of that extra money, and use it to pay down debt.
- Take the remaining 25% to 20% of that money and use it to build savings.
- If you have a larger amount that you can put aside for these efforts, consider tweaking so that maybe you have an 85% to 15% ratio of debt pay down to building savings.
What do you think is the best course of action in this economy? Build up savings or pay down debt?
Disclaimer: I am not a financial professional. Any information you get from this site is not intended as advice. It is likely to be incomplete, and it may not apply to your individual circumstance. Do your own research, consider your situation and/or consult a professional before making money decisions.
Ultimately, the decision needs to come down to one thing: what each individual feels is best and most comfortable for themselves. Some people have never been savers, so taking an aggressive debt-reduction stance would be nothing new, except that rather than spending they are paying down debt. Some people are strict savers, so pulling back a bit on the savings contributions to increase the debt payments may be a little difficult. There really is no right or wrong way in general, just what is right for each individual. Personally, I think it is a bad idea to ignore saving altogether (regardless of interest rates) unless there is already a significant savings built up.
As usual, Eric, your insight is right on. Naturally you should do what you are most comfortable with. And I tend to agree that unless you’ve got your savings already built up, you shouldn’t ignore this vital part of finances. Especially now. What happens if you need that money? A cushion is especially needed in this economy.
Hi Miranda
Thank you for taking the time with such a comprehensive answer. Much appreciated.
Best regards
Thanks for reading!
Thanks Miranda. I think the biggest problem with pf blogs is that so many writers think that what works for them will automatically work for all others. That’s why I don’t really answer questions directly since I can never get enough information from what readers submit. How can you give guided advice if you don’t have all the pertinent information to begin with? As for what happens if someone needed the money that they didn’t save, well experience tells me that they will bitch and moan that the creditors are at fault for giving them access to credit that they couldn’t handle. Honestly, I believe that if people would take responsibility for their actions, and learn from their mistakes, many of today’s problems would not be problems any more.
Certainly, I agree that a certain level of personal responsibility needs to be brought back. At the same time, some of our problems are the result of the unscrupulous and greedy preying on others. It’s a mixture right now, and some people who might have done their best, are in a bad place due to others.
There’s a psychological aspect to this. You want to build the “habit” of saving. Even if it’s just a little amount to get you into the idea of always putting something away.
If a person know they won’t be going into credit card debt again (they’ve curbed their free-spending ways) then they probably could take their savings to pay down their credit. This will save them in interest and when it’s done those payment amounts can go into savings. If an emergency were to arise you could always go back to the credit card IF NEEDED.
Though another aspect is we can’t really rely on credit cards to be there for us these days. You may need to build that savings now because down the line a credit card company might decide to shut down your account and you’ll have nothing but your savings.
So maybe the best answer is a little bit of both?
I’m all about the little of both approach. I completely agree, FFB, that a habit of saving is important. Even if it is just $10 a week while you are paying down debt. And you make a good point about the credit cards and the state of the credit market as well.
You both make excellent points. FFB is completely right, as I have heard of people with credit scores in the 800’s having their accounts closed down. But, that leads to another problem because if that happens, there is no more paying the minimum and the person is forced to repay the entire balance in one lump sum or face going into collections. That further exacerbates the problem of saving vs. paying down current debts. I do think you have hit on a key point though, Miranda, as even contributing $10 a week to savings on a regular basis can help to get people into that savings state of mind. Once it becomes an automatic response then it should become easier to increase deposits over time. Of course, once people see the balance gradually increasing it should really occur to them how important and rewarding saving can be.
I agree that once you see your balance rising, you can enjoy saving more. Additionally, it provides peace of mind, since you are preparing for the future.
In my opinion, it depends on the situation as Eric indicated. Once people have a nice cushion of money (a year to sixth month’s worth of expenses in a savings account), then it may be prudent to begin paying down debt. As tempting as it is to pay down debt, it’s not wise to do so until you have that cushion of money.
One of the issues with getting rid of all the debt, and completely neglecting savings, I think, is that what happens if you lose your job (possible in this economy), and you don’t have any savings? Then you are stuck using the credit cards you just paid off. And you are back in debt. I think there’s a delicate balance, and it depends on your situation. PERSONAL finance
I’ve never heard of a credit card company shutting down a paid off account.
I do know a bunch of people who don’t have the discipline to pay off their credit cards but wouldn’t touch savings. (what about them?)
I think you’re right, David, about not shutting down a paid account. I haven’t heard that, but it could be a relatively new development. (Although I’ve heard plenty about shutting down inactive accounts recently.) I really don’t know that there’s anything someone can do if they don’t want to/can’t pay down their debt. If they have sufficient savings to help them through disasters, and they’re reasonably content with making credit card payments and doing it with interest, there’s not much that can be done. And, really, if they are comfortable with it, and not in danger of completely folding, I suppose it’s not the end of the world. You have to WANT to make the necessary changes first.
For myself, I would pay down the debt first. Say the CC rate was just 9%, that’s still higher than any stock fund has done in the past year. The best return for my money was paying off the CC cards and then saving money. Once those CC cards are paid off I started working on an emergency account.
I like this idea in theory, Passive, but I am a little wary of not having ANY savings. Especially in uncertain times where anything can happen. But if you are going strictly on a money paid out in interest v. money earned in investments (including savings), the current environment lends additional weight to your argument.
Paying down high interest debt only makes sense. Saving also only makes sense and with some practice both can be done.
I’m almost debt free and regularly save 12% of everything that comes in, plus another 12% for my business… heck, even my cats have a savings account for vet bills and such.
Anne Wayman, now blogging at http://www.aboutfreelancewriting.com
I love the cat savings account, Anne! If you know you’ll have to spend money on it at some point, you should have a savings account for it.
I am going back and forth between paying off our student loans and car loan, extra on mortgages, and saving. We’ve got a nice sized emergency fund but with today’s economy I feel better if I have more cash in the bank knowing I can pay off the debt if I want to later.
Good for you! I think you make a good point about feeling better about being able to pay it off later. It may be more fiscally accepted to pay it off now, but it may not be good for your emotional peace of mind. It’s all about what you’re comfortable with.
Great article!
You can submit it to BankFiesta.com to share with others, hopefully will get you some additional visitors too.
Cheers
I like your ratio.
We saved a little and paid off a lot. When my husband was laid off it was SO nice to not have bill collectors calling on the phone, because we didn’t owe anyone money.
It meant we have less savings but we’re lucky and could increase the freelance load in the household. I know many can’t do that.
Thanks, @dealman, for the recommendation. And, thanks jenny, for weighing in. I think that, depending on how comfortable you feel, it can make a difference. And it is a nice feeling to be out of debt. Good for you!
Some very interesting ideas that you bring up Miranda. I’ll definitely take them into consideration while trying to tackle my own debt situation. I just started a blog on my journey to financial freedom. Maybe I can use some of your blog posts and references? http://thedebtguy.wordpress.com
Thanks for stopping by, debt guy! You are welcome to use excerpts (properly attributed and linked) but not full posts. I look forward to reading some of your posts on your journey to get out of debt!