Saving Up Versus Paying Off Debt: Getting Your Priorities Right – Guest Post
For many of us, the balancing act between debt and savings is an ongoing one – a constant battle to boost our savings and reduce our debt, when often we are achieving the opposite. So are we wasting our time trying to balance our personal finances in favor of a savings account over credit card debt when the latter is just so much more determined to rise? Conventional wisdom once put being debt free as the highest priority – higher even than having an emergency fund. However, when credit markets crumbled and cash was king during the Global Financial Crisis, many financial analysts and advisors began encouraging you to take up your balancing beam again and build up your cash reserves while paying down debt.
To help you decide which approach is right for managing your personal finances, consider the benefits of building an emergency savings fund versus paying off your debts and decide which option will be your priority.
Saving an Emergency Fund
If you want to start an emergency savings fund it is because you don’t want to rely on your credit card for every little unforeseen expense, so choose a savings goal which will help you cover those emergencies, while still being achievable, as this will help you maintain your financial confidence.
For example, if you have:
● An emergency savings fund goal of $1,000.
● A credit card debt of $5,000.
● A credit card interest rate of 15%.
● A minimum monthly credit card repayment of $100.
You want to know whether you are better off channeling your money to paying off your credit card, or sending any extra funds you have to a savings account. If you were to put aside $100 a month towards your emergency fund goal, you would reach $1,000 in 10 months – less than a year. During those 10 months you also would have:
● Made $1,000 worth of credit card repayments.
● Paid $603.19 in credit card interest.
● Paid off $396.81 from your credit card balance leaving $4,603.19.
However, to pay off your credit card balance in full it would take another 28 months, and cost an additional $859.01 in interest. This means, by starting an emergency savings fund instead of focusing on repaying your debt:
● It will take 38 months – over three years – to clear your credit card debt.
● It will cost you $1,462.20 in credit card interest.
As a result, the benefits of starting a savings fund while you are in credit card debt are primarily psychological, and depend on your own personal situation. For example, using your credit card to pay for things becomes a habit and when you have some money set aside in an emergency fund you feel relief at not living week to week on your credit card. You also now have the opportunity to break the bad habit of credit card debt by not using your credit card anymore, because you don’t have to turn to the plastic each time you face an unexpected expense – now you have an emergency fund so your credit card debt is no longer increasing.
Next take a look at your own circumstances, for example do you own an old car which is regularly in need of repairs? Then chances are you are going to have an emergency expense to deal with at the mechanic in the future, and so an emergency fund is valuable to you. Or perhaps you have seen recent cutbacks at your company or in your industry and you’re not sure about your job security – then an emergency fund can offer a level of security, knowing that if you do need extra funds you can access your savings and you won’t be charged interest, saving you from another financial worry.
It also doesn’t make sense to rely on your credit cards in an emergency because there is always the possibility that your provider will reassess your account and lower your credit line or even close your account. In the fine print of most credit card agreements it will state that the provider has the right to adjust your account terms at any time. However, having access to your own cash savings is something you can rely on in an emergency.
Paying Off Debt
In the same example above where you have:
● A $5,000 credit card balance.
● A 15% interest rate.
● A $100 monthly repayment.
You could put the extra $100 each month you were using to build your emergency fund, to pay extra off of your credit card balance. If you focused on repaying your debt you would:
● Pay off your credit card balance in 31 months, or two and a half years.
● Pay $1,032.66 in credit card interest.
● Be able to use the $200 you now have free every month to build a $1,000 in five months.
This means you have spent 36 months, paid off your credit card debt, built and emergency fund and saved over $400 in credit card interest.
However, remember that in this situation, if you have an emergency expense during the time you are paying off your credit card, you will have to use that card to pay for the emergency. This will then set back your plans because you have increased your credit card balance and interest charges.
Another consideration in paying off your debts before starting a savings fund is how well you are currently coping with those debts. For example if you are struggling to meet your minimum payment amount each month and the high interest rate is compounding your debt higher each month, then it is important to focus on reducing your credit card balance before you do anything else. Also consider whether you have a high interest rate on your credit card because often the interest you earn on your savings doesn’t outweigh the interest you are charged on your credit card. Therefore, unless you have a low interest rate card or are enjoying a low balance transfer interest rate, it is usually more financially viable to pay off your credit card debt as soon as possible, just like in the example above, where you can save $400.
Plus, paying off your credit card debt, or even working on paying it down faster, gives you more financial breathing room. For example, when your credit card repayments are lower – or gone for good – you have greater cash flow and the chance to make clear decisions about your personal finances, and what to do with that extra cash. Therefore, even if you focus on just paying off your lowest interest credit card because that will be the easiest, and with that repayment out of the way each month you can use the extra money to pay off other debts, save for an emergency, save for an investment, lock away your savings in a term deposit or simply take the time to consider your options.
Saving vs Paying Off Debt
While it can be stressful to have the weight of credit card debt hanging over you, in most cases it is best to start saving an emergency fund as soon as you can, even if you are in debt. An emergency fund will benefit you over paying off your debt because:
● Credit cards are an expensive form of finance. When you use your credit card for an emergency expense, it is because you don’t have the financial ability to meet that cost any other way. Therefore, when you use your credit card you are simply compounding your financial problems, adding high interest and credit card fees to cause yet another emergency expense when your credit card statement and bill arrives next month.
● Credit cards are unreliable. The interest rate on your credit cards is variable and can go up without notice, increasing the cost of your emergency spending even further. Plus, if your provider finds that you are struggling financially they may lower your credit limit or call in your debt.
● Save when debt is manageable. Having debt is not the taboo it once was and it is acceptable to have some debt while you are building your emergency savings fund, as long as you are able to manage the repayments and don’t incur high penalty fees.
● Stop increasing your debts. The first key to reducing credit card debt is to stop spending on your cards, and when you have built an emergency savings fund, you can use the money in that account for unexpected expenses, rather than charging them to your credit card and undoing all of your hard work.
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