Should Americans Prioritize Saving or Debt Repayment?
With housing, educational, and medical costs on the rise, people are so focused on their expenses that they’re having difficulty saving or paying down debt. Survey results estimate that anywhere from half to more than three-quarters of workers are living paycheck to paycheck, unable to put anything aside.
As a result, Americans aren’t prepared for financial emergencies such as the current pandemic. 37 percent of adults wouldn’t be able to manage a $400 emergency expense without borrowing money or selling belongings, according to the Federal Reserve. At the same time, many Americans are saddled with debt. Collective non-housing debt reached $4.2 trillion in the first quarter of 2020.
If you’re covering your expenses and wondering whether you should devote your extra income to savings or debt repayment, that decision should depend on factors such as the interest rates associated with your debts and the status of your current savings.
Focus on High-Interest Debt First
Some types of debt have high interest rates that require your immediate attention. Payday loans, for example, are intended to be repaid within a couple of weeks and have APRs reaching 400 percent. And auto title loans risk of seizure of your vehicle, so you’ll definitely want to prioritize these loans (four in five borrowers lose their vehicles to repossession as a result of default). Credit cards can have high APRs as well, especially if you’ve missed a payment and are now paying a penalty APR.
In most cases, you should prioritize these debts over saving. That’s because interest can quickly get out of control and make it impossible for you to keep up with expenses. The longer you take to pay off your debt, the more you’ll pay, and the more you’ll have to budget to be able to save anything at all.
Always Cover Your Minimum Payments
Keep in mind that, even in scenarios where it makes sense to prioritize saving, you’ll always need to make sure you make you’re making the minimum payments on your account. That’s because your payment history is the primary factor used in calculating your credit score. If you begin falling behind on minimum payments, you’ll tank your credit. And a bad credit score can cost you up to $45,000 because of the cost difference in accessing auto loans, home loans, and credit cards. If you prioritize saving above even your minimum payments, you won’t be able to save enough to offset the harm done to your credit score.
Always Keep Cash in an Emergency Fund
Your next priority after clearing your high-interest debt and meeting your minimum payments should be to fill an emergency fund with enough cash to weather job loss. If the current pandemic is any indication, loss of income can occur at any time, as can financial setbacks such as medical bills or car repairs.
Most financial experts recommend saving between three and six months worth of expenses in an emergency fund in order to be prepared for unexpected costs or income cuts. Since the Great Recession, some financial experts have said that may not be enough, recommending closer to a year’s worth of expenses. That may seem unrealistic or even impossible to many low-income households, but families should aim to have a minimum of $2,467 in an emergency fund. A study found that the more you can increase your savings up to that point, the less likely you’ll be to face financial hardship.
You should keep the money somewhere accessible so you can get cash immediately when an emergency strikes. A high-yield savings account may be the best option for most people, since these accounts earn extra money in interest while allowing up to six withdrawals per month.
Calculate Interest Earned Versus Interest Saved
You’ve paid off your high-interest debts, have your monthly minimum payments covered, and have a stocked emergency fund parked somewhere safe. You still have a little extra money in your budget that you can either put towards paying off your debt faster or funding a savings or investment account. Which do you prioritize now? Is it better, for example, to put more money in a retirement account, or make extra payments on your mortgage?
This depends on a number of factors, such as the APR on your remaining debt and the annual return you’d expect from the investment account. Your best bet is to calculate how much interest the money would earn if put in an account such as a 401(k) and compare that to the amount of interest you’d save by paying off the debt all at once.
For example, let’s say you’re 30 and you’ll earn an extra $10,000 this year. If you were to put that money in a 401(k) account that earns about 5 percent interest annually, you’d effectively gain $8,138 in purchasing power by the time you retire at 65, after adjusting for inflation and accounting for taxes. If you used that money to pay off $10,000 in credit card debt all at once instead of making only a 2 percent minimum payment each month with an APR of 18 percent, you’d save $8,622 in interest. But you’ll also need to take into account that $10,000 can be deposited into a 401(k) pre-tax, but you’ll need to pay taxes on the income if you use it for credit card debt.
Using your own situation, calculate the interest earned on the savings versus the interest saved on paying off the debt. The best decision for you will depend on a number of factors, and you may decide that devoting some of the money to debt repayment and some to savings is the best choice.
How to Pay Down Debt and Save
If you want to have money leftover at the end of every month, you’ll need to establish a budget. Start by adding up your monthly bills and tracking your spending in various categories. Then, look for areas where you can cut back on spending. Once you know how much you can safely set aside in a savings account, automate your savings so you’re not tempted to overspend.
You should also come up with a debt repayment strategy. The most efficient and cheapest way to pay off debt is to prioritize your highest interest debts first while keeping up with your minimum payments on all debts. You might also take advantage of a balance transfer credit card offer or get help consolidating your debt with a personal loan.
Most people underestimate how much they actually need to save, both for emergencies and for retirement. Ultimately, the more you can save, the more you’ll be prepared for setbacks, and the more securely you’ll enjoy your old age. If you have a debt repayment plan and are building savings into your budget, you’re doing better than most Americans!