October 9, 2020
By Rahul Iyer
It’s an age-old question. Should you save before you pay down debt?
It sounds logical that you should save first, this way you’re prepared for an emergency. But what about your debt? The interest that keeps accumulating can cause financial ruin. What’s the right answer?
Do both. Here’s how.
You need an emergency fund or an account you can lean on when disaster strikes. No one knows when or how it will happen, but we all know life happens.
Without some type of emergency fund, you could find yourself in even deeper waters. Without money to cover the emergency, you have to use your everyday funds. Then what? How do you pay your bills?
Before you know it, you’re swimming in debt and can’t do anything about it. Instead, save $500 - $1,000 in an emergency fund first, then move on to paying off your debt.
Once you have enough to cover a basic emergency, focus on your high-interest debt. Any debt with an interest rate over 15% is high.
Put any extra funds you have toward these debts right away. Pay the balance down as quickly as you can to avoid paying excessive interest charges.
Once you have your debts ‘under control’ you can split your funds between savings and paying off debt.
Once you’ve established your baseline, budget both savings and paying down debt each month. A good plan is the 50/30/20 budget. With this plan, 50% of your income covers your ‘required expenses’, 30% covers your wants or luxuries, and 20% covers your debt and savings.
If you bring home $7,000 a month, that means you should use around $1,400 for savings and debt pay off.
Here’s a way you can use it:
Max out your employer match contribution in your 401K (figure out the monthly amount you should contribute to max it out yearly)
Contribute to your IRA or taxable investment account
Pay down debts (pay more than the minimum payment required)
Put money in your high-yield savings account
You can play with the numbers as you see fit, but make sure you always max out your employer’s match on your 401K, otherwise it’s like giving away free money. How you manage your funds from there depends on your circumstances, goals, and how much money you have.
It’s kind of like the old adage, ‘what came first, the chicken or the egg?’ Saving before paying down debt is right in some circumstances, but not always. If you save too much and leave your debt unpaid, you’ll never realize the same rate of return.
For example, if your credit card has a 19.99% interest rate, you will never match that rate of return no matter where you saved or invested, so you get the best rate of return by paying your debt down. Do this cautiously, ensuring you have enough money saved for that impending emergency and you’ll put yourself in a good position.