The Difficult Choice Between Saving or Pay Off Debt
In this article, we will tackle the eternal question that anyone enjoying a sudden and unexpected influx of cash faces: To spend the money, to save it or to repay some of their debt.
Well, if you’re lucky enough to receive an influx of “extra cash,” (which can come in the form of a salary raise, an unexpected gift, winning a drawing, through freelance earnings or through personal loans) this might be one of the most pressing questions in your mind. Should you just spend it all and act as if nothing had happened? Should you save it for hard times or other unexpected circumstances? Or should you pay as much of your debt as you possibly can?
This “savings vs debt” debate is a common one and many people actually consider this every day. That said, let’s take a better look at all the options in order to determine which of them is the best for you.
So, if you have ever been in this truly favorable position, here you have a five-step guide to help you make the best choice:
1. Do you have a savings account for emergencies already?:
In case you don’t have it, you need to know this: We all need emergency savings accounts regardless of our financial condition. Even if we are struggling to pay our high-interest credit card debt or those personal loans that we might have eagerly taken in the last year, we can’t escape the simple reality that emergencies can happen at any time and without warning. For example, we could have the need for a sudden operation, a plane ticket to get home immediately, or for repairing some essential appliances at home. Nowadays, acquiring a credit card or a personal loan is not only not easy, but it also takes time, which is precisely what we don’t have in during an emergency. It is because of this that an emergency fund is so necessary. If you are in doubt about exactly how much you should set aside for emergencies, the magic number seems to be at least three months’ worth of expenses (or salaries).
And don’t forget about this: Even if money is not abundant, even if you are just out of school or just acquired a personal loan, you should always put a portion of your salary aside for that rainy day that will sooner or later come. For moist of you, this emergency savings account should be the top priority, far more important than paying off any debt or personal loan. However, if you already have an emergency savings account in place and ready to use, then check out the next question.
2. Do you know how much your debt costs you?:
Surprisingly, a lot of people carrying some kind of debt (like a credit card or a personal loan) fail to estimate the real amount of the existing debt they carry. If you are carrying some debt with you, sit down for a few minutes and take the time to do the math. Make a list of your debts, personal loans and whatever else is on your books. Next to each of the amounts you wrote down, write the interest rate you are being charged for it. Once you are done, multiply both numbers. The amount you get is what each of these debts is costing you every year. Here is one simple example. A personal loan of $5,000 at a yearly interest rate of 6 percent costs about $300 a year. Naturally, the more debts and personal loans you have, the bigger your debt will be.
3. How much earnings would you receive for your savings?:
You already know how much you can save if you decided to create a savings account. But what if you would instead choose to invest that extra money you have in something that could give you some returns? If you choose to do so, the most important thing to consider of course would be where to put those extra funds. A bank account that earns you a 1 percent return might not be a bad deal, but there are other opportunities, like a money market fund or a personal loan to a friend you trust. The trick here is to find the best combination of what pays more and what is more safe. As a general rule, if you manage to get a return above 2 percent in a safe and secure way, you have already found your perfect investment, since that is the maximum rate that the market offers without you having to face any significant risk.
Now that you’ve considered this, take a few minutes to compare what you found with what you learned from questions two and three. Now, ask yourself: Would I be better off paying a good chunk of my debt or saving it in an emergency savings account benefits me more financially? Find your own answers using as much information as you possibly can find and use it to make a final decision.
4. How much do you realistically expect to earn in the near future?:
If this extra money that you just received was a one time event might make consider things quite differently than if you expect to receive another influx of cash in the near future, in the form of a gift, a return for an investment or even a freelance check. In the second scenario you will obviously have far more flexibility, since you will have more money to work with, and even more coming in the future perhaps, so you might even be able to not just destine your funds to one thing (like only to save for example), but to two of them or more (like saving and paying your debts for example).
5. Financially speaking, what do you expect to achieve in the short and mid terms?:
If you have plans that are over the normal expense level of other activities, like starting your own restaurant or business, buying a house or apartment or even traveling around the globe, then the wisest thing to do is to just save and increase the amount you have in your emergency savings account. On the other hand, perhaps paying off your debt could also help, since having your credit score clean will help you tremendously when it comes to getting a personal loan to finance your business or trip.
All in all, hold for a while before making your final choice until you at least read and put in practice what you have learned from the five questions above. Write down your numbers, think about the future and consider your current obligations, like personal loans, and you will surely make a decision you will not regret.