Saving Money vs. Paying Off Debt: Which One Should Come First?

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RgStudio/iStock via Getty Images / RgStudio/iStock via Getty Images

The average millennial carries more college debt than any previous generation, but debt and other financial problems are not limited to millennials alone. According to a recent survey, 40 percent of Americans don’t have the means to pay an unexpected $400 bill.

If you’ve tried the typical belt-tightening advice, like skipping Starbucks or going out to eat less, then read on to find out how to balance your debt with your savings and start living a more comfortable life.

Getting Out From Under Debt

Many people are forced to begin their financial journeys already saddled with a large amount of debt from student loans: About 54 percent of students need to borrow in order to cover educational costs. But with some careful financial planning, you can pay off your debt and increase your savings.

There are several financial approaches that people use, including debt consolidation, freelancing to make extra income on the side, and even investing. Choosing the right approach depends on your income, goals, and the amount you would like to save or pay off.

When to Prioritize Savings

One of the main reasons that people should prioritize increasing their savings is when they don’t have an adequate emergency fund to float them when disaster strikes. Some emergencies that could lead to even more debt include car repairs, emergency medical treatment, or unexpected job loss. Experts recommend having funds to pay at least three to six months’ worth of expenses saved up, just in case.

Another reason for choosing savings over paying off debt is having a low interest rate on your loans. Take a look at how much interest you are accruing on your loans annually. If you have loans with interest rates in the single digits, it may be a good idea to prioritize building up your savings. The idea here is that your loan amount won’t change all that much with a lower interest rate, meaning that taking some time to build up your savings also won’t have too much of an effect on your credit score.

A comfortable future retirement is another major reason. If you haven’t started saving for that scenario yet, it is crucial that you start putting a little something back each month, whether into a 401(k) or an individual retirement account (IRA). The sooner you start saving for retirement, the more returns you will see in the long run. Investing may not seem like it’s in your best interest if you have nothing saved or if you have a large amount of debt to pay off. But if your company offers 401(k) matching benefits, you’re missing out on free money if you aren’t taking advantage of these programs.

When to Prioritize Paying Off Debt

Paying off debt makes sense if the interest rates on your loans are high. In the U.S., overall personal debt is approaching $14 trillion in total. If your interest rates on money that you owe are in the double digits, you might want to prioritize paying off your debt. With a high interest rate, you could end up paying a lot more over a longer period of time if you don’t make regular substantial payments.

And, paying off a loan in full will always be in your best interest even if your interest rate is low but your minimum required payment is still high. By paying off this kind of loan, you will free up a significant amount of income to go towards saving and investing, and more than you might be able to if you were trying to pay off a loan and save at the same time.

A big benefit to paying off loans early can be an immediate positive impact on your credit score. If your score is something that is holding you back, paying off loans can boost your score so you can make other moves toward building your credit, such as paying down credit card debt or ensuring each bill is paid on time. Even simply paying down loans or credit card debt can have a positive effect on your score. Take note, though: There can be penalties on some loan types for paying them off early, so make sure that you read the fine print.

Mastering the Art of Balancing Savings and Debt

If you haven’t yet figured out how to make money while you sleep, then the art of balancing your debt and savings is an important lesson to learn. Even the thriftiest of spenders will encounter some financial woes at one point or another. It’s wise to have some money saved in case of emergencies, so you can avoid going deeper into debt and have more peace of mind. The key is to discover what your priorities and goals are, so you can build a financial plan using these tips, and go from there.