Should You Pay Off Debt or Save First?
Weighing Up Interest Rates: Debt vs Savings
One of the first things to look at when you’re deciding between paying off debt or saving is the interest rate of your debts compared to what you could earn from savings. In most cases, the interest on personal loans, credit cards or other unsecured debts is notably higher than any interest you might earn from a standard savings account. For example, while your savings might attract a modest return each year your credit card interest rates can be several times higher.
If you focus on paying down high-interest debts you’ll usually save more money overall than if you left those debts sitting and put spare cash into a savings account. This is especially true for short-term debts like credit cards or payday loans, where interest can add up quickly. Even if you’re making minimum repayments, the interest accumulating on these balances often outpaces any gains from savings interest.
By paying off these expensive debts you stop this costly interest in its tracks and reduce your total repayments in the long run.
Access to Your Money: Savings Versus Debt Repayments
That said, there’s more to the decision than just interest rates. Paying off debt frees you from regular repayments and the stress that can come with owing money, but it also means you no longer have that cash available if an emergency arises. Once your money has gone into a debt repayment you can’t simply draw it back out if you need help with a big bill, urgent repairs or medical expenses.
On the other hand, tucking money away in savings ensures you have funds you can access quickly. The security of having a financial buffer can’t be underestimated. It makes it easier to handle unexpected events and prevents you from turning to costly short-term loans or running up fresh debt.
Considering Your Future Needs: When Savings Come First
Taking the time to think about your future plans and potential financial emergencies is key. If you foresee needing a safety net (for example, if your job situation is uncertain, your car is on its last legs or you have dependents to consider) it can make sense to build up a small emergency fund before attacking your debts in earnest.
Having access to a pot of savings means you won’t need to borrow again if something unavoidable crops up. Typically, aiming for enough to cover one to two months of essential expenses is a good starting point for an emergency fund. Once you have this cushion, turning your attention to paying off high-interest debt can be the smarter move.
Finding a Balanced Approach
Many people find that a blended strategy brings the most benefit. You don’t have to do all of one or the other. For example, you might decide to keep making minimum repayments on your debts while steadily building a modest emergency fund. Once your savings reach a comfortable level you can redirect more of your budget towards debt repayment.
This way, you enjoy the reassurance of having money on hand for emergencies but you’re also working to eliminate debts that may be soaking up a big portion of your income in interest payments. Over time, as your debt reduces, you free up more cash to put towards your savings and investment goals.
Identifying When Debt Repayment Should Take Priority
The type of debt you carry should also influence your decision. If your main debts are high-interest and unsecured, such as credit cards, it’s wise to put extra effort into clearing these as soon as possible. The financial cost of letting these debts linger is usually much larger than any advantage gained from growing a standard savings account.
However, if your debts have lower interest rates (such as a student loan or home loan) there is less urgency in prioritising them above saving, especially if you don’t already have a buffer set aside.
Shaping Your Financial Security
Ultimately, there’s no one-size-fits-all answer to whether you should pay off debt or save first. The best decision is shaped by your personal circumstances: the terms of your debts, your future plans and how much you value having access to funds in a pinch. Start by clearing the most expensive debts or at least meeting their minimum payments while building a small safety net. Once you’re not living paycheque to paycheque, you can focus on becoming debt-free and then watch your savings flourish with peace of mind and confidence.