Debt vs. savings: Who gets paid first?
Dear Opening Credits,
I've heard that you should always pay your debts down before saving anything. Is that true? For example, if you have a bunch of student loans, should you pay those off before starting a savings account? -- Jane
Sure, from a basic math standpoint, it would make sense to pay off all debt before beginning a savings plan. After all, lenders add finance fees to an amount owed, so you're losing money when you hang on to balances. That's especially true considering how low interest rates are on savings and how high they can be on loans.
Having said that, however, you should still be putting cash aside for emergencies and enjoyment as you're paying off those obligations.
Everyone, as unique as we are, has to develop their own personal finance strategy that works best for our specific needs and lifestyle.
With that in mind, here are some generalities about how to efficiently move from the operating in the red to black. However, consider these to be guidelines, not gospel:
- Have at least three months' worth of essential expenses in savings -- no matter how much you owe. Cash in hand (or in the bank, rather) is self-guaranteed protection. If you were to lose your job, it might take a while to secure another. During that time, you'll still need to pay for rent, food, gas and other necessities. You don't want to move back in with your parents or couch-surf with friends, do you? Three months is a decent base, but add an additional month for each person relying on you for support or if the employment market in your area or field is particularly tough.
- Save at least 10 percent of your monthly net income. The simpler and more habitual you make savings, the better. That's why I like this rule. Just take 10 percent off the top of your paycheck and deposit it into a savings account. So if you bring home $3,300 a month, immediately tuck away $330. In a year you'll have $3,960. Many employers can do this automatically for you through a 401(k) contribution or via a separate direct deposit into another bank account.
- Delete the most expensive debt first. Not all balances are created equal. Some are far more costly than others and need to be eliminated as quickly as possible. When calculating which creditor should get the bulk of your money, rank them by interest rate. Send more to the account charging the highest rate, and the minimum to the rest. Once your most expensive debt is paid off, move on to the next most-expensive debt and so on. When creating your list, mind that the interest you pay on federal student loans (and mortgages, too, by the way) is typically tax deductible, which means a break on your income taxes. Therefore, they usually go at the bottom.
- After you've blasted the balances, pump up savings. Once you are debt-free, reroute all the money you've been handing to your lenders to yourself. Augment your crisis fund (so it reaches at least the three-month mark, preferably more), increase your retirement contributions and save for other goals and activities.
- Prepare your credit so you can borrow to earn cash and stuff. Don't add to your debt while reducing it, but still use your credit cards wisely (meaning continuing to charge things you'd normally pay for every month, such as gas, and pay that off immediately so no interest is accrued). It's important to build your credit rating so you can qualify for premium plastic later. One good way to increase a credit score is to consistently borrow and repay with a credit card. Once your score is high enough, you may want to apply for a credit card that allows you to build points for cash, services and products. Use it, but pay the balances off before the due date. Then you'll always earn and never owe.
These are the basic principles of how to best approach debt and savings. Now tweak them to suit your personality and lifestyle. The idea is to enjoy yourself while also making smart decisions. As the late, great Katharine Hepburn once said, "If you obey all the rules, you miss all the fun." I couldn't agree more.
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Published: March 20, 2013
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