Debt vs. savings: Who gets paid first?
Erica Sandberg is a prominent personal finance authority and author of "Expecting Money: The Essential Financial Plan for New and Growing Families." She writes "Opening Credits," a weekly reader Q&A column about issues for people who are new to credit, for CreditCards.com.
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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?
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:
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.
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.
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.
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
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.
See related: Is it possible to pay off debt too quickly?, Need to pay off debt fast? Prepare to make sacrifices
Erica Sandberg is a nationally renowned personal finance authority. She’s host of several financial web shows, and a frequent guest for media outlets such as Fox, Forbes, Nightly Business Report and NPR. Erica previously was affiliated with Consumer Credit Counseling Service and was KRON-TV’s on-air credit expert. Her book, "Expecting Money: The Essential Financial Plan for New and Growing Families," was published in 2008 by Kaplan Press.
Send your question to Erica.
Published: March 20, 2013