A lot of people wrestle with whether to pay off debt or save money first. It’s an important question because how you approach debt and savings can have a big impact on your finances. Recently I asked some readers the following question related to the repay debt or save first issue:
Let’s assume an individual has $10,000 in credit card debt at 14.99% interest and their employer matches 401(k) contributions dollar-for-dollar up to 6% of gross pay. Should this person:
- pay off his or her credit cards first before investing in the 401(k)
- invest at least 6% in the 401(k) immediately to take advantage of the employer contribution
- or take some other approach?
This question comes up in a lot of different ways:
- Do you pay down your mortgage or invest?
- Which debts do you pay first?
- Do you wait to invest until all your non-mortgage debt is paid?
These are important questions, and some answer them with unbending, dogmatic, “I’m right, you’re wrong” type of answer. I don’t think there is only one right answer to these questions. Instead of thinking in terms of black and white, consider these 8 factors in making the right decision for you:
1. The Numbers: The starting point is to look at the hard, cold numbers. With today’s low interest rates on bank accounts, the numbers typically suggest that you pay down your debt (at least non-mortgage debt) first.
2. Zero Percent Options: While credit card debt can come with double-digit interest rates, there are options. When my wife and I were climbing out of debt, we took advantage of several 0% balance transfer credit cards. This allowed us to pay no interest on our debt, which in turn allowed us to save and get out of debt at the same time.
3. Cashflow: Does one option improve or hurt how much cash is available to you? This often comes up in deciding which debt to pay first. For example, by paying down a home equity line of credit, you have the line of credit still available to you in case of an emergency. The same is not true when you pay down a car loan.
Also, it may be worth paying off a low balance, low interest debt to increase your monthly cash flow. This is the Dave Ramsey Debt Snowball approach. While this is a factor to consider, unlike Ramsey, I don’t think it is always the deciding factor.
4. Employer Matching Contributions: If one option is to contribute to a 401(k) in which your employer matches your contribution, this strongly favors saving first. At the very least, consider contributing enough to your 401(k) to get the maximum benefit of the match, and then putting any remaining cash to high interest debts.
5. Your Credit Score: A good credit score can help you get out of debt faster. With a high score, you can take advantage of lower interest rates as part of a refinance or 0% credit cards as mentioned above. Paying down revolving credit is one way to quickly increase your credit score.
6. Flexibility: The choice to pay down debt or save first is a bit misleading. You can do both at the same time. That was the approach we took, and I suspect it’s the approach that most people take.
7. Motivation: Particularly if you have a lot of debt to repay, it can be disheartening to spend years chipping away at it with nothing in the bank. While this factor ignores the numbers, motivation is critical. While some are motivated just by seeing the debt reduced each month, others need a little cash in the bank to feel comfortable.
8. You: It is important to know yourself. Can you pay down debt, never borrow again, and then begin investing? This, too, is the Dave Ramsey approach. The problem is that many pay down the debt, and then borrow more, creating a never-ending cycle of pay debt–borrow–pay debt–borrow. The result is a lifetime of debt with no savings. If that’s you, don’t wait to pay off all your debt before saving. For our Question of the Week, only you can assess this factor.
In the final analysis, it’s important to remember that with high interest debt, the fastest and cheapest approach is to pay down debt first. The other factors listed above, however, may make it wise to alter that approach in specific circumstances.Topics: Personal Finance