For many households, it’s a personal fiance dilemma: Should they try to pay down debt first, or build up savings? In the aftermath of the Great Recession, opinions have clearly tipped toward the ditch-your-debt side.
According to the August poll by the National Foundation for Credit Counseling, Americans are choosing to deal with what they owe: 89% of those surveyed said they value paying down debt over saving money; just 11% chose saving first.
America has a new aversion to debt, and with a national revolving debt tab of $798 billion as of June, and household debt averaging around $11,000, who can blame us? According to the NFCC, new purchases are more likely to be paid for with debit cards than credit.
A Question of Opportunity Cost
At face value, paying down debt sounds like it’s always a good thing, but if it comes at the expense of saving, it’s a bit more complicated.
“It is a good idea to pay down debt over savings if you have already started a savings account,” says Harrine Freeman, author of How to Get Out of Debt: Get an “A” Credit Rating for Free.
Making your debt demon the top priority also makes sense if you are someone who loses sleep over debt, if you’re trying to reshape your debt ratios and credit scores, or if you will benefit more from better cash flow later than today, says Rich Arzaga, founder of Cornerstone Wealth Management.
Then too, the value of paying down debt is directly proportional to the interest charged, says certified financial planner Michael Kresh.
Credit card debt, which can often exceed 20% interest, should always be a priority to pay down, he says. But all questions regarding how you allocate your money should be looked at through the lens of opportunity cost.
For example, is the interest you’re paying on money you owe greater or less than the return on an alternative investment you could make with the funds?
If you have credit card debt at 14%, paying it off is like earning 14% on those funds — a better profit than you are likely to make leaving the money elsewhere. And if the money you’d use is sitting in a low-interest bank account, you net much more by paying off that plastic. On the other hand, if you can refinance your mortgage to 3.5% – 4% (the lowest rates in our lifetimes), keeping a low-interest loan active while putting money into other investments can garner you a net profit, says Kresh.
Paying down debt also might not be the best move if you’re likely squander the cash surplus once the debt is paid; if you’re getting the benefit of an interest write-off to help offset your income taxes; or if you have the ability to manage debt in the short term or long term, says Arzaga.
Advocating for Saving
Not everyone agrees on the question of putting debt first.
To pay off debt before you have an emergency fund in place makes no sense, says Kevin Lynch, an assistant professor at The American College. Getting a cash cushion in place should be the first order of business, he feels.
Generally, people should be saving 10% of their income, says Thomas Fox, community outreach director at Cambridge Credit Counseling. “Although with the recession people began to save again, and it’s now around 5% of income, in countries like Japan, the savings rate is 25%, and it’s 50% in China.”
In this uncertain economy, you should be looking to have money to cover at least 10 months of expenses where you can readily put your hands on it, says Fox.
If you do choose to focus on debt, don’t get too relaxed once it’s paid off. Instead, reallocate the amount you had been spending each month on freeing yourself from debt toward another major financial goal, such as retirement, education, buying a new car, or whatever tops your list.
In the best of worlds, we would split the difference: “Pay down debt and contribute to a savings account at the same time,” says Freeman. “That way you will have an emergency fund and pay down debt which increases your credit score, reduces credit card usage and improves your financial life.”
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