Getting Out Of Debt
Should You Save, Invest, or Pay Off Debt?
If you're one of the millions of Americans struggling with debt, you may be facing a constant battle of wondering what to do with your money. Should paying off debt be your priority, or is it just as important to bulk up your savings or try your luck with investing?
Truthfully, all three are important, but that's likely not the answer you're looking for. How you should prioritize your money depends on your personal financial circumstances, and each option also has its own unique advantages.
Here’s how to help determine if you should save, pay off debt, or invest to better ensure your money is well-spent.
Benefits of paying off debt first
No one likes having debt hanging over their head. It's frustrating having to commit a percentage of your hard-earned monthly income to credit card or loan payments.
Alleviating this financial and mental stress is one major benefit of paying off debt first. Other benefits of prioritizing debt elimination include:
Less money spent on interest
More money for basic living expenses
Extra money for savings or investing
Boost in credit score
That last one is particularly important, especially if you want to buy a home or finance a vehicle someday. A better credit score means lower interest rates, which equals less debt you'll accrue when taking out a loan. Check out Varo Believe Card if you need some help building your credit score.1
Eliminating debt can certainly improve your overall financial and mental well-being, but that doesn't necessarily mean you should spend all your money on it.
Should you pay off debt or save money?
Let's get into the pressing question of whether it's better to pay off debt or save your money. It may be tempting to play the game of "let's see how quickly I can wipe out my debt," but this may not always be in your best interests. Especially if it leaves you with a big old zero in your savings account.
If you wait until your debt is gone before putting money away, frankly, increasing the balance in that savings account may never happen. Depending on how much debt and interest you've accrued, it could take years to pay off. You most likely want to retire someday, and one way to really do that is by saving money.
Benefits of building your savings
Sometimes, unexpected events occur, such as losing a job, having a large medical expense, or needing a major vehicle repair. These situations can take a toll on your bank account, especially if you don’t have an emergency fund ready to go. If you don't have an emergency fund yet and want to make the most of your savings, explore a high-yield Varo Savings Accounts with no hidden fees or minimum required balance.2
Even a small emergency fund can offer some financial security during a crisis. Research shows that having between $250 and $750 can reduce your risk of being evicted or missing a bill payment.
Of course, the more money you save, the more financially secure you can be. Depending on your monthly expenses, it may be worth contributing a portion of each paycheck to your emergency fund. Even if you can only set aside a small amount at a time, it'll add up eventually.
How to choose between paying off debt or saving money
While everyone's situation is different, there are a few common factors to consider if you're torn between eliminating debt and building an impressive savings account balance.
Type of debt
If you're carrying any toxic debt, such as high-interest credit cards, car title loans, or payday loans, it can be a good idea to try to eliminate them immediately, or at least as quickly as possible.
High-interest rates can do some serious damage to your budget and create an endless hole of debt that feels nearly impossible to climb out of. You may want to contribute as much money as you realistically can toward these balances until they're gone or at manageable amounts.
Low-interest debts, including auto, mortgage, or federal student loans, aren't as damaging and can be paid as normal. As long as you're meeting the minimum monthly payment, there’s no need to stress too much over them. This debt may still be annoying, but it's not out to get you.
If you don't have toxic debt and all your regular payments are made, feel free to throw a few extra bucks towards your emergency fund.
Current emergency fund balance
If your emergency fund balance is currently zero, that could be a problem. Even if saving money isn't your top priority, it’s always helpful to have some funds set aside for emergencies and your own peace of mind.
One way to determine how much money to keep in your emergency fund is to figure out the sum of all your monthly expenses. Try accumulating as many months of living expenses as you can. This way, if something happens with your job, you'll have a cushion to fall back on until you find employment again.
If you're actively employed but still find yourself digging into savings for bills, you may want to revisit your budget or cut back on your savings contributions. Your emergency fund isn't meant for regular expenses or everyday purchases.
Having a steady, secure job with above-average pay can provide more financial freedom and may render the "should I pay off debt or save money" question irrelevant. If you're in that situation, give yourself a pat on the back and enjoy.
Unfortunately, that isn't the reality for everyone. If you don't feel secure in your job, you may want to prioritize your emergency fund. Aggressively paying down debt without saving any money can lead to a dangerous cycle.
For instance, say you put all your extra money toward your debt until it's gone. Congratulations! That's no small feat. However, if you lose your job, it won't matter that you're debt-free if you have no emergency fund to cover your expenses while unemployed. You may end up turning to credit cards or loans and build all that debt back anyway, sending you back to square one.
Now, this doesn't mean your entire paycheck has to go toward savings. Contribute just enough to make you feel safe for a few months so you aren't scrambling if you lose your job.
Should you pay off debt or invest your money?
Let's dive into our next question of, "should I invest or pay off debt?" At the risk of sounding repetitive, both are preferred but not always realistic.
Investing early in life means you likely won't have to work forever and can reap the benefits of retirement someday. Sound ideal?
It sure does, but not if investing means you'll get stuck paying high-interest debt for years to come. However, striking a balance between these two financial goals can help you make the most of your money.
Benefits of investing
Investing when you're young can provide one of the greatest benefits: time. The earlier you start investing, the more time you have to bulk up your retirement funds.
For example, let's say you open a Roth IRA at 25 and contribute an annual investment of $6,000. With an annual return of 7.00%, you'll earn about $1.28 million by the time you're 65 thanks to compounding interest.
Compounding interest refers to interest earned on your interest. When you invest money and earn interest, that amount gets added to your original investment to increase what you've earned over time. This can help your money grow without any effort on your part.
Another perk of investing first is the tax benefits that come with certain debt. For instance, interest on student loans and mortgages is tax-deductible. These deductions can reduce your annual taxable income, which can mean the IRS will take less money from you.
That doesn't mean you should never pay off these loans. But it may not be the worst idea to invest your extra money over paying off debt.
How to choose between paying off debt or investing
There really isn't a right answer, and both paying off debt and investing are good financial goals. But if you're really indecisive about where to put your money, considering the following factors may provide some guidance.
Time until retirement
Carrying debt into retirement isn't ideal and should be avoided. Not only is it an expense you don't want to worry about when you're supposed to be kicking back and relaxing, it can actually have financial consequences.
For example, old federal student loan debt can result in your Social Security income being reduced or taken. If you want to travel the world during retirement, lingering loan payments from past debt may throw a wrench in those plans.
Getting debt under control while you're young can benefit you later on, but don't abandon investing altogether. Instead, contribute what you can while still making your debt payments.
Paying off high-interest credit card debt should always be your main focus. This debt can drag you down and may cause you to lose money.
If you invest while carrying credit card debt, you may end up paying a higher amount in interest than you're earning through your investments. This can mean you're losing money, and when it comes to planning for a future of financial freedom in retirement, that's the last thing you want to do.
In this case, aggressively paying down debt may work in your favor. The faster you cut it loose, the sooner you can start investing and earning compounding interest. This is the interest that puts more money in your pocket instead of taking it away.
Amount of debt
Having too much debt can negatively affect your credit score and result in higher interest rates for future loans. The amount of debt you owe compared to your total available credit is your credit utilization ratio. A high ratio can lower your overall credit score.
If you have a high ratio and are only making the minimum monthly payments, you may want to reevaluate your budget. Paying down that debt is crucial if you plan to take out a car or mortgage loan someday.
Having a high interest rate can raise your monthly expenses and cause you to pay more money than you need to. This is bad news if you want extra money to invest. If you put a bit more money toward your debt and invest a little less until that debt feels more manageable, you may be thankful in the future.
Create a budget
The word "budget" gets thrown around a lot and for good reason. Having a solid monthly budget can provide clear insight into how you're using your money and ensure you aren't overspending or wasting it. The 50/30/20 method can help.
With this method, 50% of your paycheck should be spent on needs, including housing, bills, and groceries, while 30% can be dedicated to wants, such as eating out or splurging on concert tickets. What the last 20% goes to is up to you.
This is the portion of your paycheck to use for saving, investing, or paying down debt. Pick one to prioritize, or split the 20% between all three. There really is no wrong decision as long as you feel good about it.
You don't have to decide whether you want to use your extra money to save, invest, or pay off debt right this second. If you can swing it, try contributing a little to all three. If you can't, you may want to consider focusing on paying down high-interest debt, building an emergency fund for financial security, or investing to someday achieve your dream retirement.
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