Paying off debt and saving money can both help you build your nest egg and become financially secure. But choosing which thing to do with your money is not always easy to prioritize.
Here are a few rules of thumb that almost everyone should follow in the beginning.
First, tackle your high-rate debt
Some types of loans lead to so much interest and fees that you could quickly get stuck in a debt trap—which means you’re basically trapped in a cycle of only being able to pay the minimum balances and you’re never actually getting to the actual principal of the loan.
What kinds of loans might that be?
For many people, credit cards can be considered high-interest debt, as the annual percentage rate (APR) is often in the mid-teens or twenties. These rates certainly are high, and if you carry a balance it can make it difficult to pay off credit cards.
However, even a 30% APR can seem cheap compared to some types of debt, such as payday loans (which often have an APR of around 400% to over 500%). Additionally, new types of subprime (a term referring to borrowers who have poor credit) loans are emerging. These include high-rate installment personal loans and lines of credit. Similar to payday loans, they often have APRs of several hundred percent—sometimes over 1,000% APR. In short, before borrowing you’ll always want to read the fine print.
If you are in debt, first focus on paying down:
- Payday loans
- Credit card debt
- High-rate installment loans
- High-rate lines of credit
- High-rate secured loans (such as an auto loan)
If you have a lot of credit card debt—as many Americans do—you may want to first start with the high-rate loans, skip to the next step, and then come back to the credit card debts.
Build a mini emergency fund
Once you’ve eliminated the ultra-high-interest debts, you might want to switch your focus to saving money. Although you may still be paying down other loans, having an emergency fund can offer financial security and help reduce money-related stress.
A full-blown emergency fund is usually defined as enough savings to cover three to six months’ worth of your necessary expenses. But you can start with a mini fund, such as $500 or $1,000, which is more than many people have in their savings. It’s also enough cash to cover common emergencies, such as a spare set of tires, doctor’s appointment, or bills for a week or two if your hours are cut at work or you lose a job.
A credit card might be an option for some emergency expenses, but credit card issuers can also lower your credit limit. It may be better to keep your emergency fund in a high-yield savings account, knowing that you’ll have access to the money when you need it and allowing it to grow over time if you don’t.
Knock out remaining credit card debt
If you built your emergency fund before finishing off your credit card debt, go back to focusing on the credit card debt. You may be able to slowly pay it off by making higher-than-minimum monthly payments. You could even send multiple payments a month, perhaps aligning with your paychecks.
For those with good credit, a debt consolidation loan or balance transfer credit card could be better alternatives. With a debt consolidation loan, you may be able to take out a low-rate loan, and use the funds to pay off your high-rate credit card debt. Just be careful to avoid using your credit cards too often and winding up back in credit card debt.
Balance transfer credit cards offer an introductory 0% APR on transferred balances, sometimes for up to 15 to 21 months (depending on the card and offer). You can then pay down the balance without any interest accruing. You may have to pay a balance transfer fee—often 3%—but the best balance transfer offers don’t have this fee, either.
The gray area—it may come down to personal preference
When your debt has a very low interest rate, you may be able to earn more interest with a certificate of deposit (CD), or another type of low-risk investment. In that scenario, focusing on saving may be best as you’ll earn more than you would spend on accruing interest.
On the other hand, if your debt has an interest rate above 8%, you should probably focus on paying down the debt. Even if you invest the money in the stock market, you might only expect an annual average return of around 8% over a 20- or 30-year period. There could be tax advantages to contributing to certain retirement accounts, but there’s also there’s no guarantee that your money will grow at that rate. Paying off debt is similar to getting a guaranteed return on your money.
The answer is murkier when your debts have an interest rate around 3% to 8%. You might earn more money investing, but paying off debt could lead to peace of mind. That’s why there’s often a back and forth about what’s “good” or “bad” debt and whether you should save or invest.
In the end, while math may drive your decision, it could come down to your personal preferences. If you’re looking for the greatest gain and don’t mind low-rate debts, focus on saving and investing. But if you’re tired of bills, put your extra money toward your loans.
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Louis DeNicola is a freelance personal finance writer and credit enthusiast. You can find him on Twitter @is_lou.
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