In uncertain financial times like these, we all tend to focus more sharply on money matters. This is actually good news, because this new focus can help us educate ourselves and develop healthier financial habits for the future. One question that comes up frequently in analyzing personal finances is, should I pay off debt or save money?
We hear a lot about how Americans don’t save enough for the future, and how important it is to have an emergency fund for a rainy day. But we also hear a lot about the importance of getting out from under crushing credit card debt. So it’s only natural to wonder which is more important.
At first glance, you might think the answer is always “pay off debt first.” But there are a few things that you should consider before taking this advice.
1. Know Thy Enemy. Sometimes consumers do the wrong thing, for the right reasons. For example, given all the hair-raising news about eroding home equity and foreclosures, many consumers are pumping extra cash into paying off their home mortgage, rather than directing that money towards other more potentially dangerous debt like credit cards.
It is unwise to pay down your relatively low-interest, tax-deductible home mortgage, student loans, or business loans if you carry other more volatile forms of debt.
2. Break the Piggy Bank. As painful as it sounds, many times cashing in your low-interest savings account to pay off a high-interest credit card is the right choice.
Interest accruing in most savings accounts can’t keep pace with the interest accruing on a credit card account, so it is generally a wise move to raid the savings account to help get out of debt.
3. Divide and Conquer. When analyzing debt, carefully consider what motivates you the most towards repayment. Does paying interest drive you nuts? Perhaps paying off your highest interest rate card first make sense. Do you need some quick wins? Maybe you should pay off a couple low-balance cards early in your plan. However you decide to do it, figure out a way to single out one debt and make it your top priority.
Pay the minimums on your other cards until you slay the beast with the highest interest level, the highest emotional involvement (a personal loan to in-laws, for example), or the lowest balance (following the debt snowball method). Then move to the next worst offending debt and so on.
4. Know Thyself. There are two schools of thought regarding saving vs. paying off debt. One school of thought is that you should pay off the debt entirely before beginning a savings regimen. This works well until the bottom of your hot water heater gives way unexpectedly and you wind up with a hefty cleanup charge, which might lead to a credit card tailspin.
If you are the type of person who can stick with a payment plan, regardless of occasional setbacks, you should pay of your credit card debt first. If you are more likely to be derailed and disheartened by an unexpected expense, it might be wiser to focus on creating a rainy day fun, while committing to a cash-only plan for new purchases.
Once a small nest egg is built, then the attack on debt can be renewed with more confidence.
5. Hands off the Cookie Jar. In the rush to get out of debt, some people consider tapping into or liquidating their 401(k) or IRA funds. This is a poor personal finance move, since not only will you be gouged by Uncle Sam upon withdrawing the funds prematurely, you will also be losing the long-term impact of those funds on your overall financial well-being.
Some folks might stop short of cashing in their retirement funds, but instead decide to take a loan out against their 401(k). This can be a viable option for a disciplined borrower, but beware that failure to payback the loan from your 401(k) in a timely manner can result in weighty tax consequences and stiff penalties. Also keep in mind if you are laid off, or you decide to switch jobs, the loan may be due in full immediately.
For those tackling debt, how have you decided to go about it? Save first, pay off debt, or a little of both?