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Deciding Whether to Save or Pay Off Debt

March 01, 2021
Deciding whether to save or pay off debt

For many Americans, living in debt had become a way of life. Then the COVID pandemic hit, forcing many people to heap on more debt. A survey by CreditCards.com revealed that 34% of millennial credit card holders claimed to have fallen further into debt as a result of the pandemic. 

Left unmanaged, debt can become overwhelming, taking a toll financially as well as emotionally. It can also wreak havoc on your credit score and restrict your ability to save for your future. With so many negative implications, should paying off your debt become your first priority, taking precedence over creating an emergency savings fund?

It's a question at the forefront of many American's minds these days - to save or pay down debt.

Most financial experts agree that the answer is yes to both things; you should work to pay off  your debt while saving at the same time. The key is to strike a balance that allows you to become debt-free while gaining the peace of mind knowing that you have money for a rainy day.

Start by creating an emergency fund. Although there are many food reasons for tackling your debt first, it's important  to prioritize emergency savings to avoid piling on more debt when the unexpected happens. A general rule is to have at least three-to-six months' worth of expenses saved, but you don't need to start with that amount (although you will eventually want to build to this level at some point in time).

Just having a small amount of savings can go a long way to getting you back on the road to good financial health. This type of financial cushion can also help relieve the mental stress that comes from living paycheck to paycheck.

With your emergency savings safely stocked away, it's time to turn your attention to reducing your debt. How you should attack your debt depends largely on the type of debt you have. If you primarily have student loans, for example, you can investigate options for deferring payments or qualifying for forbearance or loan forgiveness through your loan provider. If your debt primarily consists of credit card debt, however, these options are not available. In this case, debt consolidation may still be a viable alternative via a credit card balance transfer whereby you consolidate all credit card debt onto one low-rate credit card that will save you money on finance charges. 

Some people choose to prioritize their debts by size, paying off the smallest ones first and then eventually chipping away at the largest ones. This provides a psychological advantage by being able to check off more types of debt in a shorter period of time.

A smarter approach, however, is to rank your loans based on interest rates instead of by total dollar amount. By tackling those debts that carry the highest rates, you can save more money by eliminating higher interest rate payments. Types of debt that typically carry higher interest rates include credit cards, payday loans, and rent-to-own payments, among others.

Whichever approach you take, try to make payments beyond the minimum each month to further reduce interest expenses. Once you've paid off your debt, you can then focus on aggressively building your savings.

There are several good reasons to pay off debt as quickly as possible:

  • You can reduce the amount of interest paid over time. This is particularly helpful if you have high-interest credit card debt, as high interest rates continue to fuel the downward spiraling into more debt.
  • It can help improve your credit score.
  • Once your debt is paid, you can focus fully on saving and other financial goals.
  • Getting rid of debt can remove an emotional and/or mental burden.

When deciding whether to pay off tax-deductible debt versus saving, don't worry about losing the tax deduction, since the deduction is typically worth less than the annual interest you would have paid on the loan.

It's important to note, however, that there are exceptions to the value of paying off debt first, and you need to consider your specific situation when prioritizing  your payments. Some of the most common reasons for saving first and paying down debt later include:

  • Debt with a very low interest rate
  • Access to an employer 401(k) match program
  • No emergency savings
  • Lack of retirement savings as you need time for compound interest to start building.

No two individuals have the same financial situation, so there is no single solution that fits everyone's needs the same. You need to figure out your own priorities and then develop a plan and budget that frees up cash to pay down debts while maintaining at least a minimal emergency savings fund.

The information and recommendations contained herein is compiled from sources deemed reliable but is not represented to be accurate or complete. In providing this information, neither Cortland Bank or its affiliates are acting as your agent or is offering you any tax, accounting or legal advice. 

By selecting any external link on www.cortlandbank.com, you will leave the Cortland Bank website and be directed to an unaffiliated third-party website that may offer a different privacy policy or level of security. The third-party is responsible for website content and system availability. Cortland Bank does not offer, endorse, recommend or guarantee any product or service available on that entity's website.
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