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Reduce Debt or Save Money

Source: stck.xchng Photo: jgdsgn

Source: stck.xchng Photo: jgdsgn

One of the age-old battles in the personal finance realm is this: Should I reduce debt or save money? Which is the best path? Build up a ton of savings and then focus on debt reduction? Or should you eliminate debt, and then concentrate on saving money? Both of these are noble and necessary budget goals. Even during good economic times, it is a tough decision to make. During an economic recession, the choice is one that many are agonizing over. The battle is on.

Corner #1: Pay Debt Off

One of the most compelling arguments for paying off debt is the interest. Interest charges on consumer (mainly credit card debt) debt are huge. If you have the household average of $8,100 in credit card debt, and you are paying 19.99% interest, you will pay around $1,600 in interest charges on top of what you pay toward the principal. Different credit cards have different interest rates, of course, and the minimum payments are meant to stretch out your repayment term by years. Which means your interest charges add up even further. And, if you have paid late or gone over the limit, you have those fees added on to your total and you are paying a default rate in excess of 27.99%. And that doesn’t even include other debt you might have. Imagine if you decided to forgo savings for 8-12 months while you really concentrated on debt reduction. Besides, your savings efforts are only going to yield between 2% and 6% (if you’re really lucky), which isn’t much when compared to the interest you are paying to creditors. Eliminating debt, and then focusing on savings, can be really tempting at this point.

Corner #2: Bank It

While the argument for paying off debt first is a good one, it doesn’t account for peace of mind. Financial problems can cause stress, and that stress can start affecting other areas of your life. Whether or not you think it is a good thing, emotion plays a big role in personal finances. This means that if you are emotionally concerned about your finances, things may not be going well. Besides, what happens if you knock down most of your debt and an unexpected emergency comes up. With no savings to draw on, you are forced to pull out the credit cards and charge the car repairs or most of the medical expenses. You have worked so hard, and now you are right back in the debt hole. If you had just muddled through the minimum payments, saving money, before starting to reduce debt, this situation wouldn’t be so bad.

Can’t we all just get along?

It is easy to see both sides of the fight. But maybe it doesn’t have to be an either-or proposition. What if you can do both? The first step is to look at your household budget. Figure up your income and expenses, and look for ways to cut waste. Some studies and experts are of the opinion that between 10% and 15% of the average household’s monthly income is wasted on unnecessary expenses. For a household that earns $4,000 a month, that’s between $400 and $600 that goes to waste. Let’s be extra conservative, and say only 7% of that income, or $280, is going to waste. Make a plan to stop wasting that money and use it in a more constructive manner to improve your personal finance situation.

Next, consider your position. Is your job relatively stable? Do you already have some savings set aside? How much? With any other decision-making partner in your household, figure out a division of savings and debt payment that you are comfortable with. If you have a relatively stable job, and some savings, maybe you could put 15% — $42 — of your (formerly) wasted income toward savings each month. The other 85% could go toward debt reduction. $42 isn’t a lot, but if you are in a reasonably good place (excepting your debt) the important thing is to keep saving money. When you get a windfall or a bonus, divide that “extra” money up according to your plan, and use it for debt/savings.

If you have no savings, and you are concerned about your job, your wasted money should perhaps go mostly to building up a safety net, using higher yield options, such as a rewards checking account, CD ladder, money market investment or even short-term bond funds. And, if you are indecisive about the whole thing, go 50-50 on debt reduction and building up savings. The important thing is to make a plan and stick to it, developing better personal finance habits. Once you have paid off your debt, put the money you were using to make debt payments into savings.

Obviously, you should try to squeeze more than just 7% of your income out for savings and/or debt reduction. If you can find 15% — or even 20% — that would be much better. You will build your savings and pay down your debt faster.

20 Responses to Reduce Debt or Save Money

  1. If I had cc debt of 9% and a savings rate of only 1%, I would go with the debt repayment option first. Once the debt was paid in full, I would then move that same amount of money over to a savings account.

    Scott @ The Passive Dad’s last blog post..Help Jump Start The Economy And Buy A New Car You Can’t Afford

  2. Miki says:

    the debt/savings discussion is very similar to the diet debate. The best diet/budget in the world won’t help unless you do the behavioral changes necessary to sustain the results in the long-term——a concept with which most Americans seem to be unfamiliar.

    Miki’s last blog post..Empathy And Innovation

  3. I agree with Passive Dad, but to a certain extent. I would first set up an emergency fund equaling 6 months of your expenses. Then, I would look to see if you have any “bad debt”, or debt where you are charged greater than a 9% interest rate.

    Great post!

    Happiness Is Better’s last blog post..Book Review: Ready, Fire, Aim – Zero to $100 Million in No Time Flat

  4. James Clark says:

    Many of us have used the credit issue we are facing now to death. Get out of debt and ask your self why all the largest buildings in all our towns are Banks or Insurance Companies. We are giving our money away every day in record amounts , with no equity coming out of it or value coming to us. Lost net worth,last year alone Americans lost a total of 51.4 trillion

  5. Ben says:

    Ideally, the best way is to eliminate the higher interest rates first and then focus on saving. 3 steps forward, 2 step back is not effective when you could be allocating your resources towards long term debt reduction (interest is time’s best friend). But you must keep in mind that you will need to pay your credit cards at the minimum anyway. Snowballing your debt is a good strategy but the absolute best strategy is to simply START. If you don’t do anything then the argument is moot.

    Ben’s last blog post..Recession Rhymes

  6. Glen Craig FFB says:

    This is an argument that can drive a person nuts! At least someone like me who was in a lot of credit card debt. For me it makes sense to get rid of your high interest CC debt. You get an instant return with the interest you are not paying. In a real emergency you can tap the CC again. Once you start paying off debt well you may see yourself getting offers for low interest cards or better yet a 0% interest card. It could be a good idea to transfer your higher interest balance to these cards, pay off more principal, and pour a little more into your savings as you aren’t paying ever-increasing CC% (or at least much lower interest).

    FFB’s last blog post..Is Saving 8 to 12 Months Expenses Even Possible Or Practical?

  7. Miranda Marquit Miranda says:

    I think the hardest thing for many when it comes to putting EVERYTHING toward cc debt is the current economy. What happens if you lose your job and have no savings? You are right back where you started. However, I do think that in many cases, if you have an emergency fund, it can be beneficial to aggressively attack your debt. But, in the end, you have to do what gives you financial peace as well, even if it means taking a little bit longer to pay off your debt.

    I also think Miki makes an excellent point: You have to change your overall habits long term, or it doesn’t matter whether you make a big push for savings or debt repayment. It’s important to break the cycle, getting into habits of saving and getting rid of the bad habits that lead to debt.

    Miranda’s last blog post..Will the Recession End in 2009?

  8. Miki says:

    Thanks, Mirandaa, but in my cynical opinion (IMCO)I really doubt that the don’t-spend/save mindset will last nearly as long as the “experts” are saying.

    Like cashing in an IRA to offset a diminished college fund so their darling boy can start college imediately. Stupid!

    Sheltering kids from what’s going on is the most unfair thing a parent can do!(I’ll be writing about his Thursday at http://www.leadershipturn.com)

    Miki’s last blog post..MAP And Innovation

  9. jeflin says:

    There are good debts and bad debts so if you are hard up on cash, keep the good debt. However, if you have savings and the money is not working for you (as in lying under your mattress), then clear off all debts.

  10. Rick Vaughn says:

    Miranda,

    This is critical question in almost every budget. I would lean towards saving money first. Even if it’s 10 dollars a pay check. The reason being if it’s down to the end of the money and you need gas in the car its better to have $10 cash then pay the interest on $10. Hope that makes sense?

    Rick Vaughn’s last blog post..Understand Credit Repair Properly

  11. Mr. Insurance says:

    Debt, the thing that can destroy a country. I always wondered why countries allow debt in the first place? What do you think?

  12. Franco says:

    Countries like Argentina don’t allow debt, and I believe it really helps their economy. Other countries are not that lucky, mostly Americans are totally relying on debt, not a healthy economy

  13. Kiten says:

    I agree with you too.

  14. Mack jackson says:

    Thanks for sharing such great post, it will surely help many people to get such detailed info. According to me there are some chances of unexpected expenses for which you need some amount of money so for that saving is very much essential.

  15. I would always first cut debt out the way, because while your saving your debt is earning interest, so pretty much pointless. Good post dude.

  16. Coles Myer says:

    I need to save as much money as I can so that when I pay all of my debts I will still have money to spend. Nice job on this post.

  17. Damon Day says:

    Great post Miranda,

    It is a question that is often asked and of course the answer depends entirely on the individual and the situation as you aptly pointed out. I agree with Ben, that the best thing to do is start. Don’t waste time agonizing over it. Even if it is seemingly a very small amount, just start saving some and apply more toward your debt.

    Everyone can always cut out something. It is just a matter of making tough choices and paying yourself first. Maybe you can’t afford 200 cable channels and should cut down to the starter package. I agree that easily 10% to 15% of most family budgets are spent on either outright waste or things that they don’t really need to have. For most families, they are just not realistically making it a priority to save money or pay down debt

  18. Ross says:

    I never had the slightest doubt that getting rid of my home mortgage was a first priority. Paying interest on my home loan was simply a dead waste of valuable income. Once the mortgage was eliminated then REAL saving & investing commenced.

    Here in Australia we do not receive any tax breaks for paying interest on a home mortgage so paying such interest is a waste.

    Thanks for the inforamtive post.

  19. Brent Wilson says:

    It is obvious that paying your debt off is better than saving. Paying off debt means you are saving in a an even more powerful way.

  20. Personally I thinking savings are not rewarded properly. Whereas debt repayment is.

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