Should I Build Up Savings or Pay Down Debt?

by Sophia Bera on July 16, 2014

If you’re like most Millennials, you have a lot on your plate. And you’re trying to do it all, too!

It’s wonderful that you’re so driven, but trying to juggle many financial priorities at once can quickly become complicated. After all, most of us only have so much cash to go around each month. When we’re working toward more than one financial goal, how do we know what to put at the top of the list as most important?

The answer to question of financial priorities gets more unclear when you have “build up savings” and “pay down debt” as items on the list. Most personal financial advice focuses on stressing one or the other, but doesn’t necessarily explain how to decide your course of action if both are goals you want to accomplish.

Take Stock of Your Savings

How much savings you actually have plays a big role in this decision. There is a big debate among financial gurus in terms of how much you should save before you pay down debt. Some feel you should have at least $1,000 (Dave Ramsey’s baby step 1), others feel like you need 8 months of savings (Suze Orman). My answer is somewhere in between.

I feel it’s extremely important to be able to have at least one month of your income in savings, before you aggressively begin paying down debt. For example, if your net pay is $1,500 a paycheck and you get paid twice a month, then save at least $3,000 before you start an aggressive debt repayment plan. This is the rule of thumb I use. Eventually, the goal is to build up 3 months of emergency savings after you’ve paid off your high interest debt.

If you only have a few hundred dollars in savings, keep paying the minimum on your debt until you can get some savings set aside. Otherwise, you’ll be using a credit card for emergencies and that’s a hard habit to break.

How to Determine If You Should Build Up Savings or Pay Down Debt

The first thing you have to determine is the amount of stress that the debt is causing you and include that as part of your decision. For some people, any debt is stressful no matter what the interest rate and they have to get rid of it as fast as possible. Others are more comfortable carrying some debt as long as it’s manageable. Everyone is different, so know yourself.

The other important piece of this equation is: the interest rate on your debt.

Look at the interest rate attached to your loans, credit cards, or other forms of debt you have. Here’s the rule of thumb that I tend to use with my clients: if your rates are higher than 5%, we need to create an action plan to eliminate that debt.

Each day that you hold onto balances on your loans or credit cards, that high interest rate is eating away at the cash you’re working so hard to make. Eliminating debts with more than 5% interest is a priority because once they’re gone, you not only free up whatever amount of money you had tied into monthly repayments, but you also stop paying the high cost to borrow money each month.

What To Do with Low Interest Rate Debts

When I say “low interest rate,” it’s relatively speaking. All debt costs you money, thanks to the interest rate attached to it — but if the interest rate is lower than 5%,  the hope is that over the long term you’ll earn enough of a rate of return higher than that.

That’s why if you have debt with interest rates under 5%, consider making contributions to your 401(k) or Roth IRA a financial priority. Contribute at least enough to earn your company match on your 401(k) and then aim to max out your Roth IRA (that’s $5,500 for 2014 — or a little more than $450 per month). Your 20s and 30s are prime savings years, and missing out on the opportunity to put money away now can cost you later.

That’s because of the crazy power of compound interest. Because compound interest increases exponentially, your savings could be worth more in the future if you start saving now than it would be had you waited — even if you contributed more later than what you can contribute right now.

Do What You Can with What You Have!

It’s so important to just start saving with whatever you can. If you can’t max out your Roth IRA right now, don’t stress. But make it a financial goal to strive for in the future.

Of course, your debt is still important. So be sure to make your monthly payments on that, and preferably payments that are above the monthly minimum. Even if you can only pay $100 extra a month on your debt, do it! Every little bit will help you get out of debt faster. Debts with an interest rate of under 5% are more manageable, but at the end of the day debt is debt and it’s costing you some cash.

Debt can be extremely stressful, so if your debt is causing you stress, then you may want to pick up a “side hustle” to try to earn more money to pay it off faster.  Think about how much an extra $500 or $1,000 a month could help speed up your savings and debt repayment.

When you manage to pay down debt, be sure to celebrate your victory! It’s hard work and you should be proud of what you accomplished. But don’t forget, there’s still a lot to achieve. From here, continue to build your savings — and your overall wealth.

If you’re already doing an awesome job paying down debt, building up savings, and starting to invest for retirement, then it might be time to take the next step and start interviewing financial planners to help maximize your financial situation and take you to the next level.

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