Should You Pay Off Debt or Save Money First? A Comprehensive Guide

When it comes to managing your finances, one of the most common dilemmas is whether to pay off debt or save money first. Both are crucial for financial stability, but the right choice depends on your unique circumstances. In this blog, we’ll explore the scenarios where paying off debt should take precedence and when saving money might be the better option. We’ll also provide actionable strategies for both paying off debt and saving money. If you need personalized mortgage advice, don’t hesitate to call O1ne Mortgage at 213-732-3074.

When You Should Pay Off Debt Before Saving Money

In certain situations, paying off debt should be your top priority. Here are some scenarios where this approach makes the most sense:

You Have Payday Loans

Payday loans often come with exorbitant finance charges, with annual percentage rates (APRs) reaching triple digits. Eliminating these loans should be your primary focus to achieve financial security. These loans typically need to be paid off within two weeks or by your next paycheck. Consider earning extra income or cutting back on expenses to pay these off as quickly as possible.

You Have High-Interest Credit Card Debt

The average credit card interest rate was 20.09% in February 2023, a significant increase from 14.56% in the first quarter of 2022, according to the Federal Reserve. Reducing credit card debt should be a top priority due to the substantial interest savings you can achieve by paying it off.

Debt is Severely Impacting Your Happiness

For some, carrying debt is a minor inconvenience, but for others, it can be a significant emotional burden. If debt is affecting your mental well-being, prioritizing debt payoff—after establishing an emergency fund—can be a worthwhile approach.

Pros and Cons of Paying Off Debt First

Paying off debt first has its advantages and disadvantages:

Pros

• Interest Savings: Paying off debt can save you a considerable amount in interest. Use a debt payoff calculator to see how much you could save.
• Lower Credit Utilization: Paying off credit card debt can improve your credit score by lowering your credit utilization rate. Experts recommend keeping your utilization rate below 30%, with 10% being ideal.

Cons

• Potential for More Debt: Without sufficient savings, unexpected expenses could force you to rely on credit cards, increasing your debt load.
• Missing Out on Investment Growth: Paying off debt before saving for retirement means you miss out on compound returns. Ideally, you should balance debt repayment with saving for retirement.

When You Should Save Money Before Paying Off Debt

In some cases, saving money should take precedence over paying off debt. Here are a few scenarios where this approach makes sense:

You Have No or Very Little Cash Saved

An emergency fund is essential to protect you from taking on more debt. Aim to save three to six months’ worth of basic expenses. This will provide a safety net for rent, groceries, utility bills, and minimum debt payments if you lose your job unexpectedly.

You Only Have Low-Interest Debt

If your debt consists of low-interest loans, such as federal student loans or a mortgage, you can focus on saving. These types of debt have relatively low interest rates, allowing you to safely pay the minimum while saving any extra cash.

Pros and Cons of Saving Money First

Saving money before tackling debt has its own set of benefits and drawbacks:

Pros

• Forward Momentum Toward Other Goals: Saving for retirement or a down payment on a house can provide a sense of accomplishment, even if you have other debts.
• Security in Case of Financial Setbacks: Having an emergency fund can provide peace of mind during unexpected crises, such as a family emergency requiring travel.

Cons

• Little Additional Progress on Your Debt: Saving first means you might not become debt-free as quickly, and you miss out on interest savings.
• Continued Impact on Your Credit Score: Paying only the minimum on your credit card debt keeps the balance high relative to your credit limit, which can negatively impact your credit score.

How to Pay Off Debt

Paying off debt requires more than just making minimum payments. Here are some strategies to help you accelerate your debt repayment:

Debt Payoff Strategies

Here are some effective ways to pay off your debt faster:

Review Your Budget

Analyze your bank or credit card statements to identify patterns in your spending. Adjust your spending to free up more money for debt payment.

Cut Nonessential Expenses

Identify nonessential expenses and make one change to start. For example, downsizing your cellphone plan could save you $50 monthly, which you can then allocate toward your debt.

Use the Debt Snowball Method

This method involves paying off the smallest balance first, then using the money you used to pay off that debt to tackle the next balance. While it may not lead to the greatest interest savings, it can provide motivation to continue reducing your debt.

Or Use the Debt Avalanche Method

This method prioritizes paying off the highest-interest debt first. Although it may take longer if the balance is large, you’ll save more in the long run by eliminating high-interest debts first.

Debt Consolidation Options

Debt consolidation can simplify your debt repayment and potentially reduce your interest rate. Here are some options:

Balance Transfer Credit Card

If you’re eligible, a balance transfer credit card with a 0% interest promotional period can help you pay down your debt without accruing additional interest. Ensure you pay off the debt within the promotional period to avoid interest charges.

Debt Consolidation Loan

If you qualify, a debt consolidation loan can bundle multiple types of debt into one account with a lower interest rate. This option is ideal if you have various debts, not just credit cards.

How to Save Money

If you decide to save money first or alongside debt repayment, start with an emergency fund in a high-yield savings account. These accounts, typically available at online-only financial institutions, offer higher interest rates, making them ideal for savings you don’t plan to draw on often.

Your next savings goal should be retirement. If your employer offers a retirement plan with a match, take advantage of it. Save at least enough to capture the full match offered.

Beyond retirement, consider investing for short-term goals in a brokerage account, saving for a home down payment, or setting up specific savings accounts for vacations or a child’s college education. Identify your most important goals and set up automated transfers to each account. Some employers offer direct deposit splits, allowing you to send money directly from your paycheck into multiple accounts.

The Bottom Line

Both saving money and paying off debt are essential for financial stability. However, with limited funds, you may need to prioritize one over the other initially. Regardless of your choice, keep an eye on your credit with credit monitoring. You’ll receive alerts when something changes, allowing you to take action quickly to protect your credit score.

If you need personalized mortgage advice or assistance, call O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your financial journey and achieve your goals.