Have you found yourself with a bit of extra income and are unsure what to do with it? "Should I pay off debt or save, you say?"
Never, perhaps, has managing your finances effectively been more important than during the current coronavirus pandemic.
According to recent consumer surveys:
34% of millennials with at least one credit card say that their credit card debt has increased directly because of the pandemic. (creditcards.com)
23% of U.S. residents say their greatest monetary regret during these times is failing to have enough money saved in an emergency fund. (Bankrate)
As these statistics suggest, both saving enough and paying off debt are critical concerns for American consumers, including northeast Floridians, at the same time as both goals seem harder than ever to achieve.
That's why every extra dollar counts so much when it comes into most households' coffers, and why it's so important to decide carefully the best way to apply that extra money.
With that in mind, congratulations, first and foremost, for both having some disposable money to work in the first place as well as wanting to apply it toward your financial betterment.
The alternative (ie. spending it on a shopping spree) will only leave you as broke and strapped as you were before you got ahold of that extra income and with little else to show for it but, perhaps, some buyer's remorse.
You have two main options of how to apply any disposable money that makes its way into your hands toward your improved financial security:
- Save it
- Use it to pay off debt
Which option you choose is a matter of several factors, not the least being your current financial circumstances and your future financial goals.
By taking the time to figure out the best of these two options for you, specifically, you can greater ensure your success in elevating those circumstances and reaching those goals.
Let's take a look at your options!
Save or Repay Debt? Factors to Consider
When deciding between saving money or paying off debt, there are several factors you should consider.
Both debt and savings involve a component of interest, but in different ways.
Interest on debt is money you pay; interest on savings is money you earn.
Therefore, one question to examine is which interest is higher:
The one you pay on your debt or the one you earn on your savings?
Remember, you're not just comparing the interest rate but the actual interest charges or earnings (as applies) based on the affected balances.
Remember, as well, to consider the power of compounding. That means the interest you pay or earn will be added to your balance due or saved, respectively, thereby increasing the future interest you will either pay or earn on that balance.
In other words, when you accrue interest on your debt, that unpaid interest is added to your balance and starts to accrue interest on itself.
And when you earn interest on savings and you leave that interest in savings, it is added to your balance and earns interest on itself.
With that in mind, consider these examples:
- If your credit card balance is currently $5,000 with an APR of 21.99%, and you make a monthly payment of $100, it will take you approximately 1 and 1/2 years to pay that balance off, and will cost you over $8,650 in interest
- If you also have a disposable income of $150 per month, and you add this to your monthly credit card payments, it will take you only two years and two months to pay off that debt and cost you only $1,285 in interest. This amounts to a savings of approximately $7,365.
- By contrast, if you place that $150 into a savings account that earns interest at a 2% annual rate, your savings after 11 and 1/2 years will be about $23,415, made up of $20,700 in initial contributions (of $150 per month) and about $2,565 in earned interest, or more than 10% of your total savings.
Note: Actual savings interest rates will vary considerably depending on your choice of savings vehicle. This, in fact, can play a significant role in whether or where you save those extra funds.
The two factors to consider when assessing potential savings vehicles are time and risk. The greater the returns you're promised for your money the more time or risk you have to accept.
Some savings vehicles provide a guaranteed return if you keep your money locked up for a set period of time.
Other vehicles allow you to take your money out whenever you want, but the return is less guaranteed and, depending on the particular savings or investment vehicle, you could even lose some or all of your initial savings plus any gains you made with it.
The phenomenon of compounding means that your decision on whether to save extra funds or repay debt with it has implications that extend well into the future, either helping you reduce your debt or grow your savings at an increasingly faster rate.
As such, you need to consider other factors besides interest implications in determining how best to apply those extra funds.
Do you have one or don't you? And if you have one, how long will it sustain you if you lose your income?
An emergency fund is an essential part of any financial plan, and, without one, a single unplanned event (eg. medical procedure, loss of work) could lead to greater financial distress or, even, financial ruin.
Therefore, if you don't have an emergency fund started yet or your current emergency fund isn't large enough to provide you a comfortable cushion (typically 3-6 months), you may seriously want to consider saving at least some of your extra income in an emergency fund, even if your interest calculations would make it seem to be lucrative to apply it to paying down debt instead.
According to financial website NerdWallet, families with $250-$750 in savings have a 30% smaller chance of missing a rent or mortgage payment compared with families having less than that amount in savings.
Some may shy away from the prospect of starting an emergency fund because the recommended size of 3-6 months of expenses seems too overwhelming. But you don't have to save all that at once.
NerdWallet suggests starting out with an emergency fund of $500 and growing it from there. You can set incremental goals along the way, such as saving one month of expenses next.
In most cases, any income you receive is taxable. If you use that money to pay off debt, you will most likely need to declare that money as income and pay income taxes on it.
If, however, you have access to a tax-advantaged account, such as an IRA or a 401(k), you can avoid paying income tax on that money (or the gains you earn by saving it, depending on your choice of savings vehicle) by depositing it into that account.
If your tax-advantaged account is through your employer and includes an employer match on contributions, you can actually increase the amount of the savings, perhaps even double it, automatically by depositing it into that account.
Just remember the withdrawal limits and penalties that apply to tax-advantaged accounts.
If you think you'll need that money in the future, don't save it in such an account, as you could end up paying taxes on it after all, along with penalties, should you withdraw it early.
When to Choose Repaying Debt
If you have what's known as "toxic debt," getting rid of that high-cost debt should be one of your primary objectives.
Examples of toxic debt include:
- Payday loans
- Credit card debt with interest rates above 15%
- Rent-to-own payments
- Car title loans
You may also want to make repaying debt a priority if you anticipate you'll need your credit score in the near future.
If, for example, you're planning to purchase or refinance a home, you know that lenders will be looking up your credit score to check your creditworthiness.
For the best chances of loan approval and the best terms and rates you can get, you'll want the highest credit score possible, and paying down debt is one way to help achieve this.
To get started using disposable funds to pay off debt and do it most effectively, follow these steps:
- Determine your expendable income after bills, food and taxes.
- List your ongoing expenses, including periodic ones, and try to eliminate costs wherever you can.
- Use that number to make a budget that includes paying down debt with your disposable income as part of it.
When to Choose Saving
In some cases, savings may need to be a top priority, while, in other cases, it may just be a good idea, if you can get away with it.
- Emergency Fund - If you don't yet have an emergency fund, or one of a sufficient size to meet your potential needs, you may want to make starting one a priority. The last thing you want is to get into even greater debt because of a sudden emergency.
- Employer-based Retirement Plan Contribution - If your employer offers a match on contributions to your employer-based retirement plan, it may be worth taking advantage of that "free money" for your future. Just make sure to contribute enough to your plan to activate that employer match.
- Build Your Savings - If your current debt is limited to low-cost debt, like student loans, car loans and credit cards with low interest rates, you may be in a position to build your savings.
Keep in mind that waiting until you're debt-free before you start saving for things like retirement may end up costing you in valuable time that your money could be compounding.
The Third Option: A Compromise
Why be forced into a binary decision: pay off debt or save when, instead, you could choose both? Apply some of the funds, perhaps half, to savings and use the remainder to pay down debt.
Alternatively, you could opt to pay some amount more than the minimum monthly payment to your debt, such as a percentage of the amount (like an extra 50%) or a flat amount (such as an extra $50), and apply the rest to your savings.
However you allocate your extra funds, be aware that you can always adjust those allocations.
In fact, as time goes on and your circumstances change, it could be wise to reassess your financial situation, including the status of your debt and savings, to make sure your chosen allocations are the most optimal for your circumstances and goals.
Pay Off Debt or Save? Get Help Making the Right Choice
If you live in Duval County or in the surrounding parts of northeastern Florida and you'd like some guidance on the best ways for you to put your extra money to work for you, speak with one of our friendly and knowledgeable financial experts. You can call us toll-free at 800-342-2352.
If you decide to save your extra money, 121 Financial Credit Union has a wide range of savings options available for you to consider, including:
- Savings accounts
- Money-market accounts
- Certificates of Deposit (CDs)
- Individual Retirement Accounts (IRAs)
If, instead, you'd like to apply that money toward paying down debt, 121 Financial Credit Union can help you strategize the best use of those funds to meet that goal.
Either way, if you are a member, you can always feel free to take advantage of 121 Financial Credit Union's free financial counseling.