Should You Pay Off Debt Before Building Up Savings?
Like most people, you're probably living from paycheck to paycheck with a big chunk of your salary going to pay off loans. In fact, Cornell University says that the average baby boomer spends half his or her salary paying off debt. But every now and then, our hard work pays off or Fate smiles on us. We get a pay raise, bonus or other windfall. What then? Should the extra money be used to pay off debts or build up savings? (I mean, after the shopping spree.)
I'll assume you have an emergency fund or a credit card that can get you through a crisis. If so, you're probably better off paying down personal loans and credit card loans before adding to a savings account. The interest rate on those types of loans is generally higher than the savings rate. Paying down an 18% credit card loan instead of saving the money at 4% nets you an extra 14% by year-end. Guaranteed. And the savings gained this way is not taxed whereas the 4% interest earned in a savings account would be taxed.
For example, if you add $50 a month to an existing savings account yielding 4%, in twelve months you'll earn $11 in interest (compounded monthly). But if you were in the 38% tax bracket (state and federal combined), your net interest would total $7.
Now, if you used that same $50 a month to increase your payments on a one-year loan of $1,000 at 18%, you'd avoid $35 in interest charges. In this example, paying off the loan would save you $28 more after taxes than adding to a savings account. And, you would pay off the loan four and a half months sooner.
Once the loan is paid off, I'd suggest that you use the money you've freed up to open a savings account. If saving on a regular basis proves difficult, use automatic funds transfer to ensure that part of each paycheck is saved.
Of course, it could be worthwhile to hold onto an existing loan, provided you can get a better return on your newfound money by investing it. There are at least two situations in which this might be true.
Suppose, for example, you have a home mortgage at a relatively low, tax-deductible interest rate. In that case, you might be better off continuing to make the low interest payments while investing your extra money at a higher rate of return.
As another example, let's suppose you participate in a 401(k) plan that matches your contributions at, say, 50 cents on the dollar. In other words, every dollar you invest earns you an immediate 50%. (Congratulations!) In that case, you might want to put your extra money into the 401(k), in order to take advantage of the higher rate of return, while paying off any existing loans on schedule
Always talk to your financial advisor when making any strategic investment decisions.