If you have outstanding debts and find yourself with disposable income, you might be conflicted about whether to save that amount or allocate it towards paying of your debt. Giving careful consideration to the pros and cons of both options can help you to make a practical decision. The following are some factors that you can include in your decision making process.

See: 5 Ways To Make Budgeting Fun

Interest Cost Vs. Interest Earned
One of the most common decision swaying factors is the cost of the debt versus the interest that could be earned on the amount saved. In this case, the objective is to determine the net financial results of the reduced interest on the debt versus the savings plus interest.

For instance, assume that you have a credit card balance of $6,500 with an annual percentage rate (APR) of 19.5%, and you make the minimum monthly payment of $130. It would take you about nine years to pay off the balance and will cost you about $7,000 in interest. Assume, too, that you have disposable income of $250 per month. If you add this amount to your credit card payments, it would reduce your pay off period to about 21 months and cost you about $1,100 in interest. This results in a saving of about $5,800.

On the other hand, if you add the $250 to a savings account, the interest you receive would be determined by the type of asset in which the amount is invested. Assuming a conservative rate of 2%, your total savings after nine years would be about $29,580. Taking these figures into consideration, your options include: making the minimum monthly payment on the credit card and adding your disposable income to a savings account, adding your disposable income to your credit card payments and start saving after the credit card has been paid off or splitting your disposable income between the credit card and your savings. (For more, read How To Manage And Consolidate Your Own Debt.)

Free Money Makes Saving More Attractive
If you choose to save the $250 in a retirement account, it could mean more money if the amount is saved in a 401(k) plan and your employer makes a matching contribution. In addition, if you meet the income requirement, you are eligible for the savers tax credit which can be up to $1,000. This credit is also available if you choose to add the amount to an individual retirement account instead of a 401(k), and helps to reduce the cost associated with funding your retirement account.

Rainy Day Fund Vs. Paying off Debt
If you do not already have a rainy day (emergency) fund set aside, it might be more beneficial to add your disposable income to such an account. A rainy day fund is generally used to cover unexpected expenses, and can be invaluable in the event of a job loss. Paying off your debt, such as a credit card balance, is not a practical substitute for a rainy day fund, as the credit card company can reduce your credit limit. Furthermore, using a credit card means incurring debt on which interest will accrue and for which you will be required to make repayments.

The Bottom Line
Consider your full financial picture when making your decision. This can include whether you have someone else you can rely on in the event you are unable to cover unplanned expenses. If you are unsure of which solution is most suitable for you, splitting your disposable income between the two options may allow you to benefit from both. Working with a financial planner may help to provide a comprehensive solution. (To learn more about saving, check out 5 Unusual Tactics To Help You Save More.)

Related Articles
  1. Your Clients

    How to Construct an Annual Review for Clients

    One of the best things that advisors can provide to clients is an annual review of their financial situation. Here are some guidelines.
  2. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  3. Term

    How Traditional IRAs Work

    A traditional IRA is a tax-advantaged retirement account that includes stocks, bonds, mutual funds and other investments.
  4. Retirement

    5 Reasons Millennials Lead in Saving for Retirement

    Say what you want to about millennials but the one thing they are doing better than any other generation is saving for retirement. Here's why.
  5. Retirement

    How Much Should You Have In Your 401(k) To Retire?

    Determining how much money should be in your 401(k) when you retire depends on several variables, many of which are uncertain.
  6. Credit & Loans

    10 Reasons To Use Your Credit Card

    There are several benefits to paying with credit instead of debit, if you use a credit card responsibly.
  7. Credit & Loans

    5 Extreme Ways To Raise Your Credit Score

    Desperate to rebuild your credit score because you can’t obtain a loan with a decent interest rate? Here are some extreme options to try.
  8. Investing

    How To Make Sure Your Healthcare Costs Do Not Ruin Your Retirement

    The best proactive plan of action for a stable retirement is to understand medical costs, plan ahead, invest properly, and consider supplemental insurance.
  9. Investing

    3 Small Steps to Maximize Your Investing Goals

    Instead of starting the New Year with ambitious resolutions, why not taking smaller manageable steps that can have a real impact.
  10. Investing

    7 Creative Ways to Save for an Early Retirement

    Take note of these out of the box steps you can take towards securing yourself an earlier, more comfortable retirement.
RELATED FAQS
  1. Am I losing the right to collect spousal Social Security benefits before I collect ...

    The short answer is yes, if you haven't reached age 62 by December 31, 2015. The Bipartisan Budget Act of 2015 disrupted ... Read Full Answer >>
  2. How can you pay your Walmart credit card?

    Holders of Walmart credit cards can make payments on their balances due by mail, online or at Walmart and Sam's Club stores. ... Read Full Answer >>
  3. Where else can I save for retirement after I max out my Roth IRA?

    With uncertainty about the sustainability of Social Security benefits for future retirees, a lot of responsibility for saving ... Read Full Answer >>
  4. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  5. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  6. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
Trading Center