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. Retirement

    Suddenly Pushed into Retirement, How to Handle the Transition

    Adjusting to retirement can be challenging, but when it happens unexpectedly it can be downright difficult. Thankfully there are ways to successfully transition.
  2. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  3. Retirement

    5 Secrets You Didn’t Know About Traditional IRAs

    A traditional IRA gives you complete control over your contributions, and offers a nice complement to an employer-provided savings plan.
  4. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  5. Retirement

    Are Fees Depleting Your Retirement Savings?  

    Each retirement account will have a fee associated with it. The key is to lower these fees as much as possible to maximize your return.
  6. Savings

    How Parents Can Help Adult Children Buy a Home

    Owning a home isn't easy thanks to stringent lending standards. Thankfully, there's ways parents can help their kids buy a home.
  7. Retirement

    Retirement Tips for Doctors

    Learn five tips that can help physicians get back on schedule in terms of making financial preparations they need to retire.
  8. Investing Basics

    Do You Need More Than One Financial Advisor?

    Using more than one financial advisor for money management has its pros and cons.
  9. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  10. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. Is Apple Pay safe and free?

    Apple Pay is a mobile payment system created by Apple to reducing the number of times shoppers and buyers have to pay for ... Read Full Answer >>
  5. Can you use your Walmart credit card at Sam's Club?

    Consumers can use their Walmart credit cards to shop at Sam's Club. However, they cannot use their Walmart credit cards when ... Read Full Answer >>
  6. How can you cancel your Walmart credit card?

    Walmart offers two types of credit cards: the Walmart MasterCard and the Walmart credit card. How to Close Your Walmart Credit ... Read Full Answer >>

You May Also Like

Trading Center