Saving vs. Paying off Debt

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 off 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.

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 a 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 the following:

• 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
• Splitting your disposable income between the credit card and your savings

Making 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 saver's 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.

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.