Should You Pay Off Debt, or Save?

Deciding between paying off debt and saving money is never easy. It’s almost like a “Which came first?” problem. On one hand, being debt free means no more interest payments and the ability to save more in the long run. On the other hand, it’s important to have some rainy-day money stashed away for emergencies and, eventually, retirement. 

The truth is that there is no easy answer. It depends on your particular situation, your risk tolerance, and your daily lifestyle. As many as 3 in 4 Americans live paycheck to paycheck, so money tends to be tight for everyone. That’s why it’s in your best interest to figure out how to put your money to best use while paying off debts and saving at the same time. Let’s look at two different, “what if” scenarios to get started: 

1. Prioritize debt repayment without saving 

Most people have debt in the form of student loans, a mortgage, or an auto loan. Whatever the case, many of these people are unable to save a significant amount each month because so much of their salary goes towards paying rent and debt. So they decide not to save anything at all—at least not until their debt is completely paid off. 

The problem with this strategy is that it probably won’t work for most people in the long run. Unless you’re making enough to live comfortably in your neighborhood or work for a company that provides a pension, chances are that you may not have enough saved up for retirement. Most Americans don’t. 

That being said, prioritizing debt repayment does have its advantages. Let’s not forget that compound interest works both ways, after all. Debt accumulates when you don’t pay it down. And it’s fair to say that, generally speaking, most people do not pay off their debts as quickly as they expect to. It’s worth noting that credit interest rates are generally higher than savings interest rates, so your debt will grow more quickly than your savings. You may also find yourself reaching retirement with debt, which can make it harder to live comfortably with your retirement savings. 

2. Prioritize saving without paying down debts 

Speaking of compound interest, the main advantage of saving up early is that compound interest works heavily in your favor over time. The longer you compound your savings, the more you’ll have by the time you retire. Conversely, each year you don’t put money into your savings and retirement accounts is another year of missed compound interest opportunities. Try out a retirement savings or compound interest calculator, and see how much of a difference starting to save at age 25 makes vs. starting to save at age 30. 

Those who favor being cautious may also choose to save before paying off debt because they want to have an emergency fund ready. Even a few hundred bucks can help out in a pinch. 

When to pay off debt first 

• High interest rates: If you have credit cards or other loans with high interest rates, it’d be best to focus on paying this debt off first. The more you owe, the more you have to pay in interest over time. No one wants to be stuck in that situation. 

• Large amount of debt: Having significant debt can be a burden because of interest over time. Even if you have 30 years to pay off a mortgage, for example, that doesn’t mean you should take all 30 years to do so. Paying off more than the monthly minimum will help you reduce the extra interest you end up paying in the long run. 

• Low credit score: Your credit score is used to determine your financial health as well as how likely you are to pay back the money you borrow. Having large amounts of debt compared to your income, or a high credit utilization ratio, can lower your credit score. By focusing on debt repayment, you can increase your credit score and leave yourself open to better loans and lower interest rates in the future. 

When to save first 

• Low interest rates: Some loans, like mortgages or student loans, have lower interest rates. If this is the case for you, you may be better off prioritizing saving. As long as you calculate your interest payments ahead of time (e.g., knowing how much interest you’ll pay after 1 year, 2 years, 5 years, etc.) you should be able to save a bit without anxiety. 

• Rainy-day fund: It’s important to have a rainy-day fund because risk assessment is the number one rule of money management. If you don’t have money prepared in case of an emergency, you really should prioritize that. Without emergency savings, you’re forced to rely on credit cards and emergency loans to pay for unexpected needs, which increases your total debt and makes it even harder for you to pay off existing debts.  

• Retirement Savings: Having a sizable nest egg for retirement is an important long-term goal that you should keep in mind throughout your career. Saving early is the best way to take advantage of compound interest. If you have a 401(k) or an individual retirement account (IRA), your contribution may even be matched by your employer, which means that you’re effectively getting free money.  

The best course of action? 

All else being equal, it’s probably best to find a balance and save for retirement while also paying off your debt at the same time. When you only focus on saving, your debt balloons and becomes harder to manage. But when you only focus on paying down debt, you might end up retiring with far less than you’d expect. If you don’t have a specific plan in mind, then start by putting half of your money toward your savings and the other half toward debt repayment. The important thing is to lower your debt while saving, even if you end up doing one more quickly than the other.