Pay Off Debt or Save: Is It Better to Save Money?
Should you pay off debt first before padding that savings account? We say yes and here’s why it’s the wiser financial decision in the long run.
Why you should pay off debt: interest and compound interest
In most situations, especially in today’s financial climate, you’re better off paying off debt before setting aside money in your savings account. This is because of current interest rate trends; the interest rates at which you borrow money are almost always higher than the rates you’ll earn on money in your savings account. Simply put, this means that every dollar you borrow costs you more than you can earn on every dollar you save.
|Infographic: Compound Interest © CreditDonkey|
For example, if you put $100 into a savings account and keep it there for a year, the 1-3% rate your bank gives you will amount to about $2 earned after 12 months. A credit card, on the other hand, will charge you around 15% on outstanding balances, and possibly more. Over the course of a year, that means $100 in charges will cost you about $15 in additional interest.
In the above example, saving the $100 instead of putting it toward your credit card balance means you’ve given up $13. Even though you made $2 in interest, you’ve spent $15 paying interest on your credit card debt.
This effect is magnified by compound interest, which is additional interest that grows on existing interest. Compound interest can be either a benefit or a burden, depending on whether you’re earning it or paying it. Using the same example, if you save $100 for one year and earn $2 in interest, the next year you’ll earn interest on $102 – a total of $2.04 instead of just $2. In other words, you earn additional interest on interest you’ve already earned.
Unfortunately, the same is true of your credit card balance. Your original $100 bill becomes $115 after adding interest at the end of the year. If you haven’t paid off that portion by the next year, an additional $17.25 will be added to your total balance.
So, you’ve earned $4.04 on the money you saved, but you have to pay an $32.25 in interest on your credit card – just for a hundred dollars. The $13 it cost you to save the $100 last year is now costing you $28.21, and the gap will only get wider as time goes on.
The numbers in this example are small, but imagine what would happen if a few zeroes were added. Maybe you have a credit card with a balance of $1,000 – under our hypothetical interest rate, you’re looking at $150 in interest compared to just $20 earned in savings. You could easily end up losing hundreds of dollars every year.
You should also evaluate your financial goals. Paying off your credit card debt will likely increase your credit score, so if you expect to make a major financial decision over the next few years, such as buying a house or taking out a car loan, a better credit score will give you better terms on future loans.
Every rule has exceptions, and this one is no different. Read on for a few examples of when to save money instead of pay off debt.
Set up an emergency fund.
If you have little or no money in savings, it’s a good idea to put some cash away before you turn your attention to paying down debt. You should always have enough money saved to cover at least a few months’ worth of expenses in case you lose your job or some other urgent situation occurs. While saving, still try to pay an amount that is at least more than the minimum due on your credit cards to reduce the accumulating interest. It will save you money when you are able to more significantly pay down what you owe.
Focus on savings accounts with higher interest rates.
If the interest rate on your savings is higher than the interest you’re paying on your debt, you should put the money into this account. This is rare, but not unheard of. It’s more likely to occur with long-term debt like mortgages and student loans, especially if you have your savings invested somewhere like stocks or mutual funds. In these situations, you’ll earn more on your money by letting it sit in your account than it will cost you in interest on your debt, so saving should be your priority.
Don’t pass up free money.
Finally, it’s probably not a good idea to give up free money to pay off debt. If your employer is willing to match contributions you make to an account like a 401(k), take advantage of it. You may end up having to pay more in credit card interest, but your employer’s contribution will effectively double the amount you’re saving for retirement. This should more than make up for the additional interest costs from your credit card.
Keep in mind comparing interest rates is key in determining whether it’s best for you to save money or pay down your debt. Look at what you’re earning on the money you currently have saved, and then look at the rate you’re being charged on your debt. The one with the highest rate is usually where you should focus on putting your money.
(Graphic Writing by Annette; Graphic Design by Boris)