Should You Pay Off Debt or Invest in Savings?

The decision to eliminate your debt or put your money into savings is a tough one. There are many variables to consider before making the best decision for your situation.

When you're working on a budget, a common question is whether to use your excess cash to rid yourself of debt or build up your nest egg. Financial experts agree that savings is an important part of every budget and most recommend putting 5% - 10% of your income each month into savings. Is this a good idea when you're in debt? It's an important decision to make. While having a savings account is a way to plan for the future, becoming debt-free is an excellent strategy for creating long-term financial health.

Interest Rates

Take a look at your savings account statements to see how much interest you're earning. Now take a look at your creditor's statements for the debts you have. If you're like most people, you're probably being charged more interest on your debts than you're earning on your savings.

When you're deciding between paying off debt or investing in savings, the best choice depends on the interest rate of each account. For example, if the interest rate on your debt is 13%, you would have to find a savings option with an interest rate equal to or greater than 13% to clearly make investing in savings a better choice. Don't forget that earnings on your savings are taxable, so depending on your tax bracket, your earnings rate is even lower.

Review Your Debts

An easy way to get a big picture view of your debts is to write them down. Make a list of your debts by creditor name, amount owed, and interest rate. List them in the order of highest interest rate to lowest interest rate. Your list may look something like this:

The first thing you should notice about this list is the high interest rate on the department store account. If you're only making the minimum payment of 2% - 3% of the balance each month, it will take you over 12 years to pay off this debt. Clearly, this is the debt that you should focus on first. Ways to eliminate this high interest debt include:

• Putting the card away so you don't put additional charges on it

• Paying more than the minimum amount due each month

• Transferring the balance to one of your lower interest rate cards

• Getting a lower interest rate debt consolidation loan

• Enrolling in a credit assistance program

• Borrowing money from family or friends

Revolving vs. Installment Accounts

After you look at the interest rates on your debts, it's a good idea to look at the type of debt you're carrying. Revolving accounts, like credit cards, can be more difficult to manage because you can continue to add more debt while the payments can go on indefinitely. Installment accounts, like most personal loans, have a fixed payment amount for a fixed length of time. Typically, it's a good idea to focus on paying off revolving accounts first.

If there's no added fee for paying off your installment loans early, you may want to focus on them next. If you'll be charged a prepayment penalty, or if you'd prefer to stick with the original payment plan, this is a good time to invest in savings. If you have home equity debt, it may be wise to continue carrying this debt once it's tax deductible.

It's Your Choice

So far it may sound as if paying off debt before investing in savings is the best option. Keep in mind, most financial experts recommend budgeting 5% - 10% of your income each month for savings. They also recommend having three to six months worth of living expenses in an emergency fund. So what should you do? Here are the options so far:

• Pay off debt before investing in savings. This will look good on your credit profile, but you won't have a financial cushion if you need it.

• Make the minimum payment required on your debt and create a savings account. This will give you a financial cushion, but it will prolong the life of the debt and may cost you more money in the long run.

• Find a balance between paying off debt and investing in savings. Paying off debt now while working toward building a savings puts you in control of your money. You may want to pay slightly more than the minimum payment required on your debt and put the rest in savings.

Evaluate your situation and then determine the right mix of payments and savings for you. You can use the CareOne Credit Budget Calculator "Should I Pay Off Debt or Invest in Savings" to help you make a plan. Also, you can download a free Pay Down Debt or Invest Calculator for Windows from Wheatworks Software. For a discussion of paying off debt, read Michelle Singletary's article about debt vs. savings: Debt, a 3-Way Loser.

For more information on any of the topics covered, read the related articles in our Knowledge Center Library.

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