Is it better to pay off debt or save first?

If you’ve ever found yourself stressed about a lack of emergency savings, you’re not alone. Bankrate reports that nearly 60 percent of U.S. adults feel they don’t have enough in savings, and over 25 percent don’t have a savings at all.  

Additionally, the Federal Reserve Division of Research & Analysis recently reported that over 77 percent of Americans owe some type of debt. So, where does one find the balance between paying off debts and saving money? Let’s unpack how you can successfully conquer both, even when resources are tight.  

Build up a healthy emergency savings now 

If you’ve never had a savings plan before, starting small can be beneficial. Setting a realistic goal like $1,000 – or even $500 – can make a huge difference when unexpected expenses strike.  

We suggest building an emergency fund that covers three months of expenses. However, it’s important not to set a goal that feels too lofty in the beginning. Here are a few strategies to help you build savings into your budget. 

The 80/20 budget 

Also known as the “Pay Yourself First Budget,” this is the simple plan for those who are brand new to saving. Calculate your monthly take-home pay. This is the money that goes into your account after taxes and benefits are deducted.   

Set up an automatic transfer from your checking account into your savings account. The transfer should account for 20 percent of your take-home pay. If you already contribute to a retirement account, you can subtract that percentage from the 20 percent total.   

Example: If you contribute five percent to your employer 401(k), set up an automatic transfer of 15 percent to your high-yield savings account. 

The 60 percent solution 

If you’d like to get more granular with your savings plan, the 60 percent solution could be a good fit for you. In short, you allocate 60 percent of your take-home pay toward “committed expenses.” These expenses include necessities like mortgage or rent, food, transportation, insurance, and other monthly bills.  

Also falling under committed expenses are reoccurring monthly payments such as music lessons you have “committed” to providing your children. While the lessons are not a necessity, they are a promised expense that is billed regularly. 

From there, 40 percent of your income will be split four ways into the following categories: 

  • 10 percent to long-term savings (emergency fund, down payment for a house or car, and debt payments) 
  • 10 percent to short-term “irregular expenses” (holiday shopping, birthdays, back-to-school supplies and vacations) 
  • 10% for fun money (funds to spend on anything you’d like such as dining out and monthly subscriptions) 

Continue to make minimum monthly payments 

Making minimum payments on your credit cards is an important step in ensuring a healthy credit score. After all, payment history is the most important factor when it comes to the credit scoring system. Missing payments can lead to late fees and higher interest rates on future loans and credit lines. Too many missed payments can even result in accounts going to collections. 

Always reach out to your financial institution if you’re having trouble making minimum payments. Options may be available to you to make payments more manageable, or even skip a month of payments altogether!  

While it’s nice to pay more than the minimum payment to avoid mounting interest charges, as you’re starting out, it’s best to focus on paying minimum payments until you have a healthy emergency savings. 

Prioritize which debts to tackle first 

When deciding which debts to prioritize paying down, it’s important to remember that not all debts are created equal! For example, mortgage loans and student loans are seen as an investment. Paying a mortgage loan helps you to grow equity in your home, and going to college can result in higher-paying job opportunities. Those loans also tend to have lower loan rates than other high-interest debt like credit cards and payday loans.  

You’ll want to focus on wiping out high-interest debt first to help avoid a toxic debt spiral. Here are two tried-and-true debt repayment options to consider: 

The snowball method 

With this method, you’ll start with your smallest debt first, paying as much as you can toward it while paying the minimum payment on other debts. Once you pay that initial debt off completely, take the amount you were paying monthly and add this to the minimum payment of your next smallest debt. The minimum payment you’re making keeps growing like a snowball tumbling down a hill, but you are actually paying less overall, avoiding extra interest over time. 

The avalanche method 

With the avalanche method, the debt with the highest interest rate is addressed first, while still paying the minimum on other accounts. Once you pay it in full, move on to the next highest interest debt, and so on. 

This method is the most cost-effective and will save you more money in the long run, but it can take longer to see results. If faster successes on paper motivate you, the snowball method may suit you better. 

If debt management feels impossible or overwhelming, you’ll want to consult with a financial guidance expert. They may suggest a debt consolidation loan or a credit transfer to a lower-interest credit card.  

Don’t forget, paying down your debts could boost your credit score! Credit utilization is the second-most-important factor of your credit score, and accounts for 30 percent of your score. 

Take advantage of employer benefits 

One of the most important things you can do is financially prepare for your future. This means taking advantage of your workplace retirement plan or 401(k). Many employers offer contribution matches, so this is essentially “free money” toward your retirement.  

While maxing out the employer match may not be possible right now, (example: You contribute six percent, and your employer matches six percent) contributing what you can toward your retirement plan is important. Not only can contributing to a retirement fund lower your taxable income, it will also set you up for a comfortable future.*

As you earn promotions and raises, try and increase your contributions by at least one percent every year.  

Pro tip: Check out your company’s vesting policy before maxing out your contribution. If you’re planning to leave your job before you’re fully vested, it may be wise to contribute extra funds to a high-yield savings account instead.*

While every person’s financial situation is different, a few key concepts are universal: Everyone should have an emergency savings, and it’s imperative to make minimum payments on all debts. If you’d like help making this happen, contact our financial wellness managers today! 

 

 

* Consult a tax advisor regarding tax benefits.