We’ve all been there. We look at our savings account and then at our credit card statement. Both need attention and require money into those accounts. Which one is more important? We ask ourselves the question: how much money should I put aside for savings and how much should I use for debt repayment?
If you guessed debt re-payment, then you’re a winner! We believe that paying off debt is almost always more important. There are a few exceptions to this rule, but I’ll get into that later.
Why is paying off debt better than putting money away for savings? Well in most situations, the money that you make off investing and/or saving is not as much as the interest that you incur from your credit card or line of credit balance.
Here’s an example:
Let’s say you invest $1000 in a mutual fund that might earn you 5% interest. That’s not bad, as it would be $50 for the year and will continue to grow. Conversely, you have a VISA balance of $1000, with an interest rate of 19.99%. Well, if you don’t pay that off, it will cost you around $200 in interest for the year. All in all, you’re better off to pay off the credit card. Once you’ve paid off that debt, then use that amount and put it into your savings.
Here’s another example, where the debt is your line of credit. Interest rates on line of credits tend to be much lower than credit cards and the interest on mine is around 7%. This means that $1000 debt would cost me around $70 for the year. Going back to the above savings example ($1000 at 5% into a Mutual Fund), you’re still better off at paying off the debt on your line of credit versus savings.
I would only invest my money if I knew I could earn more than 7%, which is hard to find and is never guaranteed. However, paying off that debt would guarantee me a return of 7%, because I know I wouldn’t be incurring that interest cost of $70.
It can be simple math that some people ignore because paying off debt isn’t as sexy as investing their money. So take my word for it: pay off your debt first!
What is the exception to the rule?
Any debt that was purchased using a very low financing rate (like my car or mortgage) is something I wouldn’t pay off. My car was purchased with 0% financing. If I pay it all off now or over the next 5 years, I would be paying the same amount. There isn’t any point in paying the loan off early.
So what about my mortgage? When it’s possible (i.e. no consumer debt to pay off) we put extra money towards our mortgage. While this is a nice luxury to have, we know it’s something most people shouldn’t be doing if they have consumer debt. If this is you, don’t stress because there isn’t much cost savings by doing this in the short term. It’s better to use that money and pay off other debt.
At the end of the day, you need to make your money work for you. While it seems appealing to focus only on savings and try to pay off your debt with whatever is left over, you’re going to be falling into the debt rabbit-hole. It’s also important to read your statements and know the interest rates on your debt, the account balance and when that balance is due. Simply throwing it in the trash and praying the debt re-payment gnomes will come isn’t going to solve your problem.
Does all of this still seem confusing? Don’t stress if it does – a lot of people are confused by this. Send us a note with your questions and we’d be happy to help!