Should I save my money or pay off my debts first? This is an age-old debate that might not be as straightforward to answer as you’d think.
Without a doubt, great things can certainly come from exercising either option. But where many personal finance gurus disagree is in how optimal one strategy might be over the other. How will each one affect your immediate cash flow, and what are the potential long-term benefits?
In this post, we’ll explore both strategies and help you determine which option is the best one for you and your money.
Why You Should Saving Your Money
There’s no denying that saving the money you earn is a great way to build your wealth. But the advantages of making regular contributions to your bank accounts and nest egg go way beyond just simply having more cash to do with as you please. Consider these other ways the act of saving can accelerate your fortune …
You’ll Take Advantage of Compound Interest
Compound interest is the phenomenon where money grows on top of the money you save plus any previous earnings you’ve accumulated. It’s how the average working American can slowly invest a little bit of their paycheck every other week and eventually retire decades later as a multi-millionaire.
The great thing about compound interest is that the more you save, the more you invest. And the more you invest, the greater the potential your contributions have to multiply in value.
For example, consider a person who invests $500 per month over the next 30 years with an average return of 10 percent per year. By the time they retire, their $180,000 of contributions will have grown to a value of $986,964.14.
That’s a nest egg that’s over 5 times what they personally saved! You can see this in action for yourself using this free compound interest calculator.
You’ll Get Closer to Achieving Your Financial Goals
If you have any aspirations of buying a new vehicle or putting a down payment on a home, then you’re going to need to save a significant amount of money. And to do this, you’ll want to set aside as much of your income as possible.
One useful strategy is to set up a separate bank account where these special savings goal can be “out of sight, out of mind”. You can opt to either deposit your money into that account directly, or you can sign-up to have automatic transfers made from your primary account.
You Can Build Up Your Emergency Fund
According to a survey from Bankrate.com, less than 4 in 10 Americans could handle an unexpected $1,000 expense like a car problem or medical bill that wasn’t covered by insurance. For those people, that’s a problem because it means they might have to turn to credit cards or personal loans with high interest to see them through.
To protect yourself, build up an emergency fund that has at least 3 to 6 months’ worth of your living expenses. That way, if anything happens from another unanticipated expense to a temporary job layoff, you’ll be prepared to deal with it.
Why You Should Focus on Paying Off Debt
Many people believe you haven’t fully achieved financial freedom until you become debt-free. This is because paying off your debts means you’re clear of the hold that being debt can have on your financial life. Consider the following ways that this is true …
You’ll Reduce How Much Interest You’ll Ultimately Pay
Every loan comes with some sort of interest that has to be paid back. So the sooner you pay off your debts, the sooner you’ll stop paying that interest. In some situations, this can be pretty substantial – equal to tens or even hundreds of thousands of dollars!
For instance, take someone who makes a $10,000 purchase on a credit card with a 29.99 percent APR. If they don’t pay it all off and instead only pay the $253 minimum payment, then they will be charged $27,431 in total interest over the life of the loan and it will take them over 12 years to repay.
You can try this out for yourself using this credit card interest calculator here.
Improves Your Credit Score
If you’re carrying too many revolving balances on your credit cards, then it’s going to have a significant negative impact on your credit score. That will in turn keep you from getting the best interest rates and possibly being denied for other important loans (such as a mortgage).
According to FICO, “amounts owed” count for at least 30 percent of your credit score. So it makes sense that the more you can pay these balances down, the better chances you’ll have of demonstrating to creditors that you’re financially responsible.
Frees Up Cash Flow
If you’re feeling tight on money and never seem to have enough, then paying off your debts in full and absolving yourself from these payments is going to be key.
Just think of what you could do if you no longer had to make a $500 auto loan or $800 student loan payment? You could instead snowball that money towards paying off your other debts or put them towards a different financial goal (like saving more for retirement).
Perhaps one of the best and most underappreciated reasons to pay off your debts is because of the relief and sense of accomplishment it can give you.
Many people struggle with living paycheck to paycheck, and they literally feel like they’re drowning in debt. By strategically and systematically paying off their balances, they’ll move forward in their progress and finally begin to feel like they’re in control of their finances.
The Best Strategy
As you can see, there are a lot of reasons why some people may want to lean more towards saving or paying off debt. The best solution will depend on you and your priorities. Reflect on how important both goals are to you and try to find a combination that strikes a suitable balance.
For instance, if retiring with a large nest egg is a top priority for you and your spouse, then you could focus on putting as much money into your 401k as possible after paying your regular monthly auto loan and credit card balances in full.
Or, inversely, if you’ve got several debts that are eating away at your budget every month, perhaps you might want to put a modest amount in your 401k and use the extra available income to pay down the principal of your balances as quickly as possible.
No matter which combination you decide to use, budgeting your money is going to be key. Budgeting is how you figure out how much income you have available and which expenses or goals you’d like them to be allocated to. This is where an app like Buxfer can help.
Buxfer lets you connect, sync, and automatically track all of your financial transactions. Their Budgets feature also lets you set up specific limits for each area of your expenses so that you can see (in real-time) if your spending is on track for the month.
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