Debt vs. Savings: What to Prioritize

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Two of the building blocks of personal finance are saving money and paying off debt. Everything flows from these two principles. You can’t invest, start a business or retire if you are not saving and/or you are crippled by a mountain of debt. In an ideal world, we’d be maxing out our 401k and crushing our debt, getting ever closer to eliminating them every month. Alas, we live in the real world with tons of responsibility and a finite amount of money to work with. So how do we prioritize?

While the exact answer might vary from person to person depending on their respective situation, the steps we use to reach the appropriate conclusion are the same. To make it easier, I will eliminate the variables in a hypothetical situation by using myself as an example.

Currently, I have 3 savings account: one is a CD where I get the best return I’m going to get in this interest environment. It pays me 1.25%. The other one is a money market account that pays 0.05%. It’s not as lucrative as the CD but my money is accessible with few penalties. However, money markets have an important restriction. While you can deposit money any time you want, they cap how many times per month you can withdraw before you incur a fee. It’s a fantastic tool that forces you to keep your hand out of the honeypot. But life happens and we sometimes need to access money more often than we want to. That’s where my regular savings account comes in. Hold on to your hat folks, this return might blow you away: 0.01%. I’ll try not to spend it all in one place. If you’re wondering what this has to do with anything, be patient…

The debt that is currently the biggest thorn in my side is my student loan debt. As much as I would love to keep fattening up my savings, the interest rate on that debt is 5.16%. That means, for every hundred dollar I chose to add to my savings (let’s assume we’re talking about the CD since it offers the best rate) over paying off my student loans, I am getting a return of 1.25% that is costing me 5.16%. That puts me in a whole of close to 4% annually on that $100. Of course, student loan interest is tax deductible if you itemize (which I do), but you don’t get all of it back. The IRS caps it at $2,500 gradually decreasing it as your income goes up until it disappears. So we’re talking a saving of 1% to maybe 2%, and I’m being generous, which will then net you a negative return of almost 2% and we aren’t adjusting for inflation.

So what do I prioritize?

  1. Having an emergency fund: This buys you peace of mind and keeps you from falling into debt when tragedy strikes. How much you need depends on your particular situation. But I recommend a minimum of 6 months.
  2. Saving for retirement: The most important part of saving and investing for retirement is time. The longer you save, the more time that compound interest has to work in your favor. Also, the more time you have to recover from dips in the market.
  3. Paying off high interest debt: My student loan debt at over 5% is in stark contrast with this loan I took out for an energy efficient central AC which is a 0% loan. I am in no rush to pay that off. If they want to extend it 10 more years, I’ll take it! However, I am very aggressive with my student loan debt where I send every extra unexpected funds to Nelnet. Whether it’s a raise, a bonus or a tax return check, it goes towards my student loans. I have paid off over $23,000 in the past 18 months and I have no plans of slowing down until it’s gone.

While your situation might be different, for me, this is the least expensive and most sensible order in which I can allocate my funds. If I do anything else, I am not maximizing all of my dollars. Have you taken the time to consider if your debt repayment plan and your savings strategy are optimized?

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