Should I Save or Pay Down Debt?
Personal Finance 101 warning: This topic may seem very simple, but at Linus, we get a lot of questions about saving money versus paying down debt.
Recognizing the importance of saving is the first step toward being fiscally responsible and establishing financial stability. Before I answer this question, I highly recommend that you build an emergency fund to prepare for unforeseen circumstances, such as an unexpected expense, lapse in employment or changes in economic certainty. Once you have met this goal — and congratulations, by the way — you may be wondering what comes next, saving for retirement or paying down debt. Because everyone’s situation is different, we’ve created a simple guide to help determine when to save and when to pay.
Consider The Interest Rates You’re Paying
A general rule of thumb is that you want to pay down your debt with the highest interest rate first. Higher interest rates mean higher interest payments; i.e. the cost to borrow a dollar will be greater on the loan with the higher interest rate. If this is confusing, think of interest as the price to rent money just like you would pay to rent any other asset.
Consider a scenario where you have two nearly identical loans, but one has a rate of 5% and one has a rate of 30%.
The loan with a 30% interest rate is considered more expensive because the interest payments are higher. In the scenario where you can pay off one of these loans, the best decision would be to pay off the loan with the 30% rate. After a year, you will owe $50 in interest, rather than $300 if you had paid down the 5% loan first.
Don’t feel like you have to pay down your balances in lump sums. This strategy works to save money even if you plan to pay small amounts over time. As you pay down your debt you’ll owe less every month, meaning you’ll be able to save more to reduce your debt faster. This is a virtuous cycle towards building net worth and financial independence!
Watch out for minimums and penalties!
Unfortunately, the real world isn’t this simple and there are a few other considerations to keep in mind with determining to pay down debt. Many of us have student loans, home loans, car loans, and credit card debt, to name a few. You will need to familiarize yourself with the fine print of your specific loan, but here are some things to look out for:
Minimums
Most loans and credit cards require you to pay a minimum amount every month. Missing a payment, unless you are using an introductory rate, will generally incur a penalty. Keep this in mind when determining which debt to prioritize. It may not make sense to skip a credit card payment to pay more on your student loans if it comes at the cost of a penalty fee, negatively impacting your credit score.
Early Repayment Penalties
Although less common with credit cards, some student loans and mortgages include early repayment penalties in the small print. A bank or lender will include these terms to ensure that underwriting your loan is profitable. Although fees are generally worth avoiding, there may be cases in which you can save more in interest payments than the cost of the fee when you pay off the loan.
Consider The Type of Debt
Is there such a thing as good debt? Contrary to popular belief, debt is not necessarily bad. For example, a small business loan may provide the liquidity you need to make a return on an idea for a business. Similarly, investing in your skills by taking out a student loan may help to increase your earning potential in the future. When used properly, debt instruments can be a very powerful mechanism to leverage your potential.
When you become over-leveraged, meaning you’ve taken on more debt than you have the ability to repay, then you have problems. This generally begins with an over reliance on credit cards. Because the interest rates are high, paying the minimum amount may not be enough to keep the total amount you owe from spiraling out of control. With credit cards, it is advisable to pay off the balance every month, rather than paying the exorbitantly high interest rates (generally 24–30%).
Properly managing your credit cards and paying your other loans on time will have a profound impact on your credit score. Having a higher credit score will allow you to have access to lower interest rates and overall more financial opportunities. If you avoid debt entirely, then it can be difficult to build enough credit history to access student, home, automobile or small business loans. This is why the right amount of debt can be extremely empowering.
Shouldn’t I be saving?
If you feel like you have a handle on your debt and you’re making your monthly payments while saving money in an accessible emergency fund, then you may be wondering which is more efficient — paying down debt or saving?
As when evaluating debt, the answer requires us to compare the interest rates. For example, if I borrow $1,000 at 5%, is it better for me to pay off the loan and eliminate my debt, or put the money into savings? Well, the answer requires us to know what our savings options are. Currently interest rates on savings accounts are extremely low, generally below 1%.
If you borrowed $1,000 and placed it into savings, then after a year you would have earned $10, but would have to pay $50. This would result in a net loss of $40. In this scenario, you would be better off paying down your debt of $1,000. You can easily apply this evaluation to our own personal situations. Although we may not have the opportunity to borrow at one rate and save, you may be wondering what to do with the $50 or $100 you’re able to save every month.
Consider the Risks
When evaluating where to invest savings, it may be tempting to consider speculative assets such as stocks, bonds or cryptocurrencies. While these assets may potentially yield greater returns, investing in them also introduces the potential loss of funds that is not present when leveraging a deposit account. A good gut check is to analyze what you would do in the worst case scenario where you’ve lost your funds.
If you’re considering paying off debt or saving money, you should consider high yield deposit accounts like Linus, which carries significantly less risk than stocks and pays up to 4.5% APY. This way, you’re not risking your principal and will at least have enough funds to pay off your debt balance.
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