Pay off debt or start saving?

Partly inspired by this thread:
It seems the axiom that is tossed about constantly is that people should start saving money “before you think you can afford it”. That seems like good advice, but the one problem that I’ve never seemed to get a straight answer on is in terms of personal debt. Wouldn’t it be better to pay off debt first, if it is at an interest rate higher than you could possibly get in an IRA or savings account?
I owe somewhere north of $20k in student loans at an interest rate of 6.8%. I’m pretty sure it’s near impossible to find any sort of savings plan that pays more than 6.8% return. Therefore, logically I should be putting every cent possible toward paying off that debt before putting a single dollar into a long-term savings account, right? That seems like common sense but doesn’t match up to the constant “OMG SAVE MONEY ASAP!” message that seems to be the core of most basic financial advise. What am I missing in this equation?

I think that you need to have some sort of emergency savings cushion should things go wrong (e.g., major car repairs/replacement, medical bills), but it’s also important to get that debt loan removed as soon as you can. If you have enough savings to support yourself for 3 months, I’d look at throwing extra incoming cash towards paying off the loan.

Yeah, I’d say it’s not a question of 100% one way or the other, but one of what portion should go to each. In this case, I’d say the majority to the loans for the reasons you outlined in the OP but still put a small portion in savings because you never know when you’ll need it.


I think everyone should get into the habit of saving something, even if it’s just $5 a week. Putting what you can live without into an account to think for the future.

I wouldn’t feel comfortable without having a six month emergency fund. That’s six months worth of money tucked away to cover all of your basic needs expenses (taxes, mortgage/rent, utilities, food, insurance) should you lose your job.

I think my first goal would be paying the minimum amount on my student loans while I build that emergency fund. Once you have that you can increase the amount you pay on your loans and then start a general savings account/IRA.

Are you taking advantage of your company’s 401K? You’d always want to make sure you’re putting in at least the amount of the company match. FREE MONEY!

A savings plan is the safest investment you can make, which is why is it pays such a low return. You could find mutual funds with a long-term return higher than 6%, however there is a much greater short-term risk.

But I digress.

Yes, you are correct that you should pay off your debt as quickly as possible. The issue here is “liquidity”. If you put every extra cent into paying off your loans, you wont have any cash on hand for an emergency. You may be forced to use your credit card at a much higher interest rate (20% or more).

I would recommend after paying off your monthy bills, credit card charges and loan payments and 401k, putting whatever is left into a savings account until you have an amount equal to about 6-12 months worth of your expenses.

After than, start paying down loans.

I almost forgot. The reason you want to start socking money away in a 401k or savings account even with the loans is that the interest on those funds are going to compound over time.

A 401k is good because, not only does it compound over time, it will reduce your taxable income. Similarly, if possible, set up direct deposit of some amount into a savings account. It is much harder (in my experience) to spend money in a separate account without a good reason as compared to putting everything into a checking account with a promise to make the transfer later.

Sometimes the best rate of return on paper isn’t the best rate of return in actuality. Having a buffer is needed so you don’t get into a tricky (and expensive) bind.

First off, I set my autopay to pay more than my mortgage payment every month, and always have, so I don’t even feel this part (less than $100). This helps me be thriftier by feeling like I have more bills than I really have to pay. Then, I try to keep a certain buffer of savings – more than I used to, but now that I have a house, there are possibilities for significant expenses. Plus, when the economy sucks, I want to be able to float quite a few months with no job, just in case. Whenever I exceed this buffer, I put a lump sum against the mortgage. I’m doing this because I couldn’t put down the full 20% on my house when I bought it last year, so I have to pay PMI every month, and I want to get this paid off ASAP so I can stop paying that monthly bill. Once that’s done, I want to boost my buffer so I could live on it for a lot longer if needed, and to plan for eventually upgrading to a nicer house.

So in your case, you need to build up a comfortable buffer first. It all depends on what you’ve committed to pay – you can cancel your cable if things get bad, but you can’t really cancel your car payment or a two-year lease. If your car breaks down, you have to fix or replace it to get to work and live your life. If I were you, I would work towards this buffer as soon as possible but it doesn’t hurt to start putting an extra $25 or $50 a month towards the loan ‘invisibly’. As time goes on, keep inching up this number.

I also think it’s a good idea to plan for what to do when times are good. When I get ‘windfall’ money - like a big tax refund, or a bonus, or whatever - I try to put at least half towards debt. A lot of people will go out and blow it right away, but I figure, I’d rather indulge just a little and pay a lot less in interest by being responsible.

Keep a buffer for savings, but, especially in the case of things like credit debt, you’re potentially bleeding more in interest every month than you would be gaining by putting more into savings. Depending on your specific finances, I’d recommend paying debt first.

I feel pyschologically you need about $1,000 in cash at any given time. Of course there are better ways, it’s obviously better to pay down debt than save, but having $1,000 in cash, in the bank or buried in the backyard or wherever :slight_smile: makes you FEEL better. And that is important too.

In today’s employment climate, a year’s living expenses in the bank is not a crazy suggestion, although it could take awhile to get there. I can attest to the fact that getting laid off suddenly is no fun. If I hadn’t had that cushion in the bank, it could have been dicey. As for general savings, it doesn’t get any better than paying off loans, credit cards, mortgages and the like. Unless you’re willing to take large risks in investments, you can’t make that kind of interest.

The issue isn’t that a savings account pays less than 6.8% (none do) but that without a savings cushion you’ll probably have to pay significantly more than that to access money if needed.
The next time your car’s transmission takes a dump, or your hot water heater springs a leak and you have to put the repair cost on a credit card, you’ll probably be paying 13% + for that money. Now compare the credit card interest rate to that of the student loan…

Some would say that, by definition, debts must be paid before savings can occur. If debts exceed assets, you have no savings, regardless of how much money’s in the bank.

I’m a fan of :

  1. Getting six months of living expenses in the bank - while adding no more debt.
  2. Pay off debts.
  3. Take full advantage of 401k.
  4. Expand savings to twelve months.
  5. Continue to save at least half of what you set aside in steps 1-3.
  6. Put ‘windfall’ money, raises, etc. into savings. Only give your checking account a ‘raise’ when you really need it.

Use automatic deposit for your savings, into a different bank than checking to make it harder to withdraw.

Learn the basics of dollar cost averaging as a beginning investment strategy.

Remember that savings and money market accounts guarantee that someone else makes more from your money than you do.

Isn’t the whole point of “save now” is that you’ll make interest off the interest over time? If that’s true, you’d need to think of the rate on your money over the long term.

Also, and this is just me being paranoid from a few long-ago years of poverty, if you have no savings at all; then when your car breaks/back hurts/apartment floods you have to use your credit cards. Credit card debt can send you into a expensive cycle of horror.

You should pay off debt that has a higher interest than your savings…unless, you do not think that you will have access to that debt sometime in the future and may need it, in that case save some and pay down some on the debt.