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Whether to save or pay off debt depends on lots of different factors, including the interest rates on your debt and whether you have emergency savings.
But there's one rule that applies no matter what your individual situation is: If you don't have any cash set aside, first start an emergency fund. Your goal should be to save three to six months of expenses for emergencies, but even saving $1,000 would make a difference to start. That may keep you from relying on credit cards for unexpected expenses like car repair or travel to see a sick family member.
Once you have that cushion, here's how to decide which goal to tackle next.
When to Pay Off Debt Before Saving Money
If you have high interest debt from credit cards, personal loans or payday loans, prioritize paying that off first. Send more than the minimum to your creditors each month to get rid of the debt, even if that means earning extra income or cutting back on expenses. You can aim to spend less on meals out, for instance, or cancel subscription services you don't use.
Making payments on time, every time is the largest contributor to a good credit score. Paying off a debt early won't necessarily positively impact your score on its own. But along with saving on interest, you'll lower your credit utilization, or the amount of debt you have relative to your credit limit. Experts recommend using no more than 30% of your available credit at any point; keeping your utilization rate at or below 10% is ideal.
To reduce credit card debt, consider these options:
- A balance transfer credit card with an interest-free promotional period. If you're eligible, you'll have up to a year or more to pay down your debt without racking up additional interest charges. Make sure you get rid of the debt in that time to avoid paying interest once the promotion term ends.
- A debt consolidation loan. You may be able to bundle multiple types of debt, not just credit cards, with a consolidation loan at a lower interest rate than you currently have. If you have just a single credit card balance to pay off, though, a balance transfer credit card is likely a better option.
When to Save Money Before Paying Off Debt
An emergency fund will protect you from taking on further debt, depending on what emergency expenses you may incur. Regardless of the type of debt you have, ideally you'll also set aside a little bit each month to eventually have three to six months of basic expenses saved, which is what experts recommend. That will give you the security to cover rent, groceries, utility bills and minimum debt payments if you unexpectedly lose your job.
If you can't save each month, consider contributing part of your tax refund or bonus at work to your emergency fund. Sure, you can still use part of it for fun stuff like new hiking boots. Depriving yourself could make you so miserable you end up falling off track. But putting a portion aside in savings will give you a sense of accomplishment—and, more important, protect you when unexpected future expenses pop up.
In some cases, you can skip right to saving, instead of sending extra to your debt each month. If you have low interest debt, such as federal student loans or a mortgage, you can likely safely pay the minimum and focus on saving with any extra cash you've got. (However, adding extra principal payments to your mortgage each month can reduce the life of the loan, and thus the interest you'll pay.) Once your emergency fund is in good shape, boost your retirement savings or work toward building a down payment for a house or car.
How to Pay Off Debt
To get out of debt, focus on eliminating your costliest debts first. That likely sounds easier said than done. Here's how to see where you stand, then attack your debt strategically:
- Take a deep breath and honestly assess what you owe. If you're not sure, check your credit report, which will show your outstanding balances. Make a list of your various types of debt, their amounts and their interest rates, which you can find on your account statements.
- Prioritize paying off the highest-interest debt first. Credit cards, personal loans and payday loans should be at the top of the list. Private student loans with high interest may also be a priority for you.
- Consider using a balance transfer credit card or debt consolidation loan to reduce your interest rates and combine multiple debts into one, making them easier to pay off. You can also look into refinancing private student loans to a lower interest rate. (If you refinance federal student loans, you'll lose access to protections like income-driven repayment and long periods of payment postponement.)
- You may also be able to reduce the monthly payment on some debt if you need a strategy that will make them more affordable in the long term. Federal student loans come with income-driven repayment plans, for instance, that tie your payments to income. Payments can be $0 if you have no earnings.
- To free up more money for debt payments, consider adding to your income. You could sell unused clothes, rent out a spare room on Airbnb, or ask for a raise and send any additional earnings toward the debt.
If you're feeling overwhelmed or need help making a plan to get debt-free, a nonprofit credit counselor can take a look at your situation and offer solutions. You can get a free consultation through credit counseling agencies certified through the National Foundation for Credit Counseling. See "How to Get Out of Debt" for more payoff advice.
How to Save Money
There are two major categories of expenses you can reduce to save money: fixed and variable. Fixed expenses are recurring bills that don't change, like your rent or mortgage, while variable expenses, like entertainment and meals out, can vary from month to month. Here's how to address both:
- You won't know where to cut back if you're unsure where your money is going in the first place. Make a budget so you can assess what you're currently spending and where there's room to trim.
- Target your biggest monthly expenses first, like rent and transportation. Moving into a less expensive place, getting a roommate or refinancing your mortgage can all yield big savings. Buying a used car instead of a new one or shopping for cheaper car insurance could also help bring down monthly bills.
- If you've already cut back on major expenses, or you're unable to make a change to your housing or transportation at the moment, next set your sights on smaller monthly bills, like utilities. Negotiate down your cable or internet bill, for instance, or shop for a new cell phone plan.
- Next look at variable expenses. If food takes up a big portion of your budget, try cutting out takeout for a month to see how much you save, or go out to eat just once a week instead of three times. Spend Sunday afternoon cooking for the week so you can bring leftovers to work. Cancel any subscriptions you don't use, like gym memberships or streaming video or music services.
See "10 Easy Ways to Save Money Every Month" for more tips on how to save money.
The Bottom Line
Saving and paying off debt are perhaps the most worthwhile financial goals to pursue, but they can feel at odds. To avoid losing sleep over competing priorities, make a plan to tackle one at a time, starting with your emergency fund. The more you accomplish—even taking five minutes to set up a monthly automatic transfer from checking to savings—the more you'll know you can do.
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