Paying off debt can feel like the most important part of getting on track with your finances, but it is important to also be able to save on the way. Knowing when to pay off debt or savemay not always seem clear. This can, of course, depend on your situation. However, focusing first on saving even a small emergency fund will help you avoid falling further into debt in the event of an unexpected expense.
Here’s how to know when it’s time to develop a financial plan and prioritize saving money.
Building an emergency fund
Setting aside a small emergency fund can help keep you on your feet when a crisis strikes. Before you tackle paying off your debt, focus on your emergency savings goal. Ideally, your emergency fund would be large enough to live on for a few months if you experienced a loss of income like unemployment, but starting with a smaller goal like $500 is a great place to start. Your goal will depend on your financial situation, such as income, living expenses, and other factors.
Why should you have an emergency fund? Research suggests that individuals who struggle to recover from a financial shock have less savings to help protect against a future emergency. They may rely on credit cards or loans, which can lead to debt that’s generally harder to pay off. They may also pull from other savings, like a retirement fund, to cover these costs.
50/30/20 Rule
One way to start saving for your emergency fund is by using the 50/30/20 rule. With this method, you break down your income into 3 categories. Half of your income should be reserved for needs, like housing, transportation, and groceries. Next, 30% of your income is reserved for wants, like entertainment and dining out. This is referred to as disposable income. The final 20% should be reserved for debt payments and savings. A good way to start using this budgeting method is to first write out all recurring necessary expenses, like bills and rent, to determine what must be covered in the “needs” category. You can do this by going through your credit card bill or bank statements and making spread sheet or using an app like Mint to track your spending.
Needs should be expenses that you absolutely must have in your budget no matter what. Housing costs, health care, utilities, and minimum payments on existing debt are all essential expenses that fall into the needs category. Minimum payments on debts are considered a “need” because not making those minimums will have a negative impact on your credit score.
Your wants category is made up of expenses you choose to have, but are not necessary to living your life. Things like memberships, subscriptions, entertainment, dining out, and alcohol are all considered wants. If you are hoping to pay off debt or save faster, reducing your wants category to lower than 30% will allow you to allocate more funds towards the savings category.
Your last category is reserved for saving or paying off debt faster. By prioritizing your 20% category for building your emergency fund, you can have a safety net built up for emergencies. Once you have your emergency fund established, you can direct the 20% category to paying off debt and other types of saving. Depending on your goals and income, it may make sense to reduce your “wants” category slightly in favor of more savings.
Paying Yourself First
Another way to prioritize saving if this is something that has proven difficult for you in the past is by paying yourself first. Also called reverse budgeting, paying yourself first looks like directing a portion of your direct deposit paycheck directly into your savings account, rather than transferring what is left over at the end of the month into your savings. For example, you can start by saving $100 of each paycheck. That means you “pay yourself first” before doing anything else with your money. Deposit that $100 into a savings account before paying bills, getting groceries, or buying that new toy for your kids. Starting with even a small amount from every paycheck will have you well on the way to savings.
If you’re looking to get the most out of your savings account, consider a high yield account. A high yield savings account is a savings account where you can deposit money and generally earn more interest as you save than you would with a traditional checking account. High yield savings accounts are a good place to save money free of the withdrawal limitations you might find with a retirement or other type of savings account. High yield accounts can be a good place for your emergency fund, and have the added benefit of being a separate account you won’t see as often and be tempted to withdraw from.
Pay off your highest interest debt first
If you are torn between saving and paying off debt, it is important to know the different kinds of debt you have. Once you have your savings established,you should prioritize paying off debt with the highest interest rates. Debts with high interest rates are considered the most toxic and therefore the highest priority. Toxic debt can include high interest credit cards, payday loans, and car title loans. Make paying off high interest debt a priority when your emergency fund is established and comfortably allows for it.
High interest debt should be tackled first because the high rates can quickly eat up your budget and create more debt. High interest debt is harder to pay off because the interest increases substantially each month. If you are only making the minimum monthly payment on this type of debt, you will likely just pay the interest you owe. The longer high interest debt is left unpaid, the more it will end up costing you. Focusing on eliminating these sources of debt first will help you stick to your budgeting and savings goals, and will keep you out of the debt cycle. The last thing anyone wants is to accidentally fall into the cycle of debt while trying to pay off their debt.
Methods to Pay Off Debt
One way to help you tackle paying off your debt is by using a debt calculator. A debt calculator, like this one from Credit Karma, will show you how long it will take to pay off your debt with your current payments, and will also allow you to see how it could be sped up by making higher payments, or by starting payments if you haven't yet.
One method commonly used to pay off debt with high interest rates is called a debt avalanche. With a debt avalanche, you rank all of your outstanding debts by interest rate, and start by paying off the highest interest debt first. With this method, you may be tackling your hardest debts first, but this can help save you money in the long run through interest. You may have also heard of a method called a debt snowball. With the snowball method, you tackle your “easiest” debts first. Some people find that crossing off smaller debts keeps them motivated to continue paying off their debt. Because you are not prioritizing high interest debt first with the snowball method, it can be more costly if your interest rates creep up.
Debt Relief Options
With all of this said, it is also important to know when you might need help. If you are still struggling to make the minimum payments on your debts and don’t see the possibility of paying it off within 5 years, or if your total debt is greater than half of your gross income, you may be eligible for debt relief.
There are different debt management options, including debt management plans from non-profit credit organizations, or Chapter 7 bankruptcy. It is important to thoroughly understand every aspect of debt relief and if it is right for you, as debt relief plans can sometimes worsen the situation. Because it requires you to stop making payments on your bills and because you won’t be paying your debts in full, debt settlement will severely damage your credit rating. It may take up to seven years for you to restore enough credit to apply for credit cards, loans, rental agreements, and mortgages.
Once you have your high interest debt under control and an emergency fund saved, you can begin to reprioritize and balance your debt and savings budget. All other debts should have a repayment plan, and savings should be focused towards retirement accounts and rainy day funds.
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Download nowNext step: Plan your repayment for your remaining lower interest debts
While high interest debt should be tackled first, other forms of lower interest debt should not be forgotten. Student loans, auto loans, and credit cards also need a repayment plan and should be worked into your budget as well.
If you have outstanding federal student loans, you may be eligible for income-based repayment plans or public service loan forgiveness plans. When tackling your remaining outstanding debts, it is always a good idea to contact your borrower to understand all of your repayment options.
You can utilize a debt calculator to determine how much you need to allocate to repayment, as well as how long it will take to pay off these debts. With high interest debt under control, you may consider adjusting your 20% savings category, or try a new tactic like a debt snowball to help you meet your financial goals faster. Ensure that your payments are manageable enough to allow you to stay within your budget while still saving.
Start saving for rainy days and retirement
When your debts are manageable and you have substantial savings, the next focus should be on saving towards retirement. If you have a 401K through your job, see if your employer offers a match or contribution. A 401K match is money your employer contributes to your 401K account, either wholly or partially. Some employers offer a dollar for dollar match, while others contribute a partial amount. Many employers will match at least partially, up to a threshold. Take advantage of any employer matches and contributions as it is essentially free money in your retirement account. Starting with a small retirement contribution that can be increased over time will help you balance your savings and be prepared early for your retirement.
If your employer does not offer a retirement savings account like a 401K, there are other options such as an individual retirement account. There are different types of individual retirement accounts, such as a Roth IRA, or traditional. Explore each option to see which is right for you, and what you are eligible for.
Don’t forget about the rainy days!
A rainy day fund is savings set aside for expenses that fall outside of your regular spending, but are not significant enough to be considered emergency expenses. Rainy day funds are usually intended to pay for a one-time, smaller expenditure. For example, paying for summer camp or braces for your child, or replacing a broken window in your home, or other short-term, unexpected costs. Having a small rainy day fund saved can help keep you from taking on any unnecessary debt by, say, throwing it on your credit card. A $300 car repair might not seem like much, but if you don’t have savings to cover it, this cost could easily wreck your budget. Having both an emergency fund and a rainy day fund saved will keep you out of the cycle of debt, and allow you to manage your debt repayments easily.
Deciding if you should pay off debt or save can seem like an impossible task. By first focusing on saving an emergency fund, you can set yourself up for success and avoid falling further into debt should an unexpected expense occur. Once you have established an emergency fund, start with your highest interest debt first. High interest debt is the most expensive, and should be paid off as soon as possible. After high interest debt has become manageable, it is crucial to have a repayment plan for all other debts, such as auto loans and student loans. Getting your debt under control while maintaining an emergency fund will allow you to begin more balanced saving over time, with contributions to retirement and rainy day funds.
Sources:
https://www.investopedia.com/ask/answers/022916/what-502030-budget-rule.asp
https://www.investopedia.com/ask/answers/12/pay-yourself.asp
https://www.thebalance.com/how-to-pay-off-high-interest-rate-debts-960842
https://www.creditkarma.com/calculators/debtrepayment
https://www.citi.com/credit-cards/debt-management/how-to-pay-off-debt-with-debt-avalanche
https://www.consumercredit.com/is-debt-settlement-a-good-idea/
https://www.fidelity.com/viewpoints/personal-finance/how-to-pay-off-debt
https://www.forbes.com/advisor/retirement/what-is-401k-match/
https://www.irs.gov/retirement-plans/roth-iras https://www.thebalance.com/do-you-need-a-rainy-day-fund-and-an-emergency-fund-4178821
