Save Money or Pay Off Debt?
ByIf you’ve followed along, you know that I strongly advocate entrepreneurship as a means to generate extra income and remove yourself from the “credit grid.” As you begin to accumulate extra funds, though, there is an inevitable question:
Do I save extra money or use it to pay down debt?
The question is not as simple as it sounds. I’ve talked to hundreds of folks who decide to sock the extra money into savings, figuring that they can use the money in case of extra expenses or layoffs. And on the surface, that’s not a bad idea. A financial cushion certainly helps keep you from having to depend on credit… and if your credit score is already mediocre (or worse), staying away from credit can save you thousands of dollars in interest (not to mention untold headaches).
The fact remains, though, is that your debt is costing you far more than you’ll gain in the interest your savings account generates. Some savings accounts, like those offered by ING Direct, offer up to 1.5% interest. Not bad, but far from the double-digit interest (not to mention late charges, over-limit fees and other “gotchas” charged by creditors).
For this reason, you’re effectively paying yourself by paying down your debt…. especially if you’re late on your payments or over your credit limit.
Now, does this mean you shouldn’t keep anything in savings? Of course not! Running with an empty savings account is just asking for financial disaster. When the car breaks down, the tuition bill is due or the furnace craps out, you’ll have to turn to credit (or worse, one of those nasty payday advance places. Neither option is going to help you get off the credit grid.
So which is it, Mike?
A combination of saving money back and using it to pay down debt worked well for me. Every situation is different, of course… but a rule of thumb is to figure out how much of your extra income (added to amounts you’re already paying out of your regular salary or wages) will pay off your debt in 24 to 60 months (two to five years). Two years is better, of course, but it’s not always practical.
Let’s say you’re bringing in an extra $300 a month from freelancing, websites, whatever. Now let’s say you can pay off your debt in five years by paying an extra $100 per month. Paying an extra $100 to your creditors and saving the other $200 per month helps solve both problems – it reduces your debt and gives you a financial cushion.
A couple of things to ask, though:
1) How much do you need in savings? It depends on who you ask. Six months of living expenses seems to work for a lot of people. I’d personally be more comfortable with 12 months. Whatever you choose, once you reach that goal you can decide whether you use all of your extra income to pay down debt, instead of just using a portion of that income.
2) What if your extra income increases? Let’s say that six months from now, you’re bringing in an extra $600 a month instead of $300. (This can easily happen if you’re running an online business.) There’s some merit to the idea of keeping your savings payments the same and increasing your debt payments. There’s also merit to building savings more quickly.
