Should you pay down debt or build up savings? The answer might not be obvious: while everyone wants to get rid of their debt as fast as possible, setting aside money for emergencies and retirement is also important. The decision isn’t always clear-cut, but it’s easier to make a plan once you have the facts.
Good and Bad Debt
Most people have debt. Few people can afford a car, college or a home without taking out loans, but some types of debt are better than others.
Good debt. Home and student loans are considered “good debt.” A house will hopefully gain value in the long run, and student loans allow you to continue your education and hopefully qualify for a higher-paying job. The long-term benefits of good debt usually outweigh the short-term costs. These loans typically carry lower interest rates than bad debt, and the interest paid is often tax-deductible.
Bad debt. With bad debt, there’s no hope of the purchases gaining value, interest rates are high and interest payments aren’t tax deductible. Many material goods, such as a new outfit or a car, lose value over time. Don’t feel bad about buying them — everyone needs essentials like clothes and transportation — but using a credit card or taking out a loan to pay for them creates bad debt.
Don’t Neglect Savings
Putting all your resources toward paying off debt may seem to be the best choice. However, if your car suddenly breaks down or you lose your job, you’ll need money to fall back on. Without it, turning to credit cards or loans to make ends meet just adds to your debt. That’s why it’s important to start an extra savings account specifically for emergencies (known as an emergency fund) in addition to paying down debt.
If you haven’t already done so, then it’s time to create a budget. Dedicate part of your income, rather than just the leftovers, to pay off bad debt and build an emergency fund.
• An emergency fund should be able to cover three to six months of living expenses, which seems unattainable while trying to pay down debt. Simply put a set amount of money in this account every month until you reach your target.
• At the same time, pay off bad debt, beginning with the debt with the highest interest rate.
The decision to pay down debt or save money should be based on the types of debt, the amounts owed and the size of your emergency fund. If you take the time to make these big decisions, your financial future will be more secure.