One of the top questions I get asked by clients, friends or family is, “should I pay off debts or save money for a specific goal”.
This seems like a simple question but in reality, it requires a fair amount of analysis to determine the best option. I’ll work though a couple scenarios to give you an idea of the different considerations one should make when faced with this decision.
Scenario 1: Pay off Student Loan vs. Fund Retirement:
Imagine you’ve done a great job understanding your monthly budget and you have an extra $250 per month to apply to improving your financial situation. The first item to check is the interest rate you are paying on your student loan(s). I typically look at any rate that is 6% or below as reasonable when comparing it to an investment plan. Historically a balanced investment portfolio (60% stock/40% bond) has performed in that range or above.
Next, I confirm you are receiving a full company match in your employer sponsored retirement plan. If you are not funding enough to receive the full match it could turn your $250 per month savings into as much as $500 per month once the match is added in. That is an instant 100% gain on your investment that makes it a pretty easy decision. If you are already receiving the full company match you won’t get the instant return on investment, but it still may sense to additionally fund your retirement.
In addition to the pure financial part of the analysis, you should add in the psychological element when considering this strategy. Let’s imagine you have a $3,000 loan. At $250 per month you would pay the loan off in roughly 1 year. That can be such a huge psychological win that it can trump the financial benefits I’ve mentioned above.
Scenario 2: Pay Off High Interest Credit Card Debt Or Save:
It’s not uncommon to find someone who is carrying a higher balance on their credit cards than they can manage to pay off through their monthly budget. When this happens, it doesn’t take much for the situation to get worse due to the accumulation of interest and/or the lack of savings to pay off the balance. In this situation the person is usually paying over 10% in interest to the credit card company.
Because of that I believe it makes more sense to pay off the debt. This may require you to lower or stop funding to your investment accounts until that debt is paid off. I highly recommend you spend some time analyzing your monthly spending to either find other options to redirect funds to the debt payment or to find inefficiencies in your spending. I’ve linked an article with some helpful tips. If finding “extra” cashflow isn’t possible because you are only spending your income on essentials, you need to get creative.
You can start by calling your credit card company to request they lower your interest rate. That will allow more of your monthly payment to pay down the debt and less to the interest charge. If the credit card company doesn’t offer to lower your rate you can look for balance transfer offers. They typically give you a window of time, such as 12 months, to pay off your debt at 0% interest. You need to understand, however, there are fees to transfer into these cards as well as deferred interest that can add up if you don’t pay off the balance by the end of the “free” period. With some discipline this can be a great way to pay down the debt, however.
Debt Happens, Life Happens:
In a perfect world, you will not have to deal with the stresses of extra debt, but we all know life happens. You may experience an unexpected lay off, home/car repairs or a healthcare related event and the only way to cover the expense is through taking on debt.
As discussed in my previous article “Five Financial Steps You Must Do When Laid Off”, building up and understanding your liquidity is an important exercise prior to an unexpected expense coming about. Being proactive to protect yourself against the unknown is very important because we will all face an event we didn’t expect.
In both scenarios, I highly recommend you work with your financial planner or find one to assist you. You want to make sure all information is considered when comparing the pros and cons of this decision.
As a reminder, make sure you consider items such as:
- Interest rates of your debt
- Expected rate of return for your investment portfolio
- Company Match
- Monthly budget
- Your age
- Years until retirement, college
Good luck with your saving and budgeting! Sometimes life can challenge us in these areas.
Here is a calculator that helps you analyze which decision may be best for your situation.
Here is a link to an article with some ideas that may allow you to save more money.
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