Saving vs. Paying Off Debt: Which Deserves Your Money?
By David Dierking
Dollars are an especially precious thing nowadays. Everybody’s looking to hang on to what they have. If you’re one of those people who are lucky enough to have a little of it leftover at the end of the month, you want to make sure that you do the right thing with it. Folks who are carrying debt – whether it’s on a credit card, student loan or even a mortgage – have an especially important choice to make. Should those precious extra dollars be stuffed away in a savings account or be used to pay down that outstanding debt?
The answer not surprisingly can be a little complicated. There are a number of things that need to factor into your decision such as the type of debt you hold, the rate you’re paying on the debt, your tax rate and the rate you can expect to earn if you save the money.
Considering saving your money vs. paying off credit card debt, the choice is pretty straightforward. If you put your money in an S&P 500 index fund, you would have earned about 10% a year historically (although earning that going forward from here is far from a sure thing). Put it in something more conservative and you can expect to earn less. Outstanding credit card can carry a rate of 20% to 30% or more. Addressing that credit card debt can save you 30% on every dollar you pay off and that’s going to be far better than anything you might earn on it.
When it concerns saving vs. paying off student loan debt or a mortgage, it gets a little trickier because the trade-off is much less one sided. Here is where you really need to weigh the pros and cons for both sides.
As a general rule, you could look at which side has a more favorable rate as the one that deserves your money. For example, if your student loan has a rate of 5% and you could earn 7% by saving your money, you’d want to choose to save it instead of paying off the student loan. If the loan carries a higher rate than the rate you’d receive by investing, you should pay off the loan first.
Mortgage debt should be assessed a little differently. Some people will refer to mortgage debt as “good debt”. That’s because the interest paid on a mortgage is tax deductible and that’s something else you need to weigh. If you have a mortgage with a 6% interest rate and you’re in the 28% tax bracket, the interest rate you’re essentially paying on your mortgage is 4.32%. In a lot of cases, if you’re investing long-term you can earn more than 4.5% so often times you’ll come out ahead saving your money instead of paying down the mortgage.
But if the savings vehicle you’re looking to put your money in is a 401(k), make sure you’re doing one thing first and foremost – invest enough to get the company match. If your company is still providing a match of 50% on the first 6% of salary that you invest, make sure you get it. That’s a guaranteed 50% return on your money that makes sense getting over anything but the most extreme of credit card rates.
Let’s give credit where it’s due though. If you have extra money and you’re looking to use it to pay down debt or save it, you’re on the right track either way. Understanding which spot may make more sense to park your money will help keep even more of it where it needs to be.
In your pockets.
Photo credit: Kenn Wilson
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