Pay off Debt or Save: How Do YOU Decide?
Confused about whether you should pay off debt or save the spare cash left over at the end of the month? Today let us talk about the factors that will help you decide.
Things have been going well for you. You have budgeted for your monthly expenses. Your budget factors in your rent (or mortgage) to have a roof on your head, groceries, food, gas, and electricity. You have paid off the minimum amounts due on all your debts. After all these, you have got money left over at the end of every month.
You are in luck, except you don’t know where to put in those extra dollars? It sounds like a complex terrifying decision to make, but it need not be so. In this article, we will examine the different factors and break them down to make them easy to understand and simple to calculate.
Here is your ultimate guide to help you decide whether to pay off debt or save and invest.
But before we start, I gotta add in the disclaimer:
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The Basic Pay Off Debt or Save Math
If you have $1000 of debt on your credit card(s) at 18% and $1000 in savings account at 2%, the math is quite simple. You pay $180 as interest each year while the interest you earn is $20. Clearly taking that money and paying off your debt is saving you $160 every year.
But personal finance decisions are rarely so simple. There are other factors that you need to consider in order to decide whether to use that spare change in your monthly budget to save/invest or to pay off debt.
What if you have a low-cost debt?
This one is easy. The calculation remains the same. Only the result is in favor of investments. If you have taken a no-interest car loan, have a subsidized loan from your employer then you might be better off putting your free cash flow towards investments.
What about tax?
Here is where things start becoming a little more involved. I get it. So let us take these one-by-one.
The interest earned on your savings account:
This is taxable income. In simple words, you have to pay tax on this at your effective tax rate. After paying tax, what you actually earn from your saving account is in fact even less than $20. This makes paying off your debt even more attractive.
If you have mortgage debt:
Interest paid on a mortgage is tax deductible under certain circumstances. But the process to avail the deduction is complex.So, in reality, you may not avail this benefit.
Also remember that the Tax Cuts and Jobs Act, which was passed in 2017, increased the standard deduction amounts (for single filers and for those who are married filing jointly) making it a far more attractive option. (When households file their individual income taxes they have two options for deductions. They can either claim the standard deduction or forgo it and deduct a wide range of expenses, including mortgage interest payments, through a more complex itemized process.)
For all practical purposes, the likelihood of your claiming a tax deduction on the interest paid on your mortgage is pretty remote and unlikely to be a factor that will tilt the decision.
What about penalties for prepayment?
If you are locked into a debt which incurs a penalty for prepaying an amount then it will make sense to collect your cash in a savings account for a period of time. Once you have a sufficient amount collected that makes the prepayment penalty insignificant, go ahead and prepay. In these cases, make a few bulk prepayments rather than every month.
What about long-term investments?
Not all savings are equal. If you choose to invest your savings in a Roth IRA for long-term goals like retirement then your decision between aggressively paying off debt or saving will be different.
The long-term average historical return for stock markets is roughly 7%. The S&P 500 has given an average annual return of around 10% in the 90-years since its inception in 1928. After adjusting for inflation, the historical average annual return is around 7%.
How about the cost of long-term debt? In March 2018, the average U.S. mortgage rate for a 30-year fixed loan was 4.38%.
Clearly if you are one of the lucky ones to have a loan at an attractive rate, you are better off investing. What you will save on your debt is lower than what you are likely to earn on your investments in the long term. So your strategy should be to just pay your minimum mortgage payments each month and invest your monthly surplus cash for the long-term.
When No Math is Needed
There are some scenarios where you don’t need to do any math.
Reach Your Emergency Fund Target
If you do not have an emergency fund with $1000 – $2000 then stop doing everything else. Setting up and funding an emergency fund takes priority over paying extra to even the highest cost debt. Because emergencies do occur, inevitably. And if you don’t have you will end up incurring more debt (often at even higher costs).
Ideally you want to have 3-6 months of expenses covered in your savings fund. However, if you have high-cost debt, $1000-$2000 should be sufficient to start off. You can gradually build it up to cover about 6-months of expenses. How you build it up will depend upon considerations such as:
- The stability of your job. How secure do you feel about your job? Is it an industry that is hiring currently or are lay-offs common? Is your income steady or does it vary from month-to-month?
- Your family. Do you have a partner who is working? How secure is your partner’s job? Are there children who are dependent on you?
- If you are living within your means and happy about it. Living a bare minimum subsistence live in order to build your emergency fund is not practical beyond a couple of months. You may be fine doing so for a month or two. Soon the reality of your implausible life will catch up with you. On the other hand, do you live an inflated lifestyle that is beyond your means? Then think of ways you can reduce expenses to first build up your emergency fund to 3-6 months of expenses.
- How healthy are you and your family? If you rarely need to go to the doctor or an emergency room, if you have no known medical problems, a smaller emergency fund might work for you to begin with.
- How stable is the economy? Can you find a job quickly if required?
The answers to these questions will help you decide the amount you should have in your emergency fund to provide you with a safety blanket. Once you have that amount stashed away in a savings account, you can start doing the math of the interest rates.
Are you getting the maximum match from your employer in your 401(K)?
If you are working, have access to a 401(K), and your employer matches your contributions, you may prioritize investing at least enough to avail the full match amount. This could take priority even over paying extra towards your high-debt.
Your Personal Preference
Do the math to see whether it makes financial sense to save from retiring your debt or earn from savings or investments. However, the numerical choice may not always match your preference. In such cases, look for ways to change your mindset. If it makes sense to invest but you are keen to become debt-free, set a target on a certain amount of debt you will pay off after which you will make investments a priority.
Deciding whether to pay off debt or save? Here’s how you make a decision that is best for you:
You must always pay off the minimum amounts on all your debts first. These considerations come into play only after that.
Calculate the interest you pay on your debt each year and what you earn on your savings. This is the starting point.
Tax on your interest earned makes it more attractive to pay off debt first.
For most people, claiming a tax deduction on interest on mortgage payments is an unlikely scenario.
Long-term investments or low-cost debts could tilt the balance and affect your decisions.
Be mindful of prepayment penalties
If you do not have any savings in an emergency fund, get that going first.
Next, invest in your 401(K) to avail maximum match from your employer.
It does not have to be an all-or-nothing scenario. You can set your own financial goals that take care of your personal preferences and the decisions that make greater financial sense.
Finally, saving, investing, and paying extra to pay off debt are all better uses of your money than purchases that won’t increase your net worth over the long run.
What are you saving for? A home down payment, retirement, college, family vacation, wedding, home improvement, a big purchase or invest to further your career goals?
Image from Pixabay.