Dilemma: Pay down debt or save?

savings vs. debt reduction

Savings vs. debt reduction: a balancing act to growing healthy fiannces. Image: Alan Cleaver/Flickr/CC BY

Saving and paying down debt are two of the most important goals of personal money management. However, it can be a tricky balancing act to determine which takes precedence at any given time.

Retirement with no debt

Standard wisdom says that, most of the time, paying down debt is more important than accumulating savings, since the debt probably is charging more interest than you are making off of your savings. But life is not always that cut and dried.

Ideally, we all want to retire with lots of savings and no debt. But paying down all your debt while you are young may eat into retirement savings. If a hardship should fall, such as the loss of an income, you will have no way to live except with credit cards, making that debt quickly unmanageable.

But starting to accumulate retirement savings too late is a mistake, too. By starting early, you have the benefit of a growing nest egg with compounding interest.

Build emergency fund

One solution is to build an emergency fund as a cushion before attacking the debt in a big way — ideally six months to a year’s income worth. That takes time to accumulate, however. If you have a limited income as well as a sizable debt, personal finance expert LaToya Irby recommends putting $1,000 in a savings account right away to handle small emergencies, then build that nest egg while chipping away at your debt.

Four general rules

Another personal fiance guru, Farnoosh Torabi, offers these four guidelines in negotiation the tricky balancing act between savings and debt reduction:

1) Don’t just pay minimum balances on your credit cards. You will be in debt virtually forever if you do.

2) Torabi suggests padding your debt reduction budget with half of any unexpected income, such as Christmas bonuses or gifts. I would go a step further and say put the extra half in savings and pass on the new shoes.

3) Torabi suggests putting five percent of all income into the retirement fund. If you have a 401(K) program at work with matching funds from your employer, take advantage of that, too. That is free money toward your future.

4) Torabi’s last piece of advice is the most important. Live within your means. That takes some personal honesty about your financial situation and, at times, restraint.

A balancing act

These are general guidelines and everybody’s situation is different. If your debts are low-interest student loans, it might be possible to find a savings account that pays you more. In that case, leaning a little more on the side of debt reduction may be wise. The trick it to be brutally honest about your own situation, balance your options, and make smart choices.

Sources

About.com
CBS 
US News 

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