Is It Better to Pay Off Debt or Save?

If you have some extra money after covering your essential bills, is it better to pay off debt with it or save it?

Answering this question can be complicated because there's not one right approach. In some cases, it may be better to put every dollar toward paying off debt. But in most situations, the answer isn't so clear-cut, and you may actually want to prioritize saving and investing even if you have outstanding debt.

This guide will help you determine whether you should pay off debt or save so you can make the choice that's most beneficial to your finances in the long run.

Is it better to pay off debt or save?

When you decide if it is better to pay off debt or to save money, there are a few key things to think about.

First, consider the interest rate on your debt. If you have a high interest debt such as payday loans (which can charge interest of around 400% according to the Consumer Financial Protection Bureau), then paying these loans off as soon as possible is likely the highest priority.

On the other hand, if you have a mortgage at 3.00%, paying extra on your mortgage debt likely would not make sense, as even safe investments can earn a higher return. Paying off debt could also help improve your credit score, which allows you to get better rates on financial products.

In many cases, though, you may not want to take an all-or-nothing approach. Instead, you may want to switch back and forth between saving and debt payoff.

Here are a few examples.

If you have credit card debt, that usually comes at a pretty high rate. But you may want to save up a small emergency fund of around $500 or $1,000 before you make extra payments on your card. A small emergency fund would allow you to avoid a situation where you start to pay off your balance and end up having to charge emergency expenses, which could be discouraging.

If you have a 401(k) at work and are offered an employer match, you may want to prioritize retirement investing even if you have debt at a higher rate. Your employer match is free money, and passing it up could cost you because you won't get back the chance to earn that year's matching funds.

If you already have a lot of savings, using some of that money to pay off debt could be a smart move. Most savings accounts pay around 2.00% interest or less. If you have debt at a much higher rate, keeping your money sitting in savings could be costing you much more in extra interest charges.

Ultimately, to decide which approach makes sense, you should think about whether debt payoff or saving will give you a higher return. You should also consider which approach is likely to help you stick to your financial goals.

Considering these types of issues can help you make the choice that's right for your financial situation. Whatever you decide, the steps below can help you to figure out how to pay off debt while still working toward your other financial objectives.

Step 1: Build an emergency fund

In many cases, building an emergency fund to cover unexpected expenses should be your first step before sending extra money to creditors. That way, you will have a financial cushion so you don't start to make progress on debt payoff and then end up just having to borrow money again.

Most financial experts recommend saving up an emergency fund with three to six months’ worth of living expenses. This can give you time to bounce back if you lose your job, for example. However, this one-size-fits-all approach may not make sense in every situation.

As mentioned above, if you have a lot of high-interest debt, it could be smarter to save a small emergency fund with $500 to $1,000, then shift to debt payoff. You can come back to saving for emergencies after you've dealt with your debt. 

Your small amount of savings should cover most routine emergencies, and you won't end up locking up a ton of money at a low interest rate while continuing to rack up interest charges.

On the other hand, if your job is precarious, if it would take you a long time to find another one, if you have health issues, or if there are other circumstances in your life that could make you vulnerable to an income loss or expensive surprise expenses, prioritizing saving more than three to six months of savings before shifting to debt payoff could work best — especially if your debt doesn't have high interest charges.

If you decide to prioritize saving for emergencies, you'll want to build up your savings as fast as possible. Automating transfers from your checking account into a high-yield savings account can help make that happen, so check your budget for expenses to cut and then transfer as much extra cash as you can each month into this account.

Step 2: Contribute to a retirement fund

Saving for retirement is something you may not want to put off until you are debt free — especially if you have access to a 401(k) retirement account with an employer match.

Many companies match part of the contributions you make to your retirement plan. This means they give you free money, but only if you invest first. For example, your employer might match 100% or 50% of your contributions up to a set percentage of your salary, such as 6% of annual earnings. If you made $50,000 and received a 100% match on up to 6% of earnings, you would need to contribute $3,000 annually to max out your match (6% of your pay). Your employer would then give you $3,000.

If you can earn matching contributions, you get a generous return on your investment — as much as a 100% return on your investment if your employer matches contributions on a dollar-for-dollar basis. You also contribute to your 401(k) with pre-tax money, so the government subsidizes these savings as well. A $3,000 contribution could save you as much as $660 on your tax bill if you are in the 22% tax bracket (22% of $3,000). So your contribution wouldn't actually cost you $3,000.

With the tax deduction and employer match combined, you'll likely want to prioritize 401(k) contributions before sending extra money to debt. Investing sooner rather than later also enables you to take advantage of compound growth, which occurs when returns you earn are reinvested and that extra money starts earning returns, too. The more years of compound growth you experience, the more your total balance grows.

Step 3: Pay down debt

Although retirement investing and emergency savings are top priorities, debt payoff is also important — especially if you are being charged a high interest rate. If your interest charges are above the returns you could earn by investing, focusing on debt payoff could be the right choice.

If you're working on paying down your debt, you should make a strategic plan.

Here are a few key steps to take that could help with that.

Decide which debt to pay down first

During the debt payoff process, you'll obviously need to make the required monthly payments on all your credit cards and loans. But after doing that, it's typically smart to send any extra money to one particular lender so you can get that balance paid down ASAP. If you send a little bit extra to multiple creditors instead, it will take you longer to make progress.

Here are two approaches to deciding which debts to prioritize.

The debt snowball

One option is to pay off your lowest balance loans and credit card debt first. This is called the debt snowball. You start making extra payments to the creditor you owe the least to while still making the minimum payments to your other creditors. After that debt is wiped out, you send that extra money to the next lowest balance. Repeat this process until the debt is paid off.

The benefit of this is that quickly paying off your low-balance debts keeps you excited about your efforts. The downside is you could end up paying more interest over time because you won't necessarily focus on your most expensive debts right away.

The debt avalanche

Another option is a debt avalanche. With this option, you pay off your loans and credit cards with the highest interest rates first. Because you'll be dealing with your most expensive debt, this approach will save you more money over time — as long as you stay motivated even if wiping out each debt takes a little longer.

If you feel like you might need the extra motivation that comes with quickly bringing a balance down to $0, the debt snowball makes sense. But if your goal is to pay the least amount of interest, the debt avalanche makes sense.

Debt consolidation

You could also consider debt consolidation. With debt consolidation, you could take out one new personal loan, pay off all your existing balances with the proceeds, and then work on paying that new loan. You'd ideally want the new loan to be at a lower interest rate than the debt you're repaying with it.

A balance transfer would also allow you to consolidate credit card debt and reduce the interest rate — at least temporarily. The best balance transfer cards allow you to transfer your existing debt from one or more credit cards to a new card offering a 0% intro APR.

Although you typically pay an upfront fee of around 3% to 4% of the balance you transfer, lowering your rate so dramatically can make debt payoff cheaper and easier.

Decide how much to pay down each month

Regardless of what debts you're paying off first, you'll want to make extra debt payments above and beyond the minimum payment due if you hope to become debt-free quickly.

Each extra payment you make will reduce the principal so you can reduce your balance faster.

Look carefully at your budget to decide how much extra money is available for debt repayment each month. Consider tracking your spending and looking for opportunities to make cuts temporarily while you work on achieving debt freedom.

Get professional assistance

In some cases, you may feel in over your head and unsure how best to pay off your debt. If that's the case, working with a nonprofit credit counseling agency could help. They’ll typically help you to develop a budget and a debt management plan.

If you truly don't think you have enough money to repay your creditors in a reasonable time, you could also consider debt settlement.

Debt settlement involves a negotiated agreement in which creditors agree to accept a reduced payment and forgive the remainder of your debt. It hurts your credit, especially because creditors usually won't agree if you aren't behind on payments. But it could be the right option if you have high balances relative to your income.

FAQs

Bottom line

Both saving and paying down debt are smart things to do with your money. No matter which order you do them in, you'll end up better off because you're making an effort. Taking a little extra time to decide on your priorities and being strategic when determining how to pay off debt can pay off.

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