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When you get a little extra cash, it can be difficult to determine whether you should use it to pay down your burdensome debt or save it for your future. While different circumstances require different responses, here are a few common situations to illustrate the best choice.
If you’ve been living paycheck to paycheck for a while, any extra cash should be placed in a rainy-day fund. Your car could break down, your roof could spring a leak, or any number of expensive events could happen unexpectedly. Having sufficient cash in savings to protect against these eventualities ensures that you can afford to pay down your debt and keep food on the table while still handling a crisis.
If you have debt with a very high interest rate, it’s in your best interest to pay it down as quickly as possible. This is especially true of credit card debt. Assume you have $100,000 in credit card debt with an interest rate of 10 percent per year; you have to pay $10,000 in interest. Now, assume you have $100,000 in savings earning 2 percent a year, or $2,000 in interest. That means you are losing $8,000 a year by carrying debt.
If you don’t own a house, you should start putting money aside for a down payment. While a mortgage on a house increases your debt load, it’s a vital asset that provides much-needed security. Also, the larger your down payment, the greater the equity in your house and the smaller your mortgage and future debt load.
If you are applying for a loan, such as a mortgage, and you have enough for a down payment, then you should pay down your debt. When applying for a loan, your debt-to-income ratio plays a very important role. By paying down your debt load, you improve your chance of getting the amount you need, and you can obtain better mortgage terms.