Personal Finance
June 20, 2016

Saving vs. Debt Reduction: Which Is Better?

Simple. Thrifty. Living.

You may have heard that it’s important to have money in savings to cover emergencies, give you the income you need to retire or help you achieve financial goals that are currently out of your reach. If you owe a lot of debt, however, you may wonder whether it’s worth it to save anything until you are finished paying down your debt. There are several factors you should take into account when trying to decide whether to save or reduce your debt.

Everybody should have at least a minimum of $500 to $1,000 in savings for emergencies. Otherwise, if your car breaks down or you need a new air conditioner during a heat wave you might end up with a serious financial problem. So if you don’t have any savings at all, you need to correct that regardless of your debt status. After all, if you end up charging emergency purchases that could have been covered by savings, it defeats your debt reduction plan.

In addition to that, you need to consider the terms of your savings account. Some banks charge a monthly fee if you don’t keep a minimum balance or don’t deposit a certain amount each month. If paying your debts means losing your savings to monthly fees, it may make more financial sense to slow down your debt reduction in favor of saving more. An online savings account like Discover Bank usually doesn’t have monthly fees and has no minimum balance, so it might be a good option to check out.

If you have student loan or mortgage debt, it doesn’t make sense to sacrifice your savings in order to pay extra on these debts. Since these loans have pre-calculated interest that is added to your debt, you pay the same amount of interest on these debts whether you pay them off more quickly or less quickly, so you don’t save any money by pre-paying them.

Some debts, however, such as credit card debt, come with high interest rates that can lead to you paying double or triple the original loan amount if you don’t pay promptly. If you have a high balance on a high-interest credit card, it makes sense to get rid of it before worrying about putting a lot of money into savings.

Not only do you need to take the interest on your debts into account, but you also need to take the earned interest on your savings into account. Savings account interest rates are generally very low — most banks pay less than 1% in interest on saved money. Thus, you won’t get a big return on your investment when you put money in savings.

However, there are some accounts that do pay out larger interest rates, such as money market accounts. It might be a good idea to look into your options before deciding on which savings account to sign up for.

There’s no question that both savings and debt reduction are important to your financial health. When considering how much to do of each, consider all relevant factors so you can figure out what will help you maximize your financial potential.

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