Most basic financial decisions really come down to common sense, but sometimes common sense is not always the correct path to take. When it comes to saving money vs. paying off debt, the right answer might not be the one you assume.
Think about the following hypothetical situation: You have $50 in your savings account, which is earning one-half of 1 percent in interest, and a credit card with a $2,000 balance on which you are being charged 15 percent interest. You have just received an unexpected windfall of $1,500 from your tax refund. What will you do with that $1,500?
Common sense doesn’t always work
Common sense dictates that it would make better financial sense to take that $1,500 and pay it towards your debt because your credit card is charging you a higher interest rate than what you are earning in your savings account.
But here is the problem: after you’ve paid down your debt, you still only have $50 in savings. When you’re faced with an unexpected expense, such as a transmission that’s gone out or a refrigerator that’s broken down, you have to use your credit card to pay it—and you’re back where you started. Unless you build your savings, you will always depend on credit.
The only cure for debt is savings
Debt is a disease that destroys the financial health of many individuals, including yours truly. I wasn’t able to really put a dent in my debt until I was able to build my savings. I had a spending issue because I always spent more than I earned. Once I forced myself to save money by allocating part of each paycheck to savings, I had no choice but to start spending less because I had less money to spend. I was motivated to stay on track when I started to see my savings account grow.
Should I pay off debt or save money? The answer is yes—do both
I believe if your goal is to get out of debt once and for all, you need to build your savings while you are paying down debt. Once you have $1,000 in savings, then you can decide to start putting more money towards your debt and less in savings. However you decide to allocate your money, the most important point is that you need to actually do something. Don’t be like most people who wonder why their money situation never improves.
Whether you choose to build your savings first or pay off your debt first, doing one is always better than doing neither.
So what do I think about the hypothetical situation? I would take the $1,500 and put $1,000 in my savings and $500 toward my debt. It might not make common sense, but I know the only cure for debt is to have savings.
Steve Repak is a CERTIFIED FINANCIAL PLANNER™ professional, CFP® Board Ambassador, and financial literacy speaker. He is also an Army veteran and the author of Dollars & Uncommon Sense: Basic Training For Your Money. Follow him on Twitter: @SteveRepak
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