When creating a household budget, I often recommend allocating 20% of net income toward savings for the future and debt payoff. However, when both of these items are a goal, I am often faced with the question, which one should we pay first?
When to save before paying off debt:
It is essential to build up an emergency savings fund regardless of how much debt you have accrued. The reason for this is that if emergency cash is needed and you do not have a savings fund to pull from, the only thing to do is to go into further debt. This can become an endless cycle.
I recommend saving enough money to establish one month of net income before allocating additional money beyond minimum payments to your debt payment plan.
When to prioritize debt payments over savings:
If the type of debt that you are carrying is high interest credit cards or consumer loans, it is essential to prioritize debt payoff before saving for long term goals. What is high interest? Consider that a balanced investment portfolio should earn an average annual return of 8%. This is your opportunity cost. Any debt with an APR above 8% should be paid off before investing for the long term.
Follow a process to accomplish both:
I recommend saving and paying off debt at the same time whenever possible. Here is a process to reach both of these goals:
Automate at least 10% of your gross income to saving for retirement. This is most easily done through a company retirement plan like a 401(k). If you don’t have a 401(k), set up automatic contributions into a Roth IRA or Traditional IRA.
Determine short term savings goals. Create a savings target for your emergency fund and other short-term goals like buying a house, etc. I recommend starting with a target of 3 months of net income for emergency funds.
Automate at least 5% of your net income toward your short-term savings goal
Set up a debt payment plan. In order to do this, you need to create a list of debts including the balance, interest rate, and minimum payment required. Total up your minimum payments and set up an automation to make sure they are paid each month.
Allocate additional money toward your paying off your debt
Once a debt is paid off, snowball that payment amount into the next debt. When all high interest debts are paid off, add the full payment amount to your short and long term savings goals.
Using automations to fund savings and pay off debt is a great way to make progress and stick to a plan. Make sure to share your plan with someone who can help with accountability and assist in celebrating your progress.