Essentials: Save Money or Pay Off Debt?
When you are in debt, it can feel like your only priority should be to pay it off. The monthly payments are stacking up, the interest is accumulating and the burden of owing money to someone else can make you feel like all of your other financial goals have to be put on hold. However, in this post, we are going to talk about why it is so important to work toward your other goals at the same time as paying off your debt.
There will always be something else
Our inner dialogue about our money can sometimes be deceiving. It can sound something like this: “I know I need to start saving, but I just need to get this debt paid off first.” Or, “If I just pay this off, I will have the money to save.” The problem with this, is it doesn’t allow for any uncertainty in the future. We seem to always be faced with big expenses that come up. If we don’t have adequate savings, these big expenses can push us further into debt.
Waiting can cost a lot of money
When we carry debt, we are losing money to interest that is being charged. However, if we wait to save our money, we are losing money on interest that could be earned. This is because of two important financial principles, the time value of money and compound interest.
The time value of money means that your money is worth more today than it is in the future because of its potential to earn interest. Stated another way, if you save $1 today, that dollar is worth more that if you save $1 in a year from now. Depending on the interest rate, you would have to save more than $1 a year from now to create the same value.
Consider the image below that shows the results of 3 investors. You can see that waiting to invest has a huge impact on the bottom line. Investor B waited 9 years longer than investor A but invests for a much longer time. In the end, investor B never catches up with investor A.
Image source 1
Starting early is important because it gives you more time to take advantage of compound interest. Compound interest is the concept that you earn interest on your interest. Consider the image below that shows that as your interest compounds eventually you will be earning more in interest than your contributions if you kept your savings contributions level.
Image source 2
How to make it work
It makes sense to start saving for your goals as soon as possible, but it can still be difficult to figure out how to save and pay off your debts at the same time. Here are some recommendations about how to structure your process:
1. Pay the minimum required payments until you have an emergency fund. I recommend sticking with this until you have 1 month of expenses in liquid savings that you can fall back on if there is a major need.
2. Automate a minimum amount into savings. Set up automatic regular contributions to a savings or investment account to make sure you are paying yourself first.
3. Start with high-interest consumer debt. It is a valid goal to pay off all of your debt. However, if you have a low rate on your mortgage or car loan (below 3%), you may be ok just making the regular payments on these debts and using extra money to invest. If you have high-interest debt like credit cards or personal loans, make those a priority by making extra payments to get them paid off fast.
Remember, we tend to spend money that we haven’t saved, so make sure to set up a process, automate it, and prioritize your important financial goals. It is ok to work on more than one goal at the same time and it can be really satisfying to see your net worth grow as your assets accumulate and your debt shrinks.
Need to discuss your specific situation? Schedule a session today today to talk with us.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.
1 Putnam Investments: Invest early and put time on your side. 2/2021