Debt can affect anyone—not just those who overspend but also people who budget carefully. Sometimes, an unexpected event like a job loss or medical emergency forces us into debt despite our best efforts to stay financially sound. The key is to understand your financial position and create a plan that works for you.
Deciding whether to pay off debt or save first depends on your unique circumstances. Here are three essential questions to guide you toward the best decision.
1. What’s Your Current Financial Status?
Before you determine whether to save, pay off debt, or both, assess where you stand financially. Calculate your income, regular expenses, savings, and current debts, including balances and due dates. Take note of any minimum payments and which debts have higher interest rates.
Laying out your finances helps you make an informed decision based on your personal situation. This step is crucial for creating a balanced approach to handling your debts and building savings.
2. Do You Have an Emergency Fund?
An emergency fund is critical for financial stability. Life’s unexpected events—like a sudden illness or loss of income—can quickly drain your resources, pushing you further into debt. Setting aside a dedicated emergency fund protects you from such situations.
The amount to save varies depending on your income stability. If you have a steady job with strong support systems, 3 to 6 months’ worth of essential living expenses (groceries, transport, insurance, housing) may suffice. However, if you’re a freelancer or gig worker with an unpredictable income, it’s wise to save at least 12 months’ worth of expenses.
The important thing is to store this fund in an easily accessible account with a decent interest rate, so it’s ready when you need it most.
3. What Kind of Debt Are You Carrying?
Not all debt is the same, and understanding the nature of your debt is crucial. Secured loans—such as mortgages, student loans, or car loans—typically have lower interest rates and are less urgent to pay off. Unsecured debts like credit card balances or personal loans, on the other hand, often carry high-interest rates and can quickly spiral out of control.
Prioritize paying off high-interest unsecured debts. Credit card debt, for example, can accrue interest at alarming rates. Missing payments can hurt your credit score and lead to penalties. It’s smart to consolidate or pay off such debts as quickly as possible to avoid more significant financial issues.
Example: If you’re earning 2-4% on a savings account but paying 20% or more in interest on a credit card balance, it makes more sense to prioritize paying down that debt. Holding on to high-interest debt while saving will end up costing you in the long run.
When Should You Focus on Paying Off Debt First?
If your debt is accumulating faster than you can save due to high interest rates, it’s wise to prioritize paying it off. A good metric to track this is your Total Debt Service Ratio (TDSR). This ratio measures how much of your income goes toward servicing debt. A TDSR of 45% or more is considered excessive and indicates that paying off debt should be a top priority.
To calculate your TDSR:
- Add up all annual debt payments (property loans, credit card bills, personal loans, etc.).
- Divide this by your annual gross income.
If your TDSR is high, especially with unsecured debts, it’s time to focus on paying those down first. Arrange your debts from the highest interest rate to the lowest and start tackling the most costly ones. Avoid only making minimum payments, as this will barely touch the principal amount, leading to more interest accumulating.
Can You Save and Pay Off Debt Simultaneously?
Balancing debt repayment with saving is possible, especially if your income is stable or rising. For example, if you have smaller loan balances or stable disposable income, doing both could be a practical approach.
However, it’s essential to ensure that saving doesn’t come at the expense of paying off costly debt. Reducing unnecessary expenses—like cutting down on subscription services or dining out—can free up more money to allocate toward both goals.
How to Strike a Balance
Navigating the delicate balance between saving and paying off debt is no easy task, but it can be managed with the right approach. Start by understanding your finances and addressing high-interest debts while setting aside an emergency fund.
Use the three key questions outlined here to evaluate your situation and create a strategy that works for you. The goal is not just to clear your debts but to build long-term financial resilience.
Next time you face this financial dilemma, use these insights to create a plan that meets your unique needs—empowering you to save, pay off debts, and achieve financial wellness all at once.