Is It Better to Pay Off Debt or Save Money? How to Decide

May 09, 2019

Debt is almost inescapable in America where, according to a Pew Charitable Trusts survey, around 80% of households reported they hold some form of debt.[1]

From home mortgages to car loans and credit cards to student debt, there are times when borrowing money is necessary. Few people have the cash to pay for a home or college education. With so many Americans in debt, a major question arises: should you pay off debt or save?

Carrying debt can put a damper on the future, and the statistics about Americans’ futures look bleak lately. A 2017 GOBankingRates survey reported that 57% of American adults have under $1,000 in savings, while 39% have no savings at all.[2] Being in debt isn’t ideal, but obviously neither is having no savings.

If you’re facing the question of whether to save or pay off debt, the answer isn’t a straightforward one. However, there are some good financial lessons you can apply to decide which is more important right now.

Is it Better to Pay off Debt or Save Money? Two Approaches

There are two different approaches to handling whether to pay off debt or save money, but they don’t have to be mutually exclusive.

1. The Mathematical Approach to Debt Versus Savings

The mathematical answer to whether to save money or pay off debt says that you should put your money wherever it will work hardest for you.

If you’re debating whether to pay off some debt or put excess cash into a retirement saving account, look at it this way: If the student loan interest rate is lower than the return rate from the retirement account, pay the minimum on the debt each month and put extra money into the retirement account.

Conversely, if you have high-interest debt that’s costing more than you could make on the returns from investing extra money, you should focus on paying off the debt before saving.

For example, say your only debt is a student loan with a 4% interest rate. If you can reasonably expect a 6% return from your retirement account, the mathematical solution would be to pay the minimum on your student loans and invest the rest. However, if you have a credit card balance with a 19% interest rate, it makes more sense numbers wise to work on paying off the high-interest debt.

If you need help comparing debt to savings, there are online calculators that can help determine which is a better priority for your excess income.

2. The Emotional Approach to Debt Versus Savings

Many people have a negative emotional reaction to being in debt. Therefore, when looking at whether to pay off debt or save, they decide to tackle debt first, even if the numbers don’t necessarily support that decision.

Focusing on paying off what you owe before saving creates greater peace of mind for some. The truth is, money is about far more than budgeting and simple math.

There is a great deal of emotion that impacts our everyday financial decisions. If that wasn’t the case, we’d all spend less than we make, no one would have debt, and there would be no money problems to speak of.

Do you have to choose between paying off debt and saving?

When asking whether to pay off debt or save, is it necessary to choose one or the other? Of course not.

It’s possible to put part of your excess income toward paying down debt and another part of it toward saving for your future. That does, however, require that you have a fair amount of extra income.

How Do You Calculate Whether to Save or Pay Off Debt?

Most of us believe our money should go where it has the biggest positive impact on our overall finances. For that reason, you might be leaning toward the mathematical approach.

But if your debt is spread out across multiple loans, like a mortgage, car loans, and student loans, and your investment opportunities are diverse with varying rates of return, the calculation becomes a little more complex than just comparing your interest rate on a loan to the interest you can earn from an investment account.

When you consider compound interest, things get even tougher to calculate. Certain accounts may not have the best return this year, but their potential to earn you money over time with compound interest is unmatched. You’ll lose that potential by not contributing to compounding accounts as early and often as possible.

A Step-by-Step Plan for Debt Versus Savings

If you’re feeling a little lost right now, that’s okay. It’s because there’s not a definitive right or wrong answer to whether you should pay off debt or save. However, this step-by-step plan is what we would recommend for people who have debt but want to start saving for the future.

Step 1: Max out your 401(k) match.

If you have an employer who matches your 401(k) contributions, your first step is to put as much as they’re willing to match into that account every single month.

For example, if your employer matches up to 2%, then you get a 100% return on 2% of your salary. That’s free money for your future.

Even if your employer only offers a 50% match, a 50% return is better than no interest rate, however subprime your loans may be. There is nowhere your money will be more beneficial to you, so this is your first step.

Step 2: Build an emergency fund of savings.

If you’re wondering whether to pay off debt or tackle your emergency fund first, the answer is to build an emergency fund. The last thing you want is to have to turn to credit cards and take on more high interest debt if you have some kind of emergency, like a medical bill, car repair, or home maintenance need.

The amount you’ll want to start with depends on your situation, like whether you own or rent a home, if you have children, and job security in your industry. The more financial responsibility you have, the more you’ll want to stash away just in case.

If you rent and are just starting your career, you can probably get by with a mini emergency fund of $1,500 to $3,000. If you own a home or have children, you should try to have three to six months’ worth of income in your emergency fund. That way, you can handle just about any emergency that comes your way; even if it comes to losing your job.

Step 3: Focus on paying off debt with high interest rates.

Now that you’re contributing to your 401(k) and have a small emergency fund, turn your attention (and excess income) toward your debt. Any debt you have with subprime interest rates, or rates higher than 9%, should be the first to go.

Interest rates this high will likely cost you more money than you would make on most investments. Paying these debts off as soon as possible means you’ll pay less in interest.

If you have high interest debt and know that it’s going to take you a while to pay it all off, you may want to consider refinancing with a personal loan. The idea here is to replace a high interest debt (like credit card debt) with a lower interest rate loan. For instance, if you are paying 24% APR on a credit and you take out a personal loan at 12% APR — and immediately use your loan proceeds to pay off your credit card debt — you’ll be left with a more manageable debt to pay off. In this example, 12% still isn’t ideal, but it’s a lot better than 24%!

Step 4: Decide your savings and debt priorities.

At this point, your finances are in pretty good shape. You have an emergency fund and you’ve wiped out any high-interest debt. Should you pay off other debt or save more at this point? It’s up to you now.

If your debt interest rate is below the average rate of return for the stock market — roughly 10% — then it probably makes more mathematical sense to invest your money. Interest rates above the 10% mark are considered high-interest debts and will probably be worth it to pay off before you start investing.

Having some low-interest debt remaining isn’t necessarily a bad thing. You can start working on that next, or if you have other financial priorities, start working toward those. It all depends on your debt tolerance and financial priorities.

Maybe you’ve been wondering whether to pay off debt or save for a house down payment. If buying a home is one of your goals and you’ve paid off your high-interest debt, it might be time to start saving toward your down payment. On the other hand, if getting out of debt completely is your top priority, you could keep throwing your extra income toward your remaining debts.

Step 5: Stick to your spending plan and keep building your savings.

The beauty of personal finance is that’s it’s just that — personal. You don’t have to dedicate all your extra income to paying off your debt or saving. You can do both.

Keep working toward being debt free, and keep contributing to your retirement savings, too. With the financial foundation you’ve built, you should be able to pay down your remaining debt while continuing to plan for the future.

Pay Debt or Save Money? It’s a Personal Choice

At the end of the day, the decision to pay off debt or save is a choice each individual has to make for themselves. Every situation is different. For some, it may make more mathematical sense to put the minimum payment toward debt and any remaining income toward investing. However, the desire to be debt free may sway them to do the opposite.

The key takeaway is to figure out what makes mathematical sense for your situation as well as what aligns with your saving goals and values. From there, you can make an informed decision and create a plan that inspires you to take action.