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Paying Down Debt Vs. Saving More: Which One Comes First?

Paying Down Debt Vs. Saving More: Which One Comes First? :: Mint.com/blog

The latest data from the Federal Reserve Bank of St. Louis indicates that the personal savings rate in the United States is a mere 4.2%.

That’s a big problem when most financial advisors say we should be saving 10% to 20% of our income.

Surveys show that many Americans have such a tough time saving because they’re so saddled with debt.

A number of experts say that when you’re facing the double whammy of high cost debt and a lack of savings, it’s in your long-term benefit to put all your money towards paying down your high-interest debts as quickly as possible.

Start saving by saving on interest

Trying to save money while facing high-interest debt is like trying to swim with an anchor tied to your feet.

It’s no surprise that people who have large monthly debt bills also have little money to save.

According to a new Wells Fargo Retirement Survey, more than half of respondents said debt was their “biggest financial concern.”

Of those who said they can’t save, 87% said they simply don’t have enough money and 81% said they wanted to pay down their debt first.

David Shucavage, President of Carolina Estate Planners in Wilmington, N.C., says paying down high cost debt should always come before saving.

Consider a person carrying $10,000 in credit card debt at a 15% interest rate.

If their required monthly minimum payment is 1% of the principal plus interest, they would be paying about $225 per month.

But of that amount, only $100 would be going to pay down the principal – the other $125 would be going straight down the drain in the form of interest payments to the bank.

If the person continued making only the minimum payments, they’d take almost thirty years to pay off the debt and spend almost $12,000 in interest along the way.

“Paying down debt should be a priority above anything else, including savings, because it will have a far bigger impact down the line, especially with credit card debt,” says Shucavage.

David Peterson, CFP, Managing Director with United Capital in Highlands Ranch, Colo., says before you start using big bucks to pay down your debt, put a little bit aside in your savings.

Most advisors recommend three to six months worth of living expenses but that’s not practical when you’re carrying thousands in credit card debt.

He says $2,000 is a good starting point to have some emergency money to cover unexpected bills.

“At least if you have a small emergency, you’re not adding to that debt. Save a little money but your main concern should be paying down that debt,” says Peterson.

A guaranteed return

The biggest benefit of paying down credit card debt is that it offers a guaranteed return on your money.

Using the interest rate, balance and payment plan, you can quantify and precisely determine a guaranteed rate of return.

At a time when you’re lucky to earn 2% in a certificate of deposit, earning a guaranteed 15% or more by paying down a credit card is a very good deal.

Putting more money towards paying down the debt will not only get you out of debt sooner, it will save a fortune in interest.

So while you may forgo saving now, you’ll be able to put away a lot more money once you do start saving.

If in the case above the person increased their payments to $400 per month, they’d pay off the debt in three years and pay only $2,000 in interest.

That’s a savings of $10,000 that could be put in the person’s savings account in subsequent years instead of going to the bank.

“The sooner you pay down the debt, the more you will save in interest and the more you’ll be able to save later down the line,” says Larry Rosenthal of Rosenthal Wealth Management Group in Manassas, Va.

When you’re free of debt, it should give you a lot more room in your monthly budget to save.

In the example above, if the person increased their payments to $400 then continued to save that amount once the debt was paid off, they’d be debt free and have $9,600 in the bank in five years.

“People don’t think in terms of cost or the actual dollar amount anymore, they think in terms of payments. It’s common sense. Use the calculator and find out [what you can save],” says Rosenthal.

Snowball effect

If you’re struggling with credit card debt, Shucavage says one option is to pay it off with a home equity loan or line of credit.

Doing so will likely drastically reduce your interest rate, which will reduce the amount of interest you pay and the amount of time it takes you to pay off the debt.

The lower rate and higher payments create a snowball effect that can rapidly diminish your debt.

But Shucavage recommends treading very carefully with home equity.

The danger in doing this is that you may very well rack up more credit card debt then end up in a worse situation because you now have credit card debt and home equity debt.

“You need to have extreme discipline and a personal commitment. If you won’t do any good if you rack up more credit card debt,” he says.

Another tactic is to use balance transfers from one card to another in search of lower interest rates. Many cards still offer new cardholders up to a year or more with 0% interest.

Be sure to factor in the balance transfer fee which is usually 2-3% and make a commitment to pay it off in time lest you be hit with more interest.

Finally, don’t run out and start applying for too many credit cards it too short of a period of time because it can have a negative impact on your credit score.

And applying for new credit cards may not be the smartest move if you’ve already had credit card problems in the past. Shucavage says to tread carefully and remained disciplined.

Financially, it makes the most sense to pay down your credit cards with the highest interest rates because it will save you more money.

But Peterson recommends starting with the cards with the lowest balances because paying down a card will give you a psychological boost to continue to get your debts under control.

“Do what you have to do to get rid of that debt. Focus on the long term and not you immediate wants. It takes discipline but there’s more freedom and its easier to save when you’re out of it,” says Peterson.

Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor’s Business Daily. He is the author of “Stuff About Money: No BS Financial Advice for Regular People.”