Should I Pay Off Debt or Save for An Emergency Fund?

Should you stockpile your extra cash in a savings account, or pay off that nagging credit card or student loan debt? The answer to this common financial conundrum depends on your circumstances! Four tips to help you make the smartest choice:

1. Explore ways to reduce the cost of your debt.

If you carry higher interest credit card debt but have an otherwise strong credit history, for example, look into low or no interest balance transfer offers. The lower the interest rate, the less the debt costs you. If the lower interest rate is offered as a temporary promotion, aim to pay as much of your balance as possible before the rate rises.

If you have Federal student loan debt, Betsy Mayotte of the financial education non-profit organization SALT says there many programs designed to help borrowers manage and potentially minimize what they owe.2 Some income-based payment plans might reduce your monthly amount owed, and temporarily waive interest charges until you increase your income. Professionals who work in some facet of government, public service or healthcare might be eligible for Federal student loan repayment and forgiveness options, too.

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2. Prioritize your debts by cost.

Having debt may mean most of your monthly income goes towards paying it. In turn, the rest of your cash flow is limited, making it difficult to save for emergencies. But life isn’t entirely predictable — and neither are all expenses. Even with a savings account safety net, you may have no choice but to take on even more debt when that flat tire, medical emergency or other unexpected event takes place. It’s a vicious cycle, and it takes hard work. But you can find a sense of control over your debt by prioritizing where you’ll be most aggressive with your payments so you can make real progress.

David Rae3, a certified financial planner (CFP) with Trilogy Financial Services says to start with the highest interest rate debt first. (It’s the most costly, regardless of your balance). Pay as much as you can afford towards the balance each month — while continuing to pay at least the minimum amount due on all your other loans. “If you let the credit card debt linger, you may end up drowning in spiraling interest costs,” says Rae. As you move down the list of debt, you’ll find that you have more cash to put towards your balances.

3. Be realistic about savings goals.

An emergency savings fund reduces the odds that you’ll have to rely on high interest loans or credit cards when unplanned expenses come up. But Rae acknowledges that saving the recommended three to six months worth of your income (or as much as twelve months worth if your source of income isn’t stable) may not be realistic.

“I don’t usually have my clients focus on building up the typically recommended emergency funds right off the bat — but if you are out on your own and renting, have at least two months worth of rent saved,” says Rae. (He explains this because it is one of the only things that you probably can’t put back on your credit card if you lose your income). As you gradually pay down debt, you’ll have more cash to put towards reaching those ideal emergency savings fund amounts.

4. Don’t forget the importance of investing in your future.

Setting realistic savings goals gives you a tangible number to work towards. Having that “end” in sight can help you stay motivated to save. It can also signal the right time to shift some of the cash into retirement contributions — at least to the extent that you take advantage of any “match” your employer offers. “That’s free money you get from work, and it’s a tax deduction,” explains Rae. Both benefits ultimately put more money in your pocket (even if you can’t access it for several years).

1 Experian; http://www.experian.com/blogs/ask-experian/2013/10/30/how-utilization-rate-affects-credit-scores/

2 Original source; phone interview

3 Original source; email interview

Legal Disclaimer: This site is for educational purposes and is not a substitute for professional advice. The material on this site is not intended to provide legal, investment, or financial advice and does not indicate the availability of any Discover product or service. It does not guarantee that Discover offers or endorses a product or service. For specific advice about your unique circumstances, you may wish to consult a qualified professional.

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