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Saving Vs Paying Off Debt: Which Makes Most Sense?

By now, you’ve likely heard how a good chunk of lottery-game winners end up blowing their fortune within a couple of years. This has a lot to do with that old adage, ‘more money, more problems’, but it’s also a reflection of human nature. When you come into some extra cash, be it from a winning lottery ticket, a gift, an inheritance, or even from your tax return, it’s tempting to go out and immediately spend it.

If you’re feeling responsible though, you might want to consider either putting it into a savings account or using it to pay off your debt from a previous big purchase. So the question becomes, is one course of action better than the other? There’s no one-size-fits-all answer to this question, but here are some guidelines, along with some questions that may help you to decide what to do with your extra money.

Emergency Fund

Saving For An Emergency

If you don’t already have an emergency fund, saving your money might be a good idea. It’s wise to establish an emergency fund of some sort, in the case of lost wages, a medical emergency, or a major crisis related to home or auto-related issues. In the event that you’re out of work for a few months, or need a new set of brakes, it’s much better to have cash on hand, as opposed to going into more debt and digging yourself into an even deeper hole.

If an emergency fund is something you can pull off, consider putting away the equivalent of three to six months’ worth of living expenses. That may seem like a lot of money, but consider how much money it could end up saving you in the event that you need the money in the future. Once you set up the account, also remember to always replace any funds you withdraw. If you don’t have three months’ worth of living expenses saved up, consider setting aside any cash you do have on hand in order to establish your emergency fund and determine an amount you can put away each month.

Saving For The Future

Do you have hopes of paying for a wedding? Buying a house? Starting a business? Eventually retiring? If so, then delegating cash for those future expenses is a wise idea.

Create a spreadsheet containing a list of all potential future expenses. For example, one item could be “start business x”, and you’d then assign the required amount of savings to execute your vision. Whenever possible, tack on an extra 10% to b safe. Let’s say you envision your future start-up business idea requiring about $10,000 in seed money. So, it’d be a good idea to put aside $11,000 for the venture.

It’s also true that you can’t over-save for retirement. Most experts will tell you to save “as much as you can”, and often suggest putting aside 10-15% of your income for your whole working career, beginning in your 20s. If you won’t be able to save that much, it’s worth putting any extra cash you do earn directly into your retirement account.

Photo: Shutterstock/fizkes

Should You Pay Off Debt?

Should you pay off your debt before saving up, or is saving more important? Unfortunately, the answer is, ‘it depends’. The first step toward making this decision comes down to determining how much you’d be saving by retaining your debts, as opposed to paying them off.

Make a list of all your debts and payments, and then, most importantly, note the interest rates┬áthat you’re paying on each one. For example, car loans typically have lower interest rates than credit cards. And in most cases, student and home loans usually have lower interest rates than credit cards or car loans.

You’ll want to prioritize paying off your highest-interest loans first. If you have a great deal of high-interest debt on credit cards, it’s probably in your best interest to pay them off, rather than save, especially if you already have an emergency fund in place.

Assess Where You’re At In Life

It can be tempting to take unexpected extra cash and take a vacation or go on a buying spree for things you don’t really need. However, when you come across some extra cash, the best thing you can do is sit down and take an honest look at your financial situation. Numbers don’t lie.

Open up a spreadsheet, and list your debts and loans (with interest rates) in one table. Then, repeat the exercise for your income and savings in another table. From there, put together a rough estimate of how much money you’ll need for your future plans. This will allow you to make an educated, logical decision about what to do with that sudden windfall of cash, unexpected pay raise, or sweet holiday gift. Your future self is already thanking you for your sound decision-making.