You’ve got a good budget, which leaves you with a little extra money left over after paying your bills. Or you come into a windfall. What should you do with that extra cash? Should you lower your debt or sock it away in savings?
This is one of the most frequently asked personal finance questions, and for good reason. It’s complicated and personal.
But to help you wrap your mind around these choices, here are the cases for and against paying off debt or saving your money.
The Case for Savings
Cash is king. Every business school student learns that on day one. With cash you have control, flexibility, options, power. If you have cash, then you can choose to pay off debt, invest, help out relatives, cover health care costs and other emergencies or anything else your heart desires.
The more you have saved, the less that you will be hurt by a job loss or any other financial crisis. This is the number one reason why most financial advisors suggest that you have at least six months worth of cash on hand at all times.
Now some people assume that if they pay off debt then they can simply borrow again if times get tough. That’s a dangerous bet. Terms of credit can change, banks can lower credit limits and interest rates can go through the roof. Money in savings is totally controlled by you, money you need to borrow may not be there when you need it.
The Case Against Savings
The big argument against saving money right now is the fact that interest rates are at a historic low. Banks pay virtually nothing to hold your money, and some are even charging clients to keep cash on deposit.
So while keeping money in the bank gives you a rainy day fund, it doesn’t actually grow and work for you.
The Case for Paying Down Debt
Every penny you pay in interest is money down the drain, out the window or whatever other metaphor you wish to use for cash you are wasting. If you have no debt, then you have true financial freedom and peace of mind.
The Case Against Paying Down Debt
Like being tall and thin, everyone wants to be debt-free. But like being tall and thin, you can have too much of a good thing. Some debt may actually work in your favor, and there are situations where paying off debt isn’t in your best interest.
For one, you may have debt at a ridiculously low interest rate. If you are carrying a balance on a credit card with a zero percent interest rate, then anything you earn from savings and investing is pure profit (after taxes.) If you can earn more money from investing than you pay in borrowing, you win. That’s how banks make money. They “borrow” from their clients by paying interest on deposits and lend to other clients at higher rates. You can do the same if you have very low-interest debt.
But beware, if those rates rise then you have to be prepared to close out those investments and pay off your debts.
Secondly, you may have tax implications tied to your debt. If your debt is tied to your home like a mortgage or home equity line of credit (HELOC) then you may lose valuable tax deductions linked to the interest you pay. There are complex calculations needed to find out what that means for you, but it’s a very important consideration.
The Bottom Line
So there is no cut-and-dried answer to the question of whether or not to pay off debt or save for a rainy day. You are probably best off by doing some math, trusting your gut and hedging your bets by doing some of both.