It’s one of the most common questions we hear as financial advisors: I only have a limited amount of money left after paying my monthly bills. Should I pay down my debt first or save for the future?
First things first. We can avoid this decision altogether by being smart about taking on debt. Many consumers these days are falling into the trap of bad loan deals because they’re focusing only on whether they can “afford” the monthly payment instead of whether the actual terms of the loan make sense.
Our number one rule of thumb is to never take out a loan for longer than the usefulness of the item. If you plan to keep a new car for 5 years, you should have it paid off within those 5 years instead of taking a longer-term loan to reduce the monthly payments.
Here’s another common example. If I told you that in 15 years you’d still be making payments on the cell phone you have today, you’d tell me I was crazy. But that’s exactly what happens when we consolidate our consumer debt into mortgages, lines of credit, or other long-term loans. We pay for items we’ve long forgotten about over 10, 15, or even 20 years. If you’ve already done this, you’re certainly not alone – sometimes it makes sense to reduce your interest and get things under control. However, keep this rule in mind so you can make better choices about debt in the future.
If you need to decide whether to use the “extra” money in your budget to pay down debt vs. put away savings for the future, here are a few considerations:
1. The Hard Facts of Dollars and Cents. How much interest will you save on paying down debt vs. the amount of growth you could expect to earn through investing? Example: if you have a low-interest line of credit at 4.5%, but your investment portfolio has been earning you an average of 6% per year, it would make more sense to invest your money as long as you’re still able to make the regular payments on your line of credit. However, if your debt is held on a credit card at 19% interest, it would clearly be better to pay this off first. It’s also important to consider any penalties for paying off debt early, or other fees that may come into play.
2. The 5 Year View. If you’re chugging along, making the regular payments on your debt with a plan to pay it off in a certain time frame, should you withdraw money from your existing savings to pay it off sooner? The answer lies in whether you’d have the discipline to redirect those regular monthly debt payments to a savings account or investment portfolio once the debt is paid off. Making loan payments is a no-brainer. They’re not exactly optional and we skip them at the risk of ruining our credit. However, saving money is often overlooked because it’s totally at our own discretion. In this scenario, if you kept paying off the debt as planned, in 5 years you could be debt-free and still have your savings intact (hopefully with some growth from investing.) But if you withdrew your savings to pay off the debt and didn’t subsequently save the equivalent payments, in 5 years you’d be debt-free but have no savings to show for it.
3. The Emotional Toll. Do you worry about debt on a daily basis? Or are you stressed about your lack of savings for the future? The answer could be a combination of both. Everyone has their own priorities, and what’s right for one person may not be right for someone else. Although this factor can’t be quantified, it’s still an important question to ask. It makes no sense to save a dollar at the expense of your emotional health, so you may have to make the less-desirable financial decision based on what you can comfortably live with.
There is no “one size fits all” answer when it comes to financial planning. Regardless of which choice is right for you, the important thing is that you’re making a plan to get on track, pay down debt, and save for the future. Once you’ve established clear goals and time frames, you’ll be able to put the daily stress aside and feel confident that you’re set up for financial success.