Studies show only 39% of American households can handle a $1,000 emergency based on their current savings. This demonstrates the importance of budgeting, understanding how personal finances work, and what to focus on moving forward.
A common question people have involves whether to pay off debt or save first. It’s an interesting question and one that has to be answered with care.
Here is a detailed look at what you should be doing in this situation and what to think about.
How much should I save before paying off debt?
25% of America’s population doesn’t have a “rainy day fund,” which means they live paycheck to paycheck.
This is a horrible position to find yourself in, and something people need to avoid. Yes, it’s not always easy to do so, and each individual’s financial situation is going to vary. Still, it’s recommended to find a way to save.
The premise is to focus on building a rainy day fund that can be stashed aside. This fund is going to consist of at least three to six months’ worth of expenses. By doing this, you will feel safe even when your job goes away for a little bit. Remember, you can’t predict what’s going to happen in the future, and it’s easy to get laid off in a matter of seconds.
By having the rainy day fund ready to go, you will have a financial safety net in place. This is essential and something everyone needs to have regardless of your financial situation. It’s also recommended to have this fund stashed away in a savings account to earn a bit of interest on the amount as time goes on.
Of course, there are different thoughts associated with how much you should save. Some will even suggest you try to aim higher and get more than a year’s worth of savings ready to go. This is a personal decision, but the more, the merrier.
Even if you are only able to save a month’s worth of expenses, then that is where you start. Don’t assume you are going to have everything ready in a day. It’s not going to happen, and you will have to show initiative by setting aside money every paycheck. However, after a while, you will save up enough to set up a substantial rainy day fund.
Emergencies are one of those things that are going to happen one way or another. Whether it is losing your job, having to handle medical fees, or dealing with car repairs, anything can happen. If you don’t have funds to tap into, how are you going to manage those situations? It can ruin everything and put you in a highly stressful scenario that is not good for your mental health or financial well-being.
It’s better to plan and make sure you are heading in the right direction.
Also, don’t assume any old savings account is going to suffice. This is a common mistake people make because they believe all savings accounts are the same. This is untrue, and several savings accounts are not as viable as others.
You want to look at their features, interest rate, and how well they compare to other savings accounts. Only when you have done your research is it okay to sign on the dotted line.
What debt should be paid off first?
A good starting point is to focus on a small-sized debt before anything else. It’s common to assume you should go after the highest interest rate, but that doesn’t always work out as intended. You may get overwhelmed by paying this one-off, and it may not create good habits.
Why is that the case?
There is a psychological reason behind creating what is known as the “snowball” effect. The debt snowball effect refers to targeting the smallest debt (total amount) under your name and paying it off. This helps create a scenario where you continue to work your way up the ladder and get into the habit of making sound financial decisions.
It’s a powerful way of handling debt and is often going to help get out from under your expenses.
Once you are better off, it’s time to start looking towards the higher interest loans. In most cases, this will include your credit cards as they tend to have double-digit interest rates. By going after these debts, you are going to save quite a bit in interest payments.
Remember, this is not going to be easy, and many people get confused along the way. It is not going to be as easy as snapping your finger and making things right.
Instead, you will have to take the time to sit down and budget. This means focusing on your expendable income, figuring out what you can cut down on, and then making those cuts. By doing this, you are going to have additional funds to redirect towards the debt payments. Rather than making minimum payments, you will be able to increase the amount going to these creditors.
The goal is always to work at the principal balance on your debts. This is how you are going to get out of this hole you are in right now.
If possible, you should also be taking a look at consolidating the loan. This means taking all of the loans and bringing them under one name, which helps reduce the amount of interest you are paying. In general, you are going to be paying multiple debts with multiple interest rates. These are hard to keep track of, leaving you even more confused.
The goal is to consolidate the debt and make it easier for you. Since you are only going to be focusing on one payment by doing this, it becomes a lot easier to manage over the long haul. You will find it simpler to make the payments and see results.
Most people will look at the most substantial amount under their name (i.e., a mortgage) and assume that should be their primary target. This might seem like a good idea, but it is not the right approach to take. Since your mortgage is going to be backed by the property, it is generally going to have a lower interest rate comparatively. While something like your student loan is not going to have the same backing, which results in a much higher interest rate.
Your goal should be going after the higher interest rate after you create the debt snowball effect.
Don’t continue to work on the mortgage, assuming that is the way to go. It will leave you in a tight spot as the other debts continue to rack up large interest payments.
Another mistake involves looking to may double payments as a way to get out from under the debt. Yes, this is a great option, but it is not going to be as effective as think with mortgages. You are only going to be chipping away at the principal balance. Still, it is not going to reduce your monthly payment. This means you will always be paying the same amount regardless of the balance under your name.
However, something like a credit card payment isn’t going to afford you the same luxury. The monthly payment will continue to rise as the interest increases.
Look to go after the uncontrolled monthly payments if you are going to be setting aside money for extra payments.
Does paying off debt count as saving?
Yes, paying off debt is a form of saving, and it can be noted as an option for improving your financial health. By cutting into the amount of interest you are paying monthly, it will help improve how much money goes into your savings account later on.
This is why the main goal is to create a rainy day fund and begin chipping away at the debt as soon as possible. This is how you will gain financial freedom and feel in control of your finances moving forward. Otherwise, even if you are putting aside money in a savings account, the interest payments will continue to rise, making you pay even more.
One of the primary concerns a person has to think about is retirement. What position are you going to be in, financially, when it comes to your post-retirement years? Are you going to be stable? Will you have money set aside in a savings account? Will you still be handling debt payments?
It is not a good situation to be in when you enter retirement with noticeable debt. This is not going to be comfortable on you and will only push you into a harder position moving forward. It is vital to work away at the debt when you still are working. Being strict right now is going to yield good results after you are retired.
The only time it is okay to focus on your savings is when the debt under your name has a low-interest rate. This means the interest payments are not going to spiral out of control even if you are dedicating additional funds to your savings account. This is rare, but it can happen, and it is something you are going to have to focus on when making a decision.
Of course, you always want to think about debt. Still, sometimes the interest rate is going to be staggeringly low, making it easier to save.
The central premise is to have a direction that you are going in, and that is only going to happen with budgeting. If you are not setting up a monthly budget, you will get confused. This is when you aimlessly throw money around and don’t see results.
Think about what your action plan is and how it is going to impact your finances. Are you going to stash funds for a rainy day? Are you going to be paying off credit card debt first? How much are you going to pay off? All of these questions are pertinent.
If you don’t focus on what you are doing, retirement will become even harder to execute. A lot of people get stuck in these situations without a clue as to what to do next. Create a plan and then continue to monitor how your finances are doing.
Is saving early beneficial?
It’s important to note, you can take advantage of compound interest when it comes to a savings account. This is a powerful way of turning things around and taking advantage of interest payments. For example, let’s assume you have set up a savings account and are paying a set interest rate. You will get this payment annually from the account.
A good example would be a 1% interest payment on your savings account.
In that example, let’s say you have $100,000 stashed away as a rainy day fund. By having this amount ready to go, you will receive a 1% interest rate on the $100,000, which equals $1,000 yearly. This is $1,000 for doing nothing more than stashing away money!
This is why saving early on is a good starting point.
The longer you have the money in the account, the more interest payments you are going to accrue.
Final thoughts
These are the ground rules that need to be in place before you begin making moves. There is nothing worse than doing things on a whim and then hoping it all works out! This can be dangerous and put you in a tough financial position for no reason at all.
Look towards setting up a proper savings account and then budget accordingly. You will want to make sure there is a sizable emergency fund in place as you work away at the debt. This is going to put you in a far more comfortable position heading into the future.
By taking a systematic approach to handling your debt, it becomes a lot easier to make positive financial decisions.
