American consumer debt has ballooned to nearly $4 trillion. Never before in the history of the country has the average American been so engulfed in debt. And this unfortunate reality is proving to negatively impact the ability of today’s younger generation to maintain the same kind of lifestyles that their parents were able to achieve. Increasingly, the nation’s struggling workers have turned to using debt to finance their everyday lives, putting at risk an entire generation’s future financial security and the American Dream itself. But is it better to pay off debt or save money? This is the question many ask.
Should I Pay Off Debt or Save Money First?
With so much debt threatening to consume the American buyer, an important question arises: Is it always better to prioritize paying down debt, or are there situations where saving money should take precedence? In the straightforward world that existed prior to widespread financialization and debt-fueled economics, the answer would have almost always been that using every spare penny to pay down debts as soon as possible was the optimal strategy. However, the modern realities of living in a financialized economy mean that the question has to be very carefully considered on a case-by-case basis.
It turns out that simply diverting every spare dollar that one earns to pay down debts as quickly as possible isn’t necessarily the best answer. In fact, sometimes it can be the worst. A recent report done by the Federal Reserve indicates that as many as 40 percent of Americans are unable to cover a single $400 expense. Many more lack the funds necessary to cover at least three to six months of living expenses, the minimal amount of cash reserves that most personal finance experts agree everyone should have in case of emergencies.
This means that a large majority of Americans are one lost job, layoff, car repair bill or unforeseen medical expense away from not being able to make ends meet. For these people, no matter how much debt they may currently have, saving enough money to build a minimum emergency fund of three to six months’ living expenses should always be priority one. And this includes even those who may be struggling to pay down extremely costly debt types, like credit card balances or outstanding payday loans.
The simple fact is that having sufficient cash on hand to eliminate the risk of starvation or being evicted and thrown out onto the streets is an absolute necessity, especially in today’s uncertain job climate. Relying on the idea that one can always borrow to meet those needs is dangerous. Credit scores can fluctuate over time. And many lenders, such as cash advance stores, simply won’t lend to someone who may have just lost their job. Building a solid emergency fund is not an option; it’s a necessity. Saving enough cash to handle emergencies should always take precedence over paying down outstanding debt.
Should Those with Emergency Savings Funds Pay Off Debt or Save Money?
Once someone has set aside enough cash so that they aren’t risking imminent personal catastrophe in the event of a minor financial setback, paying down debt, especially high-interest debt, becomes a much more urgent priority. Generally speaking, it is best to start with the smallest debts, which are often from things like credit cards and payday loans that carry much higher interest rates, and work up to the larger outstanding balances. However, even here, paying off debt rather than saving may not be the optimal approach.
Paying Off Debt May Cost More Than Saving
Not all debt is created equal. The tax code, market complexities and personal risk tolerance are just a few of the hugely complex factors that make it virtually impossible to formulate general rules as to when a debt should be paid off early versus when that money would be better directed elsewhere. However, broadly speaking, there are two situations in which saving money and directing it to other investments is likely to produce larger net gains than paying the debt off.
Low Interest on Debt and High Prospective Returns on Alternative Investments
The first situation where saving may be superior to paying down debts arises when the interest on the debt in question is low relative to the prospective market returns that the debtor can achieve with their cash. This may sound overly abstract. So, a concrete example might help to illustrate the point.
Say that a homeowner has a $200,000 mortgage that they are just beginning to pay off. Furthermore, the homeowner has an additional $200,000 cash sitting in the bank. Should the homeowner use that $200,000 to pay off the mortgage right away, or should they continue making normal payments and direct the capital that they would have used to pay off the mortgage towards other investments?
Because the mortgage holder has just started making payments, nearly all of the money will be going towards interest. This is all tax deductible. On a 10-year mortgage, this means that the homeowner will be reducing their taxable income by nearly $20,000 each year for the next couple years. If our homeowner is earning $100,000 per year, this will reduce their tax bill by nearly $5,000 each year.
At the same time, if this mortgage holder is able to invest that $200,000 directly into an investment property, they may be able to immediately start making another $20,000 on top of the $5,000 they just saved on the tax bill. By paying off the mortgage early, the homeowner will likely save around $50,000 in total interest expenses, assuming no early payment penalties are incurred. But they will lose $25,000 per year for the foreseeable future. Here, paying off the debt is the far worse option.
Debt That can be Consolidated or Settled May Indicate that Saving is Better
The other situation in which it may be better to save rather than pay off the debt in full is if it can be consolidated to a much lower interest rate or settled outright. Debt consolidation can save tens of thousands of dollars in interest while making monthly payments far more affordable.
Because every consumer’s debt and credit profile is different, the best way to determine if debt consolidation can save you thousands is by contacting a skilled debt consolidation expert. Christian Debt Counselors is a leader in the debt consolidation and settlement business, helping customers get out of debt and stay there. If you are in debt and would like to see how debt consolidation can improve your situation, please contact Christian Debt Counselors today. Our debt-consolidation experts can help you reach financial freedom.