Saving By Reducing: How Lowering Your Debt Can Save You Money
You may not realize it, but by paying down your debt, you ARE saving! Actively reducing your debt means you’re saving on interest, avoiding late fees, and maintaining or increasing your credit score. On this day, we’ll focus on why paying down debt should be acknowledged, utilized, and celebrated as a form of saving and a component of your financial plan.
How Does Reducing Debt Help You Save?
Consumers often think saving and reducing debt are two separate goals that must be done simultaneously or that saving money is more important than lowering debt. However, that is not always the case. By ignoring your debt load, you could inadvertently keep yourself stuck in a bad financial position. This is mostly due to the high-interest rates and your regular payments barely touching the principal balance—keeping your debt high and prolonging your payments to the creditor.
Equifax (and other credit reporting companies) suggest focusing on paying down any high balance and/or high-interest rate debt while contributing minimally to a high-interest rate savings account. By reducing debt, you will be able to save more sooner instead of continuing to barely save, while barely making a dent in your debt. As you reduce your debt, you can increase your savings.
A Real-Life Example: Pat & Terry
Let’s say Pat and Terry both have a $10,000 personal loan with a 10% APR, a minimum monthly payment of $213, and a term of 60 months. Each has $600 to allocate to debt or savings each month. Pat decides to prioritize saving and only makes the minimum payment each month, putting the extra $387 in a high-interest savings account with .5% interest. Terry decides to prioritize paying off the loan by paying $500 each month and saving the extra $100 in a high-interest savings account with .5% interest.
At the end of 5 years, Pat would have paid about $12,780 on the loan and saved $23,517.52. On the other hand, Terry would have paid off the loan in 22 months, rather than 60. Now during those 22 months, Terry would only save about $2,200. However, after that period, Terry could then deposit the full $600 into their savings account each month. By the end of the five years, Terry will have saved $25,232.05. This example shows that paying down your debt faster may lead to a significant increase in savings over the long-run.
When To Prioritize Debt Over Saving
If you have high-interest-rate consumer debt, you would likely benefit from paying down the debt rather than savings. By doing so, you may significantly increase your financial return, more so than you would investing in the stock market or using a savings account. However, there may be situations when saving should come before reducing your debt, such as having a 401(k) matching program with your company, lower interest rate debt, or student loans that can be deferred interest-free for an extended period of time.
How To Do It
If you have decided to reduce your debt to maximize your savings down the line, the best way to determine how much to pay towards your debt is by creating a budget. You’ll be able to see how much extra income you have at the end of each month. Your regular minimum debt payment should be counted in your expenses so that the extra money is genuinely “extra.” Then decide how much money you feel like you are comfortable paying extra balanced with how little you are comfortable saving each month. If you already have an emergency fund, you can probably pay more and save less. However, if you are still working on growing an emergency fund, you may want to pay extra on the debt but save more until you have a small emergency fund. If you have multiple debt accounts, pick one to focus on first. Some people may choose to focus on the account with the highest interest rate, or they may choose to focus on the smallest balance to eliminate one payment faster. It’s up to you to decide what proportion of debt repayment versus savings makes the most sense for your situation.
If you still aren’t sure what option makes the most sense for you, consult someone who can help. A free financial advisor, a tax accountant, or a private financial expert are all excellent choices. There are also free calculators and tools online that can help you figure out how long it will take you to pay off your debt, as well as how much you can save over time. You should never feel like you have to guess how to use your money best. By seeking extra help, you can drastically improve your financial situation.