Pay off debt now or save for the future?

June 21st, 2011 Mike Finlayson

At one point or another, families all across the country will ask themselves: shall we pay off debt or save for the future?

The answer to this question boils down to simple math.

Let’s say, for example, that you have saved $10,000 and deposited the money in a CD or money market fund at your bank. Given the current low-rate savings environment, you are probably earning around 1% to 1.25% of interest on your investment. That means that over a 12-month period you would earn $120 to $130 dollars in interest.

On the other hand, let’s assume you are carrying a total of $10,000 of unsecured credit card debt. Your interest rate for this type of debt is more than likely in the double digits. If we assume that the debt carries a 15% interest rate (which is average) you would accrue around $1,500 in interest on an annual basis.

Looking at the numbers in this scenario, it quickly becomes clear what to focus on. If you opted to save and only pay the minimum payment on your credit card debt, you would not make enough money to offset your debt. Instead you should have focused on paying off the debt first.

Despite this simple analysis, many people ignore the math and instead opt for a false sense of security that can result from having a large savings account.

Keep the following things in mind when you’re asking yourself the best way to move forward:

  • Analyze your debt closely and determine where your dollars are best utilized.  Go through the process of calculating your annual interest on all your debts and then determine how to best move forward. For example, it makes sense for many to focus on paying off your high-interest debt, such as credit cards, before repaying “cheaper money” like car loans or mortgages.
  • Understand the consequences of either paying debt first or saving first. For example, if you opt to save and consistently only make the minimum payment on your debt you will make very little progress on actually paying anything off. This can quickly turn into a vicious cycle that can have drastic consequences.
  • Don’t make it an emotional decision by tricking yourself into saving just so you have a larger bank account. Study your situation. Make an educated decision.
  • If you elect to focus on your debt payments, don’t completely ignore your savings. It’s important to have at least a little bit of money stashed away for emergencies.
  • Always opt to participate in your company’s retirement plan, especially if your employer matches funds. Not doing so means that you are leaving “free money” on the table.

Personal finance decisions are rarely so simple that there is a quick and easy answer for everyone. Take the time to analyze your situation and determine what’s best for you and your family. It will be well worth it in the long run.

Mike Finlayson

About the author

Mike Finlayson is Second Vice President at MidWestOne Bank. He works with MidWestOne customers to help them manage their personal finances and identify effective money management solutions.

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