Save or pay off debt? See how much it costs

Saving money and paying down consumer debt are both great things to do.

It’s very important to do them in the correct order and with the correct weighting, though.  My take is that saving an emergency fund of a reasonable amount should be done first.

But once that emergency fund is in place, pay down the debt before saving a lot more.

Why is that?  The savings account at this point almost certainly pays less in interest than what you’re paying on your debt.

Consider a typical savings account.  You’ll be lucky if you’re making 1% on your money.  That doesn’t even keep up with inflation.

We have a used car loan that’s incredibly low: 1.99%.  And even that one has a higher rate than what we’d get on a savings account.  A typical credit card rate is in double digits:  14.99%, 17.99%, or even 21.99%!

You’re filling your bucket but ignoring the holes in the bucket

Think of your net worth as a bucket.  Think of your savings account interest as an open faucet that is filling the bucket (income).  Think of the credit card interest as holes in the bucket (expenses).

Water is flowing out of the holes in the bucket much faster than it’s flowing into the bucket from the faucet for the same amount of money in your savings account and on your credit card.  The faucet is dripping in, but the water is gushing out.

Debt costs.  A lot.  Consider the cost before you save any more at nothing-point-peanuts.

After saving up an emergency fund, paying down high-interest consumer debt is usually the clear winner over saving more.

Save or pay off debt? Depends on your emergency fund

If you’re in debt, especially consumer debt, it’s certainly very important to get out of debt.  The borrower is slave to the lender, after all.

As good as getting out of debt is, though, faster isn’t always better.  If you’re paying down your debt so fast that you have absolutely no cushion in your savings account, you’re left exposed to the smallest financial emergency.  Off to the credit cards again to rack up some more debt to solve the emergency.

This is why it’s good to take a break from paying down debt to build up a small emergency fund.  Even a small emergency fund like $1,000 will provide enough buffer to weather through a car repair, a root canal, or some stitches from a playground accident.

If you’re paying down your debt already, that’s great.  If your emergency fund is lacking, then consider making the minimum payments on your debt for a while (even though this won’t pay down your debt as quickly) and use the difference to put into a savings account.

Dave Ramsey recommends saving $1,000 for an emergency fund before tackling debt head-on with accelerated payments.  Suze Orman recently recommended getting a savings account funded as a buffer in case of job loss or other emergency before paying down debt as well.

On the other hand, if your emergency fund is in good shape, then get rid of the debt!  It’s likely costing more interest than you’re getting with your savings.  (What savings account pays 14.99% interest? 😉 )

Bottom line:  Pay down your debt, but don’t leave yourself exposed to the smallest of financial ill winds.