The Advantages of Focusing on Debt Elimination or Saving

With the price of almost everything seeming to be more costly, after a period of time when American’s debt balances had become more manageable, today people are racking up debt at levels as high as at any time in the past. One of the positives that came out of the COVID pandemic was that when people were going out less, they also tended to spend less, and many had the opportunity to reduce their debt load and even build a higher level of savings. However, with costs on the rise due to a number of factors, the existence of higher debt balances creates a domino effect because if you are already challenged to make ends meet, adding a higher level of payments on debts simply stretches your resources even further. For those reasons and others, many people are looking for ways to reign in their debt balances, but that brings up the age-old question of whether to use available cash flow on paying off debts to reduce your obligations or to save and invest for the future. Quite often, people treat this question as an either/or proposition, but the reality is that it can make sense many times to do both. In this issue of the newsletter, we will discuss the benefits and drawbacks of each focus and ways to determine how much of your resources you should apply to the approach that makes the most sense for you.

Reducing your Burden through Debt Elimination
There are very few certainties in the world of finance, but when you apply your income to eliminate debts, it is easy to know how much you are helping yourself. By paying off debts, not only are you eliminating the drag created by the purchase you made, but you are also reducing the extra amount that you have to pay to cover the interest charges associated with using someone else’s money. For example, if you have incurred credit card debt, and the interest rate is 20% (credit card debt tends to be among the highest interest rate debt there is), by eliminating that debt, the payment in essence is like giving yourself a 20% return on the money used to pay it off. There are not many places you can put your money and know that it is yielding that kind of return with no additional risk taken. You simply must have the income capacity to make the necessary payments on your debts to work towards wiping them out. In the case of credit card debt and other consumer debt, because those debts are typically associated with purchases that do not hold lasting value, there is minimal, if any, downside to paying on such debts. However, there are other debts that you may have to give more thought to how you pay on them. For example, a home mortgage payment not only provides you with a place to live and the ability to increase your net worth through equity in your home, but the interest payments on that mortgage provide a tax deduction. While there can be reasons to increase payments on a mortgage, by doing so, you are putting additional available cash that can be used in the present towards an asset that cannot be liquidated nearly as quickly, and you are also potentially lessening the amount of tax deductions you have available. Make no mistake, accelerating paying off your debts is helpful financially, but the real question to ask is whether that is the most advantageous use of your funds.



Saving and Investing for the Present and Future
When people think about saving and investing, they tend to put those in the category of planning strictly for the future. Because we don’t know what will happen in the future, or honestly, if we will even be around by then, it becomes easier to forgo taking current resources and using them for an uncertain future. While some saving is focused on the future, saving can also be a valuable tool for the present time as well. That specifically applies to saving for Cash Reserves because those reserves serve as your first line of defense when unexpected things happen, such as a job loss or an emergency resulting in a major expense. On the other hand, you can also save with a greater eye on helping your future self, whether that is saving towards the purchase of a major asset like a home, or perhaps saving for retirement to help replace your current paycheck. Whether your saving is to protect you in the present or to prepare you for the future, when you put your hard-earned dollars away, you expect to be compensated with a return on your money. When it comes to savings held at a bank or credit union, often the return is insignificant, but that is because your money is at a minimal level of risk. You can earn a little more on your money by using vehicles like Certificates of Deposit (CDs) or placing your savings in an account that is higher yielding, but because the risk is still minimal, the return coincides with the level of risk. Investing, conversely, can provide you with a much larger return on your money, but in exchange for the potential return, you are placing your money at a higher level of risk and may experience losses rather than guaranteed gains. The bottom line with saving and investing is that having financial assets at your disposal that can be easily converted into cash that you can use is a valuable tool in your arsenal.

Be Flexible in Deciding What is Appropriate for Your Situation
Clearly, there are reasons to use the resources you have towards debt elimination as well as towards saving and investing, but what is important is to know what will make the greatest impact on what you are trying to accomplish. As mentioned earlier, you don’t necessarily have to choose one or the other. Quite often, it is a good idea to do some of each, using your capacity and circumstances to determine how much to apply to either strategy. If you have debts that are weighing you down, especially consumer debts, you almost can’t go wrong by applying extra dollars you have available towards paying those debts off, again because every bit of interest you shave off gives you more margin in the future. However, if you have minimal or inadequate levels of savings and investments, you may not want to sink all of your available cash flow into paying off debts because savings and investments enable you to cover the cost of things without having to use someone else’s money, and the more time you have to save and invest, it helps with the compound growth of your money. Let’s use an example to illustrate how you might approach this for your situation. For this example, we will assume that you owe $10,000 in consumer debt that averages a 20% interest rate, you have $500 for emergencies in a savings account earning 0.1%, and a retirement plan balance of $50,000 that historically has had a return of 7% in a plan where your employer matches your contributions dollar for dollar. Based on your income and expenses, including $300/month that you are already paying on those consumer debts, you have available about $500/month that can be used to save and/or apply to debt paydown. With the level of consumer debt you have currently, $2,000 of debt payments per year would only be covering interest on the debt, so by paying at the current level of $300/month, it would take a little over 4 years to eliminate the consumer debt, assuming you didn’t add charges to those balances. If you took the entire extra $500 each month and applied it to the debt, you could shorten the payoff time from 4+ years to about 15 months, but in doing so, your level of savings could leave you in a dangerous place, and you wouldn’t be furthering your retirement goals. Now let’s change things up and say that you chose to increase your monthly debt payment amount from $300 to $500 and split the additional $300/month you have available between saving and investing in your retirement plan. In that case, you could eliminate the consumer debt in about 2 years but also would grow your savings to over $4,000 and add more than $15,000 to your retirement plan balance over those same 2 years, giving you more security in the present and a better shot at achieving your retirement goals.

Like is the case with most things in the financial world, there is no “one size fits all” answer to any question, but in the case of choosing to pay down debts or save/invest, how you approach it should certainly be based on your own personal circumstances and is best determined by understanding where you are now, where you want to be, and putting a strategy in place that considers all of those factors.