Some people believe that paying off debt vs. building their savings is a balancing act. Everyone has debt. Right? We just have to live with that and do the best we can to make our minimum monthly payments. But when you find yourself with a little bit of extra money, what should you do with it?
You’ll never get out of debt if you throw that money in the bank for a rainy day. Minimum monthly payments cover mainly interest, but not principal. Those balances will take years to pay off unless you pay more than the minimum. That’s why the debt snowball and debt avalanche methods exist—to help you get out of debt when you have extra income (or commit to a budget).
But if you focus on paying off your debt, you’re not contributing as much as you’d like to your savings. So, maybe it is all just a seesaw and we’re left trying to strike the perfect balance of savings and debt repayment.
Creating more income to facilitate savings
The first question you may ask is: Okay, you’re talking about “extra” income, but where is that additional money coming from?
According to Bankrate, Americans carry an average personal debt burden of $92,727. We spend most of our lives paying off banks and credit card companies. Finding extra money in that mess is a tall task.
Paying off debt is embedded into our psyche from a very young age. Our parents had mortgages and car payments. They shopped with credit cards. You have to go back several generations to find consumers who used mainly cash.
Once you accept that there will be debt that needs to get paid, your primary goal should be the creation of additional income to pay it off as quickly as possible. It will be much simpler to save when you’re worried about the quicksand of interest payments. But, in the meantime, you’re stuck on that balance beam.
Creating extra income can be as easy as paying off your lowest balance—which is how the snowball method starts. That act adds more available cash to your budget. Other options for creating additional income can be finding a part-time job or working a side hustle to make extra cash. (We know, easier said than done.)
And again, you’re faced with the philosophical question: Do you put that extra money toward debt or deposit it into a savings account. Debt accumulates interest. Savings earns you money through interest. How do you choose?
Saving money in a tax-deferred retirement account
One of the best ways to save is to have money taken out of your paycheck and deposited into a 401(k) account. If you’re self-employed, you can open a traditional IRA. Deposits are tax deferred, lowering the amount of your paycheck that you will be taxed on now. Another option is a Roth IRA, in which you deposit post-tax dollars and don’t get hit with a tax when you withdraw funds later (as long as you’re over 59½ when you withdraw).
The IRS allows up to $19,500 deposited per year into a 401(k). The IRA maximum contribution limit is $6,000. That may sound like a lot, but once it starts coming out of your paycheck, you get used to it and learn to live on the remainder. Best of all, you can’t spend the money until you retire.
Retirement savings accounts should be a priority for everyone. We all get old (hopefully) and won’t be able to work at some point in our lives. Focus on maxing out retirement contributions while you’re still actively employed. At the end of the road, you’ll be happy that you did.
Debt snowball vs. debt avalanche: options for paying off debt
We’ve talked about savings, so now it’s time to weigh the debt payoff option.
With the debt snowball method, you pay your monthly minimums on all debts but put extra money toward the lowest balance until it’s fully paid off. Then, you repeat the process with the next lowest balance until you’ve knocked out all your debt.
The debt avalanche method is a little different. Instead of paying off the lowest balance first, you work on the debt that has the highest interest rate, and then move on to the next highest interest rate. Eliminate those high-rate debts and the pace at which your debt grows will slow down. This will eventually open up extra money for savings.
If you’re still struggling with whether to pay off debt or put money into savings, think about what those unpaid balances are costing you. A deposit of $100 a month into savings is worth nothing if your monthly interest on unpaid debt is $150. Do the math. Then, make your choice.
By Kevin Flynn
Kevin D. Flynn is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their eight wonderful grandchildren and two cats.