Is It Better To Save Or Pay Off Debt? (2024)

Saving vs. paying down debt—it’s a balancing act that many of us face. But how do you find that balance in your own situation? The answer depends, in part, on whether you’ve got enough money already stashed for emergency savings and how much high-interest debt you’re carrying. In some cases, you may want to undertake saving and paying down debt at the same time.

“It really comes down to calculating the opportunity cost of doing one thing over another,” says Dan Mathews, a CFP in the Kansas City area. “Sometimes a balanced approach can be the best approach.”

Here’s an example of that opportunity cost. If you’re likely to earn 6% in annual returns from retirement savings, but you’ve amassed credit card debt with an APR (annual percentage rate) of around 18%, your best bet likely will be to first clear out the debt. Why? Because paying 18% credit card interest will more than cancel out the 6% you’ll earn from your savings.

Jeremy Shipp, a CFP in the Richmond, Virginia area, says saving versus paying down debt should be a “coordinated and efficient” strategy that emphasizes the ability to access cash quickly. If every dollar remaining after you pay everyday expenses goes toward reducing debt, then you’re not setting aside money in case an emergency expense pops up, he says. That, then, could lead you to take on even more debt.

Setting Up an Emergency Fund

If you haven’t already created an emergency fund, experts generally recommend focusing on that before concentrating on debt reduction.

Bruce McClary, a spokesperson for the National Foundation for Credit Counseling, says an emergency fund should contain at least three months’ worth of your take-home pay. (Some experts suggest that an emergency fund cover six to nine months’ worth of living expenses or more.) If your monthly take-home pay totals $5,000, the amount in your emergency fund should be at least $15,000 based on the three-month equation. This money should be earmarked for covering emergency expenses, such as unexpected car repairs or medical bills.

What if you have less than three months’ worth of take-home pay in an emergency fund—or no money at all? In this instance, McClary believes you should prioritize building an emergency fund over debt reduction. It’s best to avoid tapping into your emergency savings to pay off debt, as you could wind up accumulating more debt when an emergency arises.

Part of your decision-making about emergency savings should include how much access you have to your money, according to Shipp.

For instance, on the debt side, take into account the difference between a mortgage and a line of credit, he says. If you wipe out the balance on your line of credit and an unexpected expense comes up, you can easily borrow again against the line of credit. But if you tack on extra money to your normal monthly mortgage payment, you lose access to that cash until you refinance the mortgage or sell the property, Shipp says.

On the savings side, consider the difference between a 401(k) workplace retirement account and a savings account. If you deposit money into your savings account, you can quickly tap into that pool of money to cover surprise expenses. But it can be costly to withdraw money you’ve contributed to your 401(k). Under normal circ*mstances, you must pay income taxes plus a 10% penalty on any 401(k) withdrawal made before age 59 1/2.

How Much Emergency Fund Should I Have?

There are guidelines—but no one right answer—for how much you should save in your emergency fund. Most experts suggest saving three to six months’ worth of essential living expenses.

When figuring out how much to save, tally up your nonnegotiable monthly expenses—things like housing, insurance, groceries and transportation. Then multiply that amount by the number of months you want to save for. For example, if you want a six-month emergency fund and spend $4,000 per month on basic expenses, you should aim to save $24,000.

Of course, the amount you should save depends on your personal situation. For instance, if you’re an entrepreneur with variable income, you might want to save more than six months’ worth of expenses to feel comfortable if your revenue dips. On the other hand, someone with a secure job and a strong financial support network might feel comfortable with only a three-month emergency fund.

Paying Off Debt

McClary says that if you’re able to zero in on paying down debt, “the golden rule” dictates that you first pay attention to high-cost debt without any collateral, such as high-interest credit card debt or a high-interest personal loan. If you’re fortunate enough to be free of high-interest debt, be sure to reduce any remaining debt balances while still carving out money for savings, he says.

Paying off any debt that’s overdue should be your biggest concern, McClary says. Past-due credit card debt may trigger late fees, while past-due mortgage payments could send you down the path toward foreclosure. Furthermore, overdue debt can damage your credit score.

Mathews offers a couple of scenarios for figuring out whether you should save money or reduce debt.

If you’re sitting on a bunch of cash in a savings account that’s earning very little interest, if any, Mathews suggests withdrawing that money and paying down debt. This lets you cut down on the interest you’re paying on the debt and pay off the debt more quickly. In this case, paying down debt “makes a lot of sense,” according to Mathews.

“Doing nothing and sitting on too much savings is the worst thing you can do,” he says.

But there’s another factor to weigh in this scenario. If you funnel money from a low- or no-interest savings account into a retirement plan or investment account, you may be able to take advantage of investment gains that outweigh what you’d earn from the savings account, Mathews says. There’s a wrinkle in that plan, though. The amount of interest charged over time if you make only the minimum payments on your existing debt could cancel out your investment gains, he says.

Mathews says he typically encourages younger people to put money into retirement savings rather than putting it toward debt reduction. But, he adds, if somebody is saddled with high-interest debt, like a stack of credit card bills, it might be wise to shift more money toward paying down the debt.

“However, I expect someone will be much better off in the long run by saving money today into a retirement plan or other tax-deferred account that is invested based on your long-term goals and needs,” Mathews says. “It has the chance to grow into something more substantial and accessible than allocating it toward home equity or even student loans.”

For someone in or near retirement, the saving-versus-paying-down-debt conversation is different, Mathews says. Folks in this stage of life tend to be skittish about debt and want to pay down all of what they owe, even their mortgage, he says. This will free up money to spend on future living expenses, vacations and other retirement costs.

Mathews believes it’s okay to carry a mortgage when you’re retired, given today’s historically low mortgage rates. Keep in mind that you may want to take advantage of those low rates now to refinance a higher-interest mortgage.

Which Debt To Pay Off First?

In most cases, it makes sense to start by paying off any high-interest debt. High-interest debt costs you more in interest—and the longer you have it, the more you’ll end up paying overall. Usually, high-interest debts include things like personal loans, private student loans and credit cards.

You should also prioritize paying off any overdue debts. Overdue debts can hurt your credit score, cause late fees and—if it’s mortgage payments we’re talking about—even lead to foreclosure.

Once your high-interest and overdue debts are paid, you can move on to paying off the rest of your debt using either the debt snowball or debt avalanche method.

• Debt snowball: This method has you list your debts in order from the smallest amount to the largest. Starting at the beginning of the list, pay off your debts from smallest to largest (while making minimum payments on all debts).
• Debt avalanche: This method has you arrange your debts by highest interest rate to lowest. Disregarding the debt amounts, start by paying off the debt that has the highest interest rate (while making minimum payments on all debts) before working your way down the list.

Strategies for Debt Reduction: How To Pay Off Debt Fast

So, what if your debt concerns override your saving concerns? Follow these three tips:

1. Go over your budget. How much money are you taking in each month, and how much is going toward expenses? Once you’ve done the math, you can get a good idea of how much money you can afford to allocate for debt reduction. If you determine you can squeeze $400 a month out of your budget, you might assign $250 of that to get rid of high-interest credit card debt and $150 to save for emergencies.
2. Look at your expenses. As you comb through your budget, see whether you can decrease or erase expenses. For instance, do you really need to subscribe to four streaming services when just one subscription might do? You may be able to shift this found money to your debt-reduction column.
3. Consider lower- or no-interest options. To help become debt-free, you may contemplate steps like taking advantage of a 0% balance transfer offer for high-interest credit card debt, or refinancing your student loans to obtain a lower interest rate. With student loans, it’s wise to weigh refinancing if a loan carries an interest rate of at least 8%. The goal here is to reduce the amount of interest you pay on this debt over the long run.

Strategies for Saving

Let’s say you decide to direct much of your financial energy toward saving money—for emergencies, retirement and other purposes. How do you go about doing it? Here are three suggestions:

1. Start small if you need to. Even if you’re able to save just $25 a week initially, that’s better than saving nothing at all. Early on in your savings journey, this money should be deposited into an emergency fund. Consider opening a savings account solely for your emergency fund so you can separate it from other pools of money, such as a checking account for payment of household expenses.
2. Set aside money for retirement. Once you’ve got a sufficient amount of money in your emergency fund, your next goal might be to bulk up your retirement savings through a 401(k) or individual retirement account (IRA). A popular rule of thumb suggests you need to carve out at least 15% of your annual pretax income for retirement; this goal includes any money your employer contributes to a retirement account.
3. Don’t overlook matching retirement contributions. If your employer matches contributions you make to a workplace retirement plan, like a 401(k), you may be throwing away thousands of dollars if you’re adding no money to your account. In this case, you may want to ensure you’re contributing at least enough to earn the employer match instead of putting that money elsewhere.

How Much Should I Save?

Once you save a healthy emergency fund of roughly three to six months’ worth of expenses, you might wonder how much of your income you should be saving. Again, there’s no hard-and-fast rule, but there are some general guidelines for how much you should save.

Many financial experts suggest the “50/30/20” rule, where you funnel 50% of your take-home income toward essential expenses, 30% toward wants, and 20% toward savings and debt repayments. This rule of thumb won’t work for everyone, though, especially those living paycheck to paycheck.

Aim for this benchmark knowing even if you can’t hit it right now, you can always adjust your savings rate in the future. And regardless of what percentage you’re saving, try to at least save enough to get any 401(k) matching dollars, if your employer offers them.

Bottom Line

Like many financial situations, there’s no one right answer to the question, “is it better to save or pay off debt?” Instead, you have to balance the importance of building an emergency fund with the benefits of paying off high-interest debt.

Generally, it’s smart to start funding your emergency savings before paying off debt. But once you have some money in an emergency fund, you may want to start paying down high-interest debt while continuing to fund your savings.