Is it better to pay off debt or save? How to decide

You’re creating your five-year financial plan, wondering: “Should I save or pay off debt?” This age-old money management question has long been debated alongside other common queries, like “Should I buy or rent?” or “Should I fund my retirement or pay for my child’s college education?”

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The truth is, there’s no simple, definitive answer. Like everything related to personal finance, prioritizing saving versus debt repayment is a nuanced decision.

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It might be better to focus on one over the other in some cases, but in others, you may want to take a balanced approach. We’ll provide some guidance and practical tips to help you decide and take action.

Debt repayment vs. saving money

Before we get into whether you should save or pay off debt, let’s look at the merits of doing each one separately.

The importance of debt repayment

Carrying significant debt can take its toll on you in many ways. Most obviously, debt may prevent you from reaching major milestones, such as homeownership or a comfortable retirement. 

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Day-to-day, debt payments can also impact your budget, leaving you with little money for fun and emergencies. Then, when an urgent situation arises, you may have to borrow more cash to cover it, putting you deeper in the hole.

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Having debt can also negatively impact your health. Financial issues may cause severe stress and are a leading cause of relationship issues. High stress over a prolonged period can cause physical effects: your debt might literally make you sick.

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Repaying your debt will help to alleviate the pressure on your mind, body, and bank account. Once your debt is gone, you’ll no longer have the burden of paying interest, so you’ll have more cash to save, invest, and enjoy. Paying off your debt will also boost your credit score, enabling you to borrow at a more favorable interest rate in the future (if necessary).

The benefits of saving money

You use your paycheck to cover your regular expenses, but what about unexpected costs and personal goals? That’s where having a cash reserve comes in.

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If you stash more funds in the bank than you need to pay your bills, you give yourself options now and in the future. Saving money can enable you to:

• Pay for an emergency in cash.
• Financially survive a layoff.
• Quit a job you hate.
• Start a business.
• Make a down payment on a home.
• Take the vacation of your dreams.
• Cover your children’s college education.
• Retire worry-free.

In short, having extra money available ensures you can respond to life faster, with less stress, and on your terms. You can feel financially secure and enjoy peace of mind (which is priceless!).

Is it better to pay off debt or save? 

Sometimes, it makes financial sense to prioritize paying off debt over saving. For example, let’s say you owe $5,000 on a credit card with a 25% interest rate. The money in your high-yield savings account only earns about 5% interest, and your investment portfolio's average annual return hovers around 12%. In this scenario, the amount of money you’ll lose to interest payments far outweighs the return you’d get on your savings.

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However, depending on the type of debt you have, the reverse may be true. For example, if your mortgage has a 4% interest rate and your 401k consistently earns 10%, the math suggests that saving for retirement is the better choice.

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In either case, you must consider the opportunity cost. Once you choose, the money is spent. You will have to forgo the benefits of the alternative you didn’t select.

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For instance, even though the numbers support saving for retirement over paying off your house, you’ll still give up the peace of mind of knowing you own the home free and clear. Plus, you’ll have far more money to save and invest each month if you don't have a mortgage payment. You have to decide what’s most worth more to you – debt freedom and cash flow or investment returns.

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The bottom line: You have to weigh both the short and long-term benefits of debt repayment and savings against each other.

Should I save or pay off debt? 

As we discussed, it may be better to save money when your debt has a low interest rate, such as a home loan or a federal student loan. In this case, your cash could earn more when invested than you’d save by eliminating your debt.

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But what about when you have high-interest debt, like a credit card balance? Normally, it makes financial sense to aggressively pay the card off before adding to your nest egg. 

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However, there’s an exception to the rule: if you don’t have an emergency fund, you should probably focus on building one before you shed your credit card debt.

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Having an emergency fund is critical for financial security. You can avoid taking on more debt when you have money set aside to respond to surprise, urgent expenses (like a blown engine in your car or a broken window in your kitchen).

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Top tip: If your debt payments leave you with little to no cash to save, paying down your financial obligations will give your monthly budget more breathing room, making it easier to save money.

How to balance debt repayment with saving money

While focusing on one objective or the other can sometimes make sense, in many cases, you may want to balance the two goals simultaneously. Here’s how to do it:

1. Take stock of your finances 

Before you allocate a single dollar towards savings or debt repayment, you need to see and assess your whole financial picture. Create a list of all income sources and all expenses, including minimum debt payments.

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Then, tally up how much you earn and how much you spend each month. Are you breaking even, taking on more debt, or enjoying a surplus in your checking account? 

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If you’re operating in the red, you must find a way to lower your costs, make more money, or both. 

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If you have money left over each month, you’re in great shape to identify and start working toward your financial goals. Your goals will help shape your money management strategy. 

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For example, if you want to improve your credit score, paying off some debt should help because you’ll lower your credit utilization ratio. On the other hand, if you’re getting married in two years, saving a percentage of each paycheck will help you afford the ceremony of your dreams.

2. Create a budget

Next, you need to create a budget, which gives your money a defined purpose and helps you achieve your objectives. There are several budgeting methods to choose from, but one popular option is the zero-based budget.

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With the zero-based budget, every dollar you make has a job to do – whether that’s covering a regular bill, paying off debt, preparing for an emergency, or saving up for a significant expense. At the end of the month, your income minus your costs should equal zero.

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Adopting a frugal lifestyle can free up more cash in your budget. Being frugal isn’t about deprivation. It’s about optimizing your expenses, so you have more resources to allocate toward the things that matter most to you.

3. Build security

Your next move is to establish an emergency fund. Your emergency cash reserve can help prevent you from taking on new debt. Plus, it gives you the confidence to handle any unpleasant surprises life throws your way.

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So, how much money should you save for this purpose? The amount you should target depends on your circumstances. Some experts think you should save several months of living expenses. However, you can begin with a much smaller goal in mind. 

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Start by saving up for a common situation, such as a flat tire or a leaky kitchen faucet. Then, you can build from there.

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You can make building your emergency fund much easier by adding it as a non-negotiable line item in your budget. Then, set up an automatic cash transfer into your account so you can’t spend the money elsewhere. 

4. Determine how to allocate your extra cash flow 

Once your emergency fund is well-stocked, you’ll have extra cash on hand. That means you can return to the question of whether it's better to pay off debt or save.

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If you focus solely on repaying debt, you’ll likely achieve debt freedom faster. However, if every spare dollar goes toward your debt, you can’t stash money away for retirement and benefit from additional years of compound interest – or use your earnings to enjoy life.

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The trick is to strike a balance that works for your life. You can do this by earmarking a small percentage of your income for both discretionary purchases and wealth building. 

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Yes, you’ll slow down your debt repayment pace a bit. However, your overall financial future will be brighter (and happier) if you sneak in some savings, too.

5. Decide on a debt repayment plan

You can streamline your journey to becoming debt-free by following a debt repayment plan. Two popular debt repayment methods include the debt snowball and the debt avalanche. Both strategies involve aggressively paying off one debt while making minimum payments on the others. 

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With the debt snowball, you commit to paying off your debts from smallest to largest balance. Following this plan, you’ll build momentum and confidence, which can help you stay motivated.

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With the debt avalanche, you prioritize paying off your debts from the highest to the lowest interest rate. This plan can help you save money in interest and spend less on your debts in the long run. 

6. Revisit your budget and finances monthly

No financial plan is set it and forget it, so it’s wise to review your progress every month. That way, you can determine if it’s time to shift your strategy. For example, once you've paid off your credit cards, you may want to save more money for retirement.

Strategies to pay off debt fast

Paying off debt can feel like an endless slog. Fortunately, there are several ways you can expedite the process.

Increase your income

If you boost your income, you’ll have more dollars to put toward your debt – without sacrificing other items in your budget. There are virtually limitless ways to increase your earnings. Here are several ideas to jumpstart your thinking:

• Rent out your home, spare room, or garage (if you own the property).
• Ask for a raise or promotion at work.
• Find a higher-paying job.
• Start a side hustle.
• Offer freelance services.
• Sell unwanted or unused items.

Important: If you have a volatile income, it’s even more important to establish different ways to make money. 

Reduce your monthly expenses

When you scale back your spending, you free up more cash for debt repayment. Consider:

• Moving to a lower-cost-of-living area.
• Getting a roommate.
• Using public transportation.
• Shopping at thrift stores.
• Buying generic goods.
• Negotiating a bill reduction with your internet, cellphone, and insurance providers.

You can also practice delayed gratification. Instead of buying something when it catches your eye, wait a few days. You may be surprised how much this trick will save you!

Consolidate your debt

Consolidating your debt can help you pay off your balance faster – often at a lower interest rate. Debt consolidation happens when you take out a bigger loan to pay off multiple smaller obligations. 

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Commonly, people take out a personal loan to pay off credit cards. However, you can also tap into your home equity through a home equity loan, HELOC, or a home equity investment for the same purpose.

Refinance your debt

Refinancing your debt involves taking out a new loan to repay your existing loan. If you refinance to a shorter loan term, you can pay off your debt sooner. You may also be able to secure a lower interest rate and save money. Borrowers often refinance student loans to get a better deal for their financial situations.

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You can also refinance your mortgage to pay off debt through a cash-out refinance. With a cash-out refinance, your new mortgage pays off your old home loan and gives you money on top for debt repayment (or other purposes).

Consider debt relief

If you’re overwhelmed by your debt and feel you’ll never get out of your financial hole, you may want to research debt relief options. One popular debt relief option is debt settlement.

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With debt settlement, you hire a professional to negotiate lower account balances with your creditors. You may be able to get out of debt for a fraction of what you owe.

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However, you’ll have to pay a fee for this service, which eats into your savings. Plus, there’s no guarantee that the company will be successful, and your credit score could take a major hit while you wait for results.

Strategies for saving

It may seem impossible to save money when you have so much debt to pay off. Here are a few pointers to help you make progress.

Start small

You don’t have to save hundreds or thousands of dollars a month to amass a tidy sum. Jumpstart your savings efforts by setting aside whatever amount you can – even if that’s $10 a month. You can contribute more when your financial circumstances change (and they will).

Automate your savings

You lead a busy life, so it can be easy to forget to transfer money from your checking account into your savings account every month. Fortunately, you can take the burden off your memory by setting up automatic deposits into your savings account. 

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You can have your employer direct deposit a portion of each paycheck into the account or have your bank perform an electronic transfer on a set date each month. 

Leverage employer matching

Don’t worry if you haven’t saved much for your golden years yet. You can catch up on your retirement savings.

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One way to do this is to get your employer’s maximum match on your retirement savings contributions. You’ll get a greater return on investment (ROI) doing this than you will paying off debt. For example, if your employer gives you a three percent match on the first three percent you contribute, that’s a 100% ROI!

Final thoughts

We’ve given you a lot of insight into the question, “Is it better to pay off debt or save?” But the truth is only you can decide which financial goal to pursue and when. 

Remember, though, that your money is a moving target. As you make progress toward your goals or your life circumstances shift, you can change gears accordingly.

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