Should you hold off on saving until your nonmortgage debt is paid off?
Simple math suggests it's better to get rid of debt before saving for retirement or an emergency fund. After all, if the savings rate is 1 percent and you have credit card debt at 14 percent interest, money is better spent paying down debt quickly.
But personal finance decisions are rarely so simple, and this method may not be the right choice for everybody.
"Like everything else in life, this decision is one of balance, not of absolutes," says Michael Rubin, president of Portsmouth, N.H.-based Total Candor, a provider of financial education.
Dean Barber agrees. The host of nationally syndicated talk radio program "America's Wealth Management Show" says there are pros and cons to each approach.
"You have to set your priorities ... and understand the consequences to either paying debt first or saving money first," says Barber, who is also president of the Barber Financial Group of Lenexa, Kan.
So which should come first -- paying off debt, or saving?
Paying Debt Before Saving
The notion of saving before paying high-interest debt is hard for some financial advisers to swallow, given the math.
Donna Fox, author of the book "From Credit Repair to Credit Millionaire," says low interest rates on savings accounts make paying off debt first a better choice right now.
"It's simple mathematics," she says.
Too many savers ignore the math and instead opt for a false sense of security, Fox says.
"People get into trouble with debt and finance when they start letting emotions vote on their outcome," says Fox. "So they feel better if they have a cushion in their savings account, even though for most people it's not the financial savvy thing to do."
She cites the example of someone who has $10,000 in savings (earning 2 percent) and $10,000 in credit card debt (at a rate of 9 percent). Anyone pleased with this situation is misguided, Fox says.
"This is like investing your $10,000 in an investment you know will lose 7 percent a year ... and being happy about it," she says.
Instead, the debtor in this example should pay down obligations as quickly as possible.
"You then have the free and clear (credit) card available as a cushion in case something goes wrong," she says.
Barber says savings are important, especially as part of an emergency fund. But he agrees with Fox that paying down debt first sometimes makes more sense.
He gives an example of a 50-year-old with $20,000 in credit card debt, $200,000 in 401(k) but no cash reserves.
"If you use the reasoning of needing cash reserves, you will incur more debt because interest is compounding on that $20,000," says Barber.
If this same person has $1,000 in disposable income per month, and if the entire amount is put toward the credit card (at 12.5 percent interest), the card can be paid off in 2.5 years, he says.
in disposable income per month, and if the entire amount is put toward the credit card (at 12.5 percent interest), the card can be paid off in 2.5 years, he says.
"At that point, the person can then start saving," says Barber.
Saving Before Paying Debt
However, others disagree with paying down debt before saving. In particular, they stress the importance of building up an emergency fund before eliminating debt.
Having a stash of emergency cash is more important in today's economic times of tight credit, says Sarah Place, president and CEO of Place Trade Financial, a full-service, discount brokerage firm based in Raleigh, N.C.
She suggests socking away six to 12 months of easily accessible cash to cover any unexpected expenses. Access to such money is especially important today, when many people have found their home equity line of credit has been reduced -- or even canceled.
Place acknowledges that it's difficult to tell people to save "in an environment where they are earning a fraction of a percent of interest on their savings" while being charged "usurious loan shark rates of over 30 percent on their credit cards."
"However, in the given economic circumstances, tough choices have to be made," she says.
Rubin generally belongs in the camp that advocates paying down debt before saving. However, he cites exceptions to the rule. In particular, he urges a "save first" approach in situations where a person's employer matches contributions to the company retirement plan.
In the given economic circumstances, tough choices have to be made.”
"The guarantee provided by a matching program is even more valuable than repaying credit card debt, so one should always maximize the match first," says Rubin, who is author of the book "Beyond Paycheck to Paycheck: A Conversation About Income, Wealth, and the Steps in Between."
Rubin also says it's OK to delay paying off debt in circumstances where interest rates are low, such as zero-rate or low-rate car loans. In such cases, it's better to make scheduled monthly payments and not worry about devoting extra cash to paying down the debt faster.
Any extra income saved then should be funneled into savings in a high-interest savings account, Rubin says.
Best of Both Worlds?
Still others suggest the best solution is to strike a balance between saving and paying down debt that you -- and your family -- can live with.
Paula Langguth Ryan of Cocoa, Fla. -- author of personal finance books, such as the forthcoming "Break the Debt Cycle -- for Good!" -- is an advocate of this combination approach.
She says paying down debt in a steady, systematic way while also building up a little emergency savings helps reinforce sound spending and saving habits that continue to pay dividends long after the debt is gone.
"You're actually retraining your money habits," Ryan says.
Ryan concedes you may net more money by paying off the higher interest rate debt rather than putting money in savings. However, she says any short-term gain will be lost if you revert to using a credit card to cover emergencies.
"You just replace old debt with new debt," she says.
Creating an emergency fund is the only way to break the debt cycle, she says. Without such a cushion, chances are good that you will fall back into debt as soon as you're in a financial pinch -- no matter how much money you're throwing at your current debt.
"Save a reasonable amount to build up a nest egg, then increase your debt payments once you've saved up a certain amount -- about $500 to $2,000 -- to cover the usual cost of emergencies you may encounter," Ryan says.
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