To save or pay off debt is usually one of the many questions we get. Today we’ll try to decipher and give general recommendations on what to look for in order to make a wise decision on this important aspect of personal finance. My main answer to it begins with a very broad non-answer ‘It depends’. The reason for that answer, which we’ll clarify better below, is that prior to answering such a specific question, we need to look into the bigger picture of the individual’s personal finances in a comprehensive way. What’s known broadly as ‘Financial Planning’ is the most important beginning point for most people, which looks at all the aspects of a family’s finances in a comprehensive way. It looks at your budgeting or cash flow, your assets and debts, your free cash flow (what’s left after all expenses), and also your goals that you have and want to achieve. Let’s begin to unravel the things necessary to answer this question.
For starters, we want to start by looking at what financial goals we’d want to achieve first. During this process, it is important to prioritize those goals from the most important to us to the least important, while also assigning a dollar value of accomplishing the goals, as well as a time-frame by when we want it accomplished. Once we have our goals defined and categorized in terms of their importance to us, then we look at the cash flow and budgeting next.
Under budgeting and cash flow, where we list our income(s) as well as all our expenses, we should see if there’s any extra cash left at the end of the month to be used for our goals. In terms of the priorities that we set up above, we then take a look at the goals and where we’d want to put that leftover money. These are definitely specific to the individual and each one of us is unique and has different goals, but certain goals are universal.
After all of the above, we finally come to your initial question, but not before checking all of the debts you have, their interest rates, and if you have an emergency fund established or not. Something even more important during these unprecedented COVID times is having an emergency fund or savings established to cover the recommended amount of at least 3-6 months of your expenses. If you don’t have such, you can work on it by adding to it periodically until you achieve such amount. Up to that point, the suggestion is to save for your emergency fund, while making minimum or regular payments on your debts. Once you have established your emergency fund and you’re comfortable with what you have in it and for how long it will last, then you can see if paying extra towards your debts or further saving more makes more sense.
The type of debt that you have matters most at this point now. If you carry credit card debt month to month (if you don’t pay the balance in full) then your best use of extra cash is to pay down those high-interest debts. Credit card debt is typically at 15%+ annual and sometimes much more, thus paying it down as fast as possible is a wise financial strategy. On the other hand, if you don’t have any high-interest debt, but just a mortgage or low-interest student or car debt, then the strategy may change. If you’re disciplined to save and invest the extra cash, then you can save or invest it while making regular (not extra) payments on those low-interest debts. On the other hand, if you don’t have the discipline to save or start investing those extra cash, then the best bet is to pay down debt, even if it is low interest.
Obviously everyone is unique, they have different goals they’d like to achieve and have different spending and behavior patterns. But if you understand the basics, as well as in order to answer a simple financial question, have a much thorough analysis and perspective, you’d come to realize what is important to you. For some, being debt-free is a worthwhile goal, regardless of the rationale or the trade-offs you’re reaping by just focusing on that debt payment and (maybe) not saving or investing much. For some others, carrying some low-interest debt is OK and manageable as long as you start investing early. Obviously you are you, but there are some universal rules of thumb to follow in order to better optimize your available options. If you need further help, please feel free to reach out to our advisors. Be safe and don’t forget to check on others during these hard and trying times.