Saving By Reducing: How Lowering Your Debt Can Save You Money
You may not realize it, but by paying down your debt, you ARE saving! Actively reducing your debt means you’re saving on interest, avoiding late fees, and maintaining or increasing your credit score. Simply put, the act of reducing the size of your outstanding obligations and the savings that come from it have positive ripples effects throughout your entire financial life.
How does reducing debt help you save?
Consumers often think saving and reducing debt are two separate goals or that saving money is more important than lowering debt – or vice versa. However, it doesn’t have to be that way. By ignoring your debt load, you could inadvertently keep yourself stuck in a bad financial position. This is mostly due to the high-interest rates and your regular payments barely touching the principal balance, keeping your debt high and prolonging your payments to the creditor.
It makes good financial sense to pay down any high balance and/or high-interest rate debts while regularly contributing at least something to a savings account. By reducing debt aggressively, you’ll eventually be able to devote more money to your savings.
A real-life example: Pat & Terry
Let’s say Pat and Terry both have a $10,000 personal loan with a 10% APR, a minimum monthly payment of $213, and a term of 60 months. Each has $600 to allocate to debt or savings each month. Pat decides to prioritize saving and only makes the minimum payment each month, putting the extra $387 in a high-interest savings account with .5% interest. Terry decides to prioritize paying off the loan by paying $500 each month and saving the extra $100 in a high-interest savings account with .5% interest.
At the end of 5 years, Pat would have paid about $12,780 on the loan and saved $23,517.52. On the other hand, Terry would have paid off the loan in 22 months, rather than 60. During those 22 months, Terry would only save about $2,200. However, after that period, Terry could then deposit the full $600 into their savings account each month. By the end of the five years, Terry will have saved $25,232.05. This example shows that paying down your debt faster may lead to a significant increase in savings in the long run.
What to prioritize
If you have high-interest-rate consumer debt, you’d likely benefit from prioritizing paying down the debt while making smaller contributions to savings. By doing so, you may significantly increase the benefit to your bottom line – more so than you would investing in the stock market or using a savings account. However, there may be situations when saving should come before reducing your debt, such as having a 401(k)-matching program with your company, lower interest rate debt, or student loans that can be deferred interest-free for an extended period of time.
How to do it
If you’ve decided to reduce your debt to maximize your savings down the line, the best way to determine how much to pay towards your debt is by creating a budget. You’ll be able to see how much extra income you have at the end of each month. Your regular minimum debt payment should be counted in your expenses so that the extra money is genuinely “extra.”
Next, decide how much money you feel comfortable paying toward your debts, balanced with how little you are comfortable saving each month. If you already have an emergency fund, you can probably pay more and save less. However, if you are still working on growing an emergency fund, you may want to pay extra on the debt but save more until you have a small emergency fund.
If you have multiple debt accounts, pick one to focus on first. You may choose to focus on the account with the highest interest rate, or you may choose to focus on the smallest balance to eliminate one account faster. It’s up to you to decide what proportion of debt repayment versus savings makes the most sense for your situation.
Get advice
If you still aren’t sure what option makes the most sense for you, consult someone who can help. A free financial counselor or coach are excellent choices. There are also free calculators and tools online that can help you figure out how long it will take you to pay off your debt, as well as how much you can save over time. You should never feel like you have to guess how to best use your money. By seeking extra help, you can dramatically improve your financial situation.