When you have debt and little savings, you face the dilemma of whether to build up your savings or pay down debt. Saving gives you the security of knowing you can handle unexpected expenses, but you are paying far more interest on your debt than you get from your savings. Paying off debt leaves you vulnerable if you face job loss or major expenses. Financial advisers vary on their recommendations for the best strategy, but they agree on a few points.
If you have any debt at astronomical interest rates, such as payday loans or car title loans, paying it off should be your top priority before you save even a penny. Payday loans often have interest and fees equivalent to an APR of over 300 percent. Plus, lenders require borrowers to pay these loans in full or to pay the fee again to roll over the loan for another pay period. If you need to roll over a loan, at least try to cut your expenses so you can get a slightly smaller payday loan next time, with slightly lower fees. Work on paying it off as soon as possible so you can put your money toward savings or other debts instead of excessively high payday loan fees.
Even when you have high-cost debt, such as credit cards or personal loans, you should still be contributing to your retirement savings. There is no substitute for starting to save for retirement early and consistently. In particular, if your employer matches your contributions to an employer-sponsored retirement account, you should contribute the full amount to get that match. This approach provides an immediate 100 percent return on your investment, which is far more advantageous than paying off even debt at high interest rates.
Financial expert and debt adviser Dave Ramsey recommends that individuals or households save $1,000 before starting to pay off any consumer debt. This $1,000 can cover expenses that come up, such as necessary car repairs, home repairs or medical costs. Psychologically, having this money and not having to use credit for these expenses helps you stay on track with getting out of debt. After you have saved $1,000, you can start paying off debt with the peace of mind that you can handle a few unexpected expenses without having to negate your progress with your debt.
Most financial experts recommend that you have an emergency savings account containing enough money for three to six months of living expenses. You can dip into this money if you ever lose your job or suffer an injury that keeps you from working. Experts vary in their opinions about whether to build up emergency savings or pay off debt first. Dave Ramsey recommends paying off all debt except the mortgage before building emergency savings whereas Liz Pulliam Weston recommends building an emergency savings account before tackling debt with lower interest rates. Consider your family situation and your access to credit as well. If you have credit cards with plenty of available credit or a home equity line of credit, you could draw on these if you lost your job, so it would be safer for you to focus on paying off debt rather than on saving emergency funds.