Personal Finance

Should I pay off my debts or build my savings?

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A common question that people ask me is:

Should I pay off my debts or build my savings?

To answer this question, let’s look at three things:

Assess How Much Time You Have

When deciding whether you should pay off your debt or save for later, you need to take into consideration something even more important: time. Through compounding, small contributions that you make now to your retirement or education funds grow significantly, allowing you enough latitude to do both simultaneously.  If you are starting late in the game, you need to prioritize.

Prioritize Your Debts

Figure out which debts have the highest interest rates, then pay those down first. Usually credit card debt is the biggest factor, then student debt. Trying to save or invest while you have high interest rates is like trying to win the Tour de France on a stationary bike. You won’t go very far, and you’ll expend way too much energy without any progress. Think of every high interest rate debt paid down as a gain. Paying down a debt that collects 15% interest is equivalent to savings that amount in the future (because you aren’t paying it!)

Think of it this way: If you have 10k invested earning 2% and another 10k in credit card debt that you pay 15% on, you’re losing money. Want to remedy this problem? Pay down your credit card debt first, then schedule for reoccurring debts. After that, look into investing and saving more.

When considering your debts don’t forget your debts to family and friends. You may not have a promissory note between you and they may not be pressing you to pay, but you don’t want put those relationships at risk and you certainly don’t want to risk your afterlife.

Focus and Create a Plan

Unless you hit the road with a plan, you’ll always struggle. After reading this, here are your action items to move forward with:

1- Budget for your expenses.

2- Understand the debt you owe and how much you’ll end up paying.

3- Create a strategic plan to pay off your debt, then look into saving and investment.

 

Emergency Funds – The Basics

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Starting an Emergency Fund

An emergency fund is an amount of money that you save for hard times. Out of sight and out of mind, you don’t use it until you absolutely, positively need it. Many advocate for at least $1000 in savings to be held in an easily accessible location (i.e. in cash or a savings account). While $1000 is a frugal choice, I’d say you probably want a little more than that. If you can save around $3000 dollars for your emergency fund, it will go a long way during hard times.

I recommend $3000 because most unexpected expenses will take a large chunk out of your pocket. Think about your last major car repair, it was probably on the low end of $500 dollars and the high end of $2000. Think about medical bills. Sometimes your insurance won’t kick in until you’ve met your deductible, i.e. the minimum you pay out of pocket in order to have a large portion of your bill covered by the insurance company. Depending on your health insurance plan, your deductible can be anywhere from $1000 to $3000 dollars. What if you had to go to an emergency room for treatment? The costs would sky rocket.

After your Emergency Fund

But what about after you’ve saved that initial 1k (or 3k)? In addition to your emergency fund, you’ll want a “Disaster Fund.” Why? Because while unexpected costs can sideline you if you have a job, those same costs can be disastrous if you lose your job or are disabled.

Generally you’ll want to save about 10% of what you make monthly for your Disaster Fund. Take this 10%, add it to your savings, and act like it is not there. Let’s say you take home 5k a month. 10% of that will be $500 dollars. How long do you save 10% for?

Let’s look at two possible scenarios that could play out in your life:

1) You lose your job.

2) You start your own business.

While the second isn’t really a disaster, you’ll probably be bootstrapping it for a while. How do you maintain an adequate lifestyle when you’re paying for everything without positive earnings? This is where the disaster fund comes in. If you’ve lost your job, it will take a minute before you get another. If you start a business, it will take a minute before you have a positive cash flow.

Most money specialists will tell you to have at least 6 months of your expenses in savings for a Disaster Fund. So if your take home pay is 5k a month, but you only need 3k of it a month to pay for all your expenses, then you’ll need to save 3k x 6 = $18,000. If you’re saving 10%, you’ll cap off your disaster fund in about 36 months or 3 years. What if you increase your savings until you get to that point? Instead of saving 10% when starting your fund, you invest 20%? You’d be saving 1k a month, and that would cut your savings time for the disaster fund in half to 18 month or 1 ½ years.

After you’ve met your 6 months of expenses in your Disaster Fund, you can scale down your savings percentage to something lower. If you are comfortable with where it is, start to invest the same amount you were saving. See some of our article on investments to get a better idea of what to do in that situation.

Bottom line: Start today to secure an emergency fund, then a disaster fund.

The Prophet ﷺ said “If I had mount Uhud in gold in my home I’d give it all away in three nights, except for some money that I’d save to pay off debts.”

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