There are valid reasons to not pay off debt with savings
In all circumstances, should I use savings to pay off debt?
If you’ve ever asked yourself this question, you’re not alone. It’s a popular belief that all debt (except the mortgage) should be completely paid off before you start stockpiling your cash. After all, paying for interest is like throwing money down the toilet.
A while back I went through the 9-week Financial Peace University Flex online course by Dave Ramsey. Dave teaches his financial strategies with “baby steps” – even though each one is far from little or quick.
After you save up $1000 and create a budget you can stick to, your #1 goal should be getting out of ALL debt except for your mortgage.
This means stopping all savings and putting every spare penny towards your debt.
Even putting a hold on your 401(k) contributions.
Even using up all your savings (except the $1000) to pay it off.
After considering what this would look like for our finances, I decided not to follow Dave’s advice. Instead, I’m keeping the savings we have in our account, continuing to contribute 10% to our 401(k), and using whatever is left to pay down our debt.
If you’re wondering if you should use savings to pay off debt, I would say there’s no clear cut answer. But, I do believe that there are certain circumstances when you should make savings the priority.
Here are 3 valid reasons why you should put savings before debt.
Time is not on your side
My husband and I are both in our 50s. We have a 401(k) that we’ve contributed to for the past 2 decades, but there were many years when we could only put in the 3% that was matched by his employer.
We’re not panicking, but we do need to get more aggressive with saving if we want to retire on time.
The sooner we can build up our retirement fund, the faster compound interest will get us to our goal faster. At this point in our lives, time is not on our side. We need to leverage every minute we get to grow our retirement savings.
If you’re behind on your retirement savings, use a retirement calculator to figure out what you need to do to catch up. Determine how much you have to start saving every month so you can build your savings quickly and retire on time.
After you increase your contributions, you may realize there’s little left to pay down your debt. Do what you can to lower the interest rates, and find ways to increase your income. These two tactics will allow you to chip away at your debt faster without taking away from your savings goals.
The difference in interest
When you compare your cost of debt to the returns on your investment accounts, which one wins?
I typically keep all credit card debt on one card with a 0% promotional rate. Our mortgage is at 4% and student loans are below 5%. Our medical bills are interest-free.
Comparing that to our retirement fund, our 401(k) consistently has returns over 10% – about twice what we’re paying on debt.
To me, this is a no-brainer. If my rate of return is double my cost of debt, I’ll want to maximize those returns by continuing to pour into that account.
Compare the rates you’re paying versus the returns you’re making. Consider your timeline to retirement, the total of your debt balances, and the opportunities you have to lower the cost of your debt.
It’s best to be debt-free by the time you retire. But, if you can increase your net worth faster by contributing to a well-performing retirement fund, it can make sense to put savings before debt.
If you decide the profitable choice is to focus on saving for retirement, just reduce your debt payments while you increase your retirement fund contributions. You’ll still make progress with paying down debt, it will just be slower.
Related Post: How To Calculate Net Worth and Why It’s Important
You’ve lost income due to a worldwide pandemic
My husband and I were both furloughed from our jobs in April 2020 because of COVID. It’s now the end of the year, and we’re still nowhere near our regular income.
When the world turned upside down, we went into full-force savings mode. We cut out what we could, deferred medical bills and student loans, and made minimum payments on our credit cards. We shifted from a debt-focused strategy to conserving every dollar we could.
We had no idea how long we would be out of work, so we put all of our efforts into building up our emergency fund.
If you’ve lost your job or part of your income due to a crisis, your main focus needs to be covering your necessary expenses.
Tighten up your budget and pull back on your debt payoff plan. Eliminate all unnecessary spending and focus on building your emergency fund.
You don’t want to compromise your ability to pay for shelter and food just so you can get your credit card bill paid off faster.
Eventually, when you get back to work and back on your feet, you can be more aggressive with debt.
Video: Pay off debt or stockpile cash?
Know what’s best for you
I’m so thankful we have experts like Dave Ramsey who we can learn from. Even just going through the 9 videos from the course, I feel more confident in how to manage our finances.
I do believe that the majority of what FPU teaches is the best plan of action for most people. Like Dave says, the steps are simple. There’s no point in complicating things. If you follow the plan, you will experience success.
However, I still think you need to consider your own personal situation, the little details and dynamics that set you apart from others, and how the baby steps fit into all of that. Then, make adjustments accordingly.
If you’re currently following the Financial Peace baby steps, I am not encouraging you to cut out steps or rearrange them, or just pick and choose what you want to use. Do a self-awareness check and determine if you’re operating out of any level of denial.
Every baby step is helpful to reach the ultimate goal of financial freedom, but I feel there is some liberty you can take to ensure that each one is the best for your own situation.
If you feel that any changes you’ve made aren’t helping you get out of debt or increase savings, then I would say go back to the original plan.
The important thing is to consider your unique financial circumstances and goals, and make sure the strategies you implement are optimizing your results.
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Should I use savings to pay off debt? Learn 3 Good Reasons Not To