In his play “Hamlet, William Shakespeare wrote, “To die, to sleep;
To sleep: perchance” to dream: ay, there’s the rub…” But a better question today might be “which comes first to save more or to pay down debt, ay there’s the rub.
10% to 20% – seriously?
Financial advisers say that we should be saving 10% to as much as 20% of our income. But the latest data from the Federal Reserve Bank of St. Louis is that the United States’ savings rate is just 4.2%. Why do so many of us have a tough time saving money? In most cases it’s because we’re deeply in debt. If you’re facing the double curse of high cost debt and little in the way of savings, what’s better? Should you put your money into savings or pay down your high interest debts as quickly as possible?
Put first things first
The simple fact is that if you have high interest debt and are trying to save money it’s like trying to swim when you have a cement block tied to your feet. Paying down high-cost debt should always come first before trying to save money. Here’s why. Let’s suppose that you are carrying $10,000 in credit card debt at a 15% interest rate. If you make just the minimum payments each month, it will take you nearly 30 years to pay off that debt and it would cost you about $12,000 in interest. As you can see from this example, your number one priority should be paying down debt before you do anything else, including putting money into savings. That’s because this will have a much bigger impact down the line – especially if you’re dealing with credit card debt.
However, most experts also say that before you start using money to pay down your debt you need to put a little bit aside as an emergency fund. Ideally this should be three to six months worth of living expenses. Unfortunately, that’s not easy to do if you’re carrying thousands of dollars in credit card debt. So instead of this, you might try to start with $2000 so you would have some money to cover unexpected bills.
Get a guaranteed return
The biggest benefit of paying down credit card debt is that it gives you a guaranteed return on your money. You can precisely determine and quantify a guaranteed rate of return by using your interest rate, balance and payment plan. While you would be lucky to earn 2% these days on a certificate of deposit, you could get a guaranteed 15% or more by paying down your credit card debt – making this a very good deal.
Save a fortune
When you pay more on your debt you will not only get out of debt faster, you will save a fortune in interest. Plus, once you pay down that debt you will be able to put a lot more money in your savings.
Back to the previous example
If you go back to the example given above of the $10,000 in credit card debt let’s assume that you increase your payments to $400 per month – instead of making just the minimum payments. In this case, you’d pay off your debt in three years and your interest costs would be only $2000. That would be a savings of $10,000 that you could then add to your savings account in subsequent years instead of your bank getting the money.
$9600 in just five years
In this example if you did increase your payments to $400 then continued to save that $400 per month once you paid off the debt, you’d not only be debt-free you’d have $9600 in the bank in just five years.
One way to get out from under credit card debt is to get a home equity loan or home equity line of credit and pay it off. This would dramatically reduce your interest rate, which will reduce the amount of interest you will end up paying. However, there is a danger to this and you should tread very carefully with the equity in your home. The problem is that you would have a new loan and if not careful, could very well rack up new credit card debt. This would leave you in a worse situation because you would now have a home equity debt as well as credit card debt. For this to work, you need to have a tremendous amount of discipline and personal commitment because if you don’t, you could easily end up in even worse shape than before you took out the loan.
Another way to get credit card debt under control would be to do a balance transfer from your high interest cards to one with a lower interest rate. There are still cards available that give new cardholders anywhere from six to 18 months with 0% interest. However, before you rush off to get one of these cards make sure that you read the fine print as some have balance transfer fees of 2% to 3%. Plus, you must pay off the credit card before your promotional period expires or you’ll be hit with more interest that could be as high as 18% or even 20%.
Snowballing your debt
Third, you could use the snowball strategy to pay off your debts. The way this works is that you start by paying off the card with the lowest balance because this will give you a psychological boost to continue paying off your debts. And when you get that first credit card paid off, you will have more money available to begin paying off the debt with the second lowest balance and so on. Where this strategy gets its name is because as you pay off that first debt you will begin to gather momentum just like a snowball rolling downhill. Many people have paid off as much as $25,000 or $30,000 in debt in just two to three years by using this strategy. It was invented by the financial guru, Dave Ramsey who explains more about it in this brief video.
The worst option
There is yet another option for getting out of debt that is sometimes called the “nuclear” option. It’s to file for a chapter 7 bankruptcy. If you can qualify for one of these bankruptcies you will get all of your credit card debts discharged (eliminated). If you have medical debts, a personal loan or personal line of credit, they should also be discharged. But there’s a good reason why this is often called the nuclear option. A bankruptcy will stay in your credit file for at least seven years. It’s likely that you would not be able to get any new credit for the first two or three years after the bankruptcy and when you can get credit it would come with a very high interest rate. Plus, there are some debts a chapter 7 bankruptcy can’t discharge, including student loan debt, alimony, child support, a mortgage or auto loan and any debts incurred through fraud.
Marked for life
The worst consequence of a chapter 7 bankruptcy may be the fact that it will stay in your personal file for the rest your life. Fifteen years from now you could get turned down for a really great job when your prospective employer saw that you had a bankruptcy. Many employers now routinely check credit reports as part of their hiring process. And like it or not, some people will always hold a bankruptcy against you because they believe it shows that you’re irresponsible when it comes to handling your personal finances. Your chances of getting that dream job may also be reduced if that prospective employer sees other negative items in your credit report such as late payments, defaults, accounts that have gone to collection and charge offs.
The best policy
What this all means is that the best policy is to get your debts paid off as quickly as possible. This should always come first before putting money into savings. It will pay off big in the long-term and when it comes down to it, what’s better – to be in debt or debt free? If you were to pose this question to that group of kids sitting around a table in those commercials that are currently running, we’re sure they’d all yell “debt-free.”