You’ve got a mini mountain of debt staring you in the face every time you check your bank account, but you’ve also got a savings account you’d do anything to bulk up. When a surplus of cash suddenly hits, it’s a financial fork in the road: Should you pay off debt or save? The answer, according to Jennifer Barrett, chief education officer at Acorns, a site dedicated to helping you bolster your bottom line, is less complicated than you think.
What to Prioritize All Comes Down to Your Interest Rate
When determining whether to pay off debt first or save, the first step is to get crystal clear on how much you owe, explains Barrett. But that requires more than a peek at your balance. You need to calculate how much you’re paying in interest on that debt, then try to get that interest rate down as much as you can.
“Credit card debt can carry an annual interest rate of 16 percent—which is the current average—or more,” Barrett says. “High interest rates can significantly add to what you owe and make it harder to pay off, especially if you’re only making minimum payments.”
Once you have a reasonable interest rate (i.e. you’re not accumulating more debt than you’re paying off every month), you’re in a better position to allocate funds to debt and savings at the same time.
Bottom line: When deciding what to prioritize—debt vs. savings—paying off high-interest debts should always come first.
How to Whittle High Interest Debt Faster
Barrett recommends making a significant dent in high-interest credit card debt by transferring a high-interest balance to a low-interest (or, short-term, no interest) card through a balance transfer offer.
But you can also call your credit card issuer directly and negotiate a lower rate to keep your balance there versus transferring it. (Just make sure you do your homework and have a balance transfer offer you’ve vetted ready—meaning you’ve done the math on any fees—so you can push them to match it.)
Keep in mind: Your credit card score is also a major factor if you want to lock in a better interest rate.
Once You’ve Reduced Your Interest Rate, Pay Off Debt *and* Save
Now’s the moment to decide the fate of that sudden surplus. Per Barrett, once you’ve negotiated and gotten your interest rates down as much as you can, your goal should be to pay off outstanding debts as quickly as you can. That said, it’s smart to save and invest a little at the same time. “This way, you’re not putting in all that effort just to get to zero. As you pay down your debt, you also have money you’re putting away that’s growing. In other words, you have interest working for you, not just against you with your debt.”
But saving doesn’t have to be complicated. It’s as simple as contributing to any employer-sponsored plan like a 401(k) and taking advantage of any employer match program. (“That’s free money, especially if they have a 100 percent match!” Barrett says.) Don’t have access to a 401(k) through your employer? Consult your bank about opening up an IRA. (For 2020 and 2021, the max annual contribution is currently $6,000 or $7,000 if you’re age 50 or older.)
You can also prioritize building your emergency savings and investing a little bit, too. “Paying down expensive debt—should be the priority, but there’s value in getting in the habit of regularly saving and investing some of your paycheck as well.” Even if you can only set aside $25 a month to savings, it’s something. As the debt is paid off, you can increase the amount you’re saving and investing, which gives you a real head start on building your net worth once your debt is gone.
How to Prioritize Debt vs. Saving in a Pandemic Year
The pandemic has reminded everyone of the importance of having some savings, especially when the future is entirely unpredictable. “We went from a booming economy to a dramatic downturn in less than a month,” Barrett says. “This experience underscores for us all the importance of having a cushion to get you through those down times.”
Of course, your approach to whether to pay off debt or save during COVID-19 comes down to how this year has affected you personally. “If you’ve lost a job or you’ve seen your income drop and you’re struggling to cover your bills, it’s more a matter of making sure that you don’t fall behind with your debt payments as you look to replace your lost income,” Barrett explains.
In other words, you want to do what you can to continue making that minimum payment on high-interest debt every month. If you can’t, your best bet is to reach out directly to your debt issuer and explain your situation and your intent to pay down that debt. You may be able to negotiate a lower interest rate, given the extremely extenuating circumstances of this year, and a payment play to stay on track and avoid any long-term damage to your credit, says Barrett.