Ask a group of financial advisers to name one thing people should do to improve their financial outlook, and “save” is guaranteed to be the top response. But given a choice between savings and debt reduction, which is more important?
If you want a mathematical answer, there’s a lot of number crunching involved. Given today’s economic climate, the interest on your debt — even the relatively low interest charged federally subsidized student loans — might be higher than what you can earn through secure savings vehicles like savings accounts, CDs and money market funds. Given this situation, paying off your student loans early could be to your advantage.
“Once you have a modest balance in your emergency fund (say around $1,000 or so), begin working on your debt reduction plans,” suggests one popular online banking service. “That way, if an emergency does come up, you can address it without adding to your debt. Once you’ve eliminated your high interest debt, you can concentrate on saving up even more in your emergency fund. It’s conventional wisdom to have at least six months of living expenses saved up in an easily accessed account.”
Of course, if the situation changes and it becomes easy to get returns on savings and investments that are at rates higher than your student loan debt, then the effects of compound interest make maxing out your savings contributions each month a better long-term choice than maxing out your loan payments.
“From a financial standpoint, if the interest rate on your debt is lower than the interest rate on your savings or investment, then you’d get a higher return by saving versus paying off debt,” says credit and debt management expert LaToya Irby. “There are also tax benefits to retirement savings. The money you contribute to a 401(k) can often [be] excluded from your taxable income, resulting in a lighter tax burden. Take advantage of your employer’s offer to match contributions to your 401(k) plan. Don’t turn down free money.”
In other words, it’s better to save when saving gets you more money than you’ll spend on the student loan. Your own specific financial situation — the interest rate you have to pay on your student loan debt, the interest rate you can earn in safe and secure investments and the impact of your savings decisions on your tax burden are all important considerations.
In all likelihood, you will be better off in today’s economy paying down your student loan debt first. There are also psychological aspects of this question to consider, however, and the general recommendation given by financial and personal wealth experts is to save something — typically a set percentage of your income — every month. This will build a strong savings habit that you can make even stronger when you clear out that student loan debt.
“Allocate 50% of all you are able to save to your emergency fund, and 50% to debt reduction until you have four to six months’ of living expenses in your emergency fund,” recommends Ted Hunter, author of Money Smart. Once you’ve built up this emergency fund, “eliminate all debt except that which involves your home and your car, then maximize the tax-deferred savings allowed to you.”
Whether you follow Hunter’s strategy or not, you’ll need to examine your specific debt obligations and savings/investment opportunities before making a decision. With low returns on today’s savings vehicles, aggressively paying down your student loan debt while still contributing regularly to savings is likely to be the best choice.
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