Pay Down Debt or Save Money?

Should you forego saving money to pay your debt all the time?

If your personal debt is overwhelming you and it presents cash flow concerns, reducing your debt should be a primary concern. You should be aware of the warning signs that you carry too much debt. Review the warnings signs here.

In some situations, saving cash may be a better option than paying off your debt. You may want to make minimum payments while saving the remainder of cash and investing it, or you may want to find a balance between saving and paying down debt. With a little time and effort, you can get a general idea of which option to use. Try using this simple 3 step process to make your choice.

1. Identify the variables
2. Run an analysis on the different scenarios
3. Choose and implement the best scenario for you

These steps are simplified to help you do-it-yourself. A financial professional is likely to follow more extensive steps and run a more detailed analysis.

Pay credit cards or save money example:

Identify Variables:

Example

• $15,000 credit card balance
• 12% interest (using a 1% charge per month for simplicity)
• $200 minimum monthly payment
• $800 a month of discretionary income to save or pay down debt
• Money saved earns a 3% rate of return
• 12 month period analyzed

Run Analysis Once you identify your variables, you can use a spreadsheet to make a comparison. Interest expense on credit cards can vary widely depending on a lenders method of calculating the interest, even if the APR is stated as the same. Because of this complexity it is easier to use simple math by dividing the rate by months, which is what I did.
Example Using Excel

• Create a row for each account and a column for the variables you identified (that effect the computation).
• Enter the input numbers you already know into the appropriate fields (cells) created from the rows and columns.
• Use calculations (functions) for the result fields like the end balance and change in equity.
• For the end balance I used the future value function. You can do this by typing =FV( into your cell. Brackets will pop up and show you which values to enter into them. Example: =FV(interest rate,# of periods,pmts,starting balance “must be negative”,type “0 or 1″)
• The change in equity is the difference between the beginning and ending balance. Add the change in the credit card to the change in the savings to return the overall result.
• I used simple math to show the “Total Payments / Deposits” and “Interest” columns for increased detail.
• Check your numbers and any functions a couple times, it is easy to make a mistake that changes the results.
• I used a starting balance of $0 for the savings account so the interest earned only reflects the deposit of what was not used on the credit card. Acquiring the correct results with a starting balance in the savings would require some additional steps.

Scenario 1 – You decide to use the entire $800 on paying down your credit cards

Total net worth change = $8,345

Scenario 2 – You decide to make your minimum credit card payments and deposit the rest in your savings accoun

Total net worth change = $7,978

Results = Scenario 1 is $368 dollars more effective then scenario 2

Implement plan

The above analysis shows the approximate difference between the two scenarios. Based on your calculations you would choose scenario 1 and allocate the full $800 to paying your credit card. Before you make that decision, consider other intangible factors. Saving $368 dollars may not be worth it if any of the following apply.

• Do you have an emergency fund? If not, you should work on building one up.
• Do you reasonably feel like you can earn a higher rate of return on what you save than what your credit card charges?
• Consider your financial behaviors. Are you less likely to spend money that comes from saved cash than the swipe of a credit card?
• Are there any other factors your life circumstances that require significant amounts of cash?

The above example assumes significantly higher interest rates on the debt than the savings. Even so, the amount of financial benefit is marginal compared to your possible need for liquidity. This is an example of how, even when it may cost less to pay the debt first, some may choose to save money and make smaller payments. Every situation must consider the tangible and intangible factors.

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