Hi there. Welcome back. A few days ago, I asked some of my Facebook friends if they had any questions/suggestions for my blog. I got a few questions and some ideas for topics that I will address in upcoming posts. Here is one of the questions that I answered and hope will provide some useful information to you all.
Question #1 – What’s Better? Saving vs. Paying Off Debt
Answer – This is the one question that I get all of the time, and I have a slightly different view on things vs. many of the popular personal finance experts out there. Suze Orman and Dave Ramsey both shout that DEBT IS EVIL and it must be paid off at all costs. I don’t disagree, but I guess I ‘m more in tune with what people go through every day and take more of a “weaning off” approach vs. the “quit cold turkey approach” that most financial experts proselytize.
First, we need to ask whether we’re talking “good debt” vs. “bad debt”. Good Debt (if there is such a thing) are debts that are associated with acquisitions/investments that have a chance to increase in value. That would include a house because they typically increase in value over time to the point where the value of the property exceeds that of the debt. Another example would be student loans because you’re investing in your surest bet – yourself. With more education and expertise, it is hoped that your earning power and ability to obtain higher levels employment (and hence, greater wages) will allow you to pay off the debt more quickly over time. Lastly, many of these debts have tax incentives associated with them (the mortgage interest deduction and student loan interest deduction). Hence, the US government is supporting you in your efforts to take on and pay off this debt.
Bad Debt is generally any debt that is personal in nature, like credit cards, personal lines of credit, auto loans, and retail credit accounts. What makes these debts “bad” are that the debts are being generated for buying “stuff”. With the exception of a car (which can be a necessity for work, transporting family, etc.), many purchases on retail and/or everyday items are “expenses” that are used up or rapidly lose value after purchase. However, the debt associated with such purchases are steep, ranging from 8,99% to 29.99%! And this debt compounds daily, which if left unchecked can lock an unsuspecting consumer into a vicious cycle of making payments on debt that doesn’t seem to go away.
Now that we have our debts straight, we can now contemplate whether it makes sense to save while dealing with debt or to apply that money to pay off the debt quicker instead. The answer is “it depends” (the typical accountant answer – sorry). It depends on the type of debt we’re dealing with and the where a person is with their savings. All of these facts help with the decision making, but I am going to present a basic framework that I use with many of my clients. It’s called waterfall budgeting and it works like this:
- Pay yourself first – 10-15% of your paycheck
- Address Necessities first – Food, Shelter, Transporation to/from Work
- Pay Minimum Amounts Due on “Bad Debt”
- Savings toward Retirement (enough to fully secure company match)
- Pay Minimum Amounts Due on “Good Debt”
- Savings towards Retirement (if you qualify, max out our Roth or Traditional IRA, or contribute to your work plan up to amount needed to meet your retirement goals)
- Pay towards non-monthly expenses – Quarterly, Semi-Annual Bills, etc.
- Fund “Fun and Splurge” bucket – 3-5% of paycheck
- Pay remaining to “Bad Debt”
Now you might say “Why are you paying both”? My mother taught me to never “cut off your nose in spite of your face”, meaning not to do something against an enemy that will wind up ultimately hurting yourself as well. If we apply this logic to the situation at hand and take all of our money in an effort to pay off debt, what happens when a financial emergency occurs and there are no savings there? You reach back for that credit card and the vicious cycle repeats itself. If you build up savings while contemporaneously paying down debt, you have a better chance of withstanding the bumps in the road along the way. And how good would it feel to have your debt paid and your savings at appropriate levels (6-12 months of expenses)? As happy as I am to wrap up this post (smile)!
Thanks for tuning in. I apologize for the overly worded post. I am trying to keep these to 500 words or less. Thanks again!