Save your money or pay off debt? It probably comes as no surprise to hear that it depends. But one thing is certain: paying off debt is not the same as saving. Here's why:
When you pay off debt, it almost always improves one aspect of your financial well-being: it lowers your monthly bills, which means you can either spend or save more. But paying off debt doesn't immediately increase your net worth, because it reduces your assets by as much as it reduces your debt. So, by itself, paying off debt doesn't do anything to advance your goal of building your wealth. It only helps if you save the amount you no longer have to send to your creditor.
Paying off debt can also make your financial situation more precarious. For example, if you deplete your savings, you may be in a worse position to cover your expenses in the event of an emergency. In fact, you should maintain an emergency fund equal in value to your living expenses for three to six months. And if you have a spouse and dependent children, maintaining a life insurance policy sufficient to meet their needs should also be a higher priority than paying off debt.
But let's say that you have both of these objectives covered. Does it make sense to be aggressive in paying off your debts? It can. It generally (but not always) comes down to comparing the potential return on your investing choices to the effective interest rates you're being charged on your loan.
Compare interest rates. If you're paying a higher rate of interest on a debt than you could earn on an investment, it makes sense to pay off that debt as quickly as you can. Such is typically the case with credit cards, when it's rare that they charge less than double digits.
If you have money left over at the end of the month, you should consider both trying to save and paying down your debt at the same time. This is especially true when it comes to tax-advantaged savings plans, like individual retirement accounts (IRAs) and 401(k) plans. If your employer matches your contributions, you should do all you can to contribute up to the maximum match before taking an aggressive stance toward reducing your debt load.
Don't forget the power of compounding. The biggest reason to save and pay down debt at the same time is that saving even relatively small amounts puts time on your side by harnessing the power of compounding. When you reinvest your returns - whether it's interest, dividends, or capital gains - your money makes more money, and you can reach your long-term goals faster.
Be careful about paying off mortgages. Owning a home free of mortgage debt remains a fond dream that influences the decisions that many Americans make. It explains why 15-year mortgages seem more appealing to some than 30-year mortgages: not only are the interest rates for 15-year mortgages generally lower, but it takes less time to pay them off, and the accumulated interest you pay is much less.
But it's not necessarily a smart idea to take out a 15-year mortgage, because the required monthly payments are generally 20% to 30% higher than the payment on the same principal amount for a 30-year loan. That means that you have less cash flow to devote to saving in a retirement plan; and if you lose your income for an extended period of time, it's harder to keep up with the payments.
On top of that, mortgage interest is generally tax deductible. Finally, the interest rates on mortgages are among the lowest consumers face. All of this means that paying off a mortgage more aggressively is one of the last things you should consider.