Why Saving Before Paying off Debt Doesn’t Make Sense

This article was inspired in part by a recent post by a very ambitious individual who’s on a mission this year to get her finances in order.  As I read through her article, I noticed a few compromises that may have been entered into, and it sparked my financial triggers.  This is simply an example to illustrate a potential flaw in her plan and is not representative of the actual numbers, but is calculated with care to ensure as much accuracy as possible with my feeble brain.

So you’ve received a monthly increase of $1000.00 and you have no idea what to do with it.  Your income is fixed, and the perception is that it’s relatively secure.  That’s another topic for another article, but we’ll pretend that it is in fact, secure and that you’re not at risk of being down-sized.  So, for this example, we’ll assume your $1000.00 is a nice, hefty raise.

What can you do with that $1000.00?  Well, there are only 3 things you can do with money.  You can invest it, spend it, or give it away.  There really isn’t anything else that can be done, unless you have debt, in which case, you can pay it off.

But what about the [false sense of] security that I get from having cash in the bank?  Well, that cash in the bank will earn somewhere around 1.3% annually.  Here’s what that looks like in a savings account over 12 months:

Okay, now that you’ve seen how insignificant the interest earned over one year is on $1000.00 saved every month, let’s look at the interest schedule on the other side of the equation.  The debt.  You have a student loan with a balance of $24,000.00 at 3.4% for example.  By simply looking at the difference in the interest rate you’re earning on the savings account, and the interest you’re being charged on the loan, it’s clear that you’re behind the eight ball, and it would be better, mathematically, to put $1000.00 towards your debt rather than your savings account.

The difference is $186.78.  In other words, if you pay your loan down by $1000.00 month, you’ll save $186.78 in interest charges which is way better than earning $83.67.

When we’re talking about dollar amounts that can be earned in a single shift waiting tables, the interest rates involved are absolutely insignificant to the equation.  The real stress is carrying the debt in the first place.  After all of this time, and all of this worry, not to mention the potential risk involved if your income were to change for the worse, it’s really not worth it to save while you have debt.  You must consider inflation, taxes, and in this particular case, since we’re already earning less than we’re spending, none of it matters.

Pay off the debt while you have the income.  Put that first $1000.00 away for emergencies only, then work your butt off to pay down the debt.  It always makes sense to eliminate risk that isn’t necessary.

For another example, let’s say that your investment is earning 6% annually, and your loan is charging you only 3.4% annually.  It would appear that you’re coming out ahead by 2.6%.  But what is 2.6% on such a small amount?  Even on a large amount, taxes, overhead managing the money, and inflation will obliterate your gains.  It’s not as rosy as it seems.

Here’s the litmus test.  If you didn’t have any money in savings, and didn’t owe anyone anything, would you borrow money at 3.4% to invest it at 6%?  No?  Didn’t think so.  There’s no sense in risking when you don’t need to risk.

Related posts

• The Ides of March was a Disaster
• Dear Mister God
• Are You Running Red Lights With Your Money?
• Women who love abusive men...
• What is a Trackback?
• @tiquette: E-mail Etiquette
• The Problem with Mint.com
• The Value of Time, The Cost of Impulse, Hover Your Mouse
• Borrowing Your Life Away
• Multitasking Isn't Real