Most people who are in debt often wonder if they should spend their extra money getting out of debt or saving up for emergencies. The truth is that there’s no straightforward answer – it completely depends on your situation. There are advantages and disadvantages to either approach, and it’s best to know these first before you decide.
Prioritizing Your Debt: Pros and Cons
One advantage of prioritizing your debt is that the longer it takes you to pay off your debt, the greater the total amount that you have to pay. This is because of the interest that accumulates every time you leave your debts unpaid.
Also, repaying your debt can have a huge psychological payoff. Knowing that you have unpaid debt often adds to your daily stress, so once you’re debt-free it will feel like a weight has been lifted. The sooner you relieve yourself of the anxiety caused by debt, the happier and the healthier you’ll feel.
There is a disadvantage, however. Choosing to repay your debt first may leave you worried about your financial future if you don’t have enough savings. In case there’s a financial emergency – such as illness or sudden loss of income – you might be pushed further into debt.
But how do you know if you have enough savings set aside?
Knowing When to Save Up First
If you feel like you don’t have enough savings to cover emergency expenses, it might be a good idea to evaluate your financial situation first before you repay your debt.
Here are some questions you can consider:
1) Do you have ample health and life insurance?
You don’t have to worry about saving up for medical emergencies if you and your family have enough insurance coverage. But, without health insurance, you should consider padding up your savings first before you focus on completely repaying your debts.
2) Is your home or vehicle insured?
Home and vehicle emergencies can be costly, so if you’re uninsured for these properties, build your savings first to cover possible emergency expenses. With enough insurance coverage, though, then you may not need to set aside so much. Review your policies, and if you find that you have enough coverage, use your extra income to pay off your debts.
3) Can your household function without your income?
If you have many dependents who rely on your income, the more you need savings in case of emergency expenses. The general rule of thumb is to save one or two months’ worth of living expenses for each dependent.
Until you’ve saved that much, pay only the minimum balance of your monthly debt repayments. Once you have enough savings, you can start rolling over your extra income to additional debt repayment.
Repay Your Debts First or Save Up?
In summary, if you don’t have dependents and you have enough insurance coverage, it may be a good idea to prioritize paying off your debts. But, if you think you don’t have enough savings to protect yourself against emergencies, it may be best to only make your minimum debt payments until you’ve saved enough.
Another way to do it is the balanced approach. Direct part of your extra funds to debt repayment, and another part to savings. The amount you’ll be contributing to either goal will depend on your specific needs.
For example, if you have some health insurance to protect yourself with, you may want to direct 70% of your extra funds to debt repayment and only 30% to savings. Or, if you have only minimal debt and can completely repay it within the year, you can send 30% of your extra money to your debt, and the rest goes to building up your savings.
With a thorough evaluation of your own financial situation, you can better decide whether to use your extra income to pay off your debt or add to your savings. There’s no single correct approach – there’s only what works for you. When you finally pick a solution that works, you’ll soon be debt free, as well as meet your savings goals.