To get out of debt or to build emer­gency fund?

Austin American-Statesman Sunday - - BUSINESS SUNDAY - By Amy Fon­tinelle

Guide­lines for when to pay down debt and when to save money.

Sim­ple math sug­gests it’s likely bet­ter to get rid of debt be­fore sav­ing for re­tire­ment or adding to your emer­gency fund.

In gen­eral, if the in­ter­est you pay is higher than the in­ter­est you earn, you’re los­ing money.

But per­sonal fi­nance de­ci­sions are rarely so sim­ple, and ditch­ing debt first isn’t the right choice for ev­ery­body. For ex­am­ple, it can mean not hav­ing emer­gency sav­ings to fall back on — set­ting you up to take on more debt when an un­ex­pected ex­pense hits.

Here are sce­nar­ios for when each choice — pay­ing down debt or sav­ing — makes more sense.

When to pay debt

When you have high-in­ter­est con­sumer debt, pay­ing it down first can help you solve on­go­ing prob­lems with man­ag­ing your money.

You’ll get a guar­an­teed “return” by cut­ting your in­ter­est pay­ments. It’s typ­i­cally more than you’d earn in the stock mar­ket and def­i­nitely more than you’d earn in a sav­ings ac­count.

Iden­tify your ex­pend­able in­come, cre­ate a bud­get based on that num­ber and in­clude pay­ing down debt as a sig­nif­i­cant part of the equa­tion. Con­sider open­ing a bal­ance trans­fer credit card, which can al­low you to con­sol­i­date all of your credit card debt onto one low-rate card and save you money on fi­nance charges.

Kevin Smith, ex­ec­u­tive vice pres­i­dent of wealth man­age­ment for Smith, Mayer & Lid­dle, says it gen­er­ally makes sense to em­pha­size debt re­duc­tion, though there can be ex­cep­tions.

“Pay­ing down a tra­di­tional loan like a mort­gage or stu­dent loan only re­duces the out­stand­ing prin­ci­pal and re­lated in­ter­est costs,” Smith says.

Mak­ing ex­tra pay­ments will save you money in the long run, but in the short term, it doesn’t cause your lender to re­cal­cu­late and lower your monthly pay­ments.

When de­cid­ing whether to pay off tax-de­ductible debt ver­sus sav­ing, don’t worry about los­ing a tax de­duc­tion if you pay off the debt. The de­duc­tion is prob­a­bly worth less than the an­nual in­ter­est you would have paid on the loan.

When to save

There are a num­ber of good rea­sons to save first and pay later, but the top rea­son is to build your emer­gency fund.

If your debt has a very low in­ter­est rate, it may make sense to save first, says Melissa Joy, a fi­nan­cial plan­ning pro­fes­sional, part­ner and di­rec­tor of wealth man­age­ment at the Cen­ter for Fi­nan­cial Plan­ning in South­field, Mich.

“If you don’t have any sav­ings, fo­cus­ing solely on pay­ing debt can back­fire when un­ex­pected needs or costs come up. You might need to bor­row again, and debt can be­come a re­volv­ing door,” she says.

Ex­perts rec­om­mend build­ing an emer­gency fund of three to six months’ worth of ex­penses and stash­ing it in a sav­ings ac­count. Com­pare sav­ings accounts to find one that pays a de­cent return.

An­other sit­u­a­tion where it makes sense to save be­fore pay­ing debt is if you have ac­cess to a re­tire­ment sav­ings plan through your job, espe­cially if there’s an em­ployer match avail­able. Try to con­trib­ute at least enough to get the max­i­mum em­ployer match.

Putting off sav­ing for re­tire­ment un­til you are debt-free could cost you your most valuable as­set: time. With com­pound­ing in­ter­est, even small con­tri­bu­tions to your re­tire­ment plan can grow sig­nif­i­cantly.

Best of both worlds?

The best so­lu­tion could be to strike a bal­ance be­tween sav­ing and pay­ing off debt.

You might be pay­ing more in­ter­est than you need to but hav­ing sav­ings to cover sud­den ex­penses like car re­pairs will keep you out of the debt cy­cle.

Ad­di­tion­ally, hav­ing suf­fi­cient sav­ings pro­vides peace of mind. Some peo­ple are un­likely to feel at ease with any strat­egy, no mat­ter how fi­nan­cially log­i­cal, that causes their sav­ings to fall be­low a level that feels right to them. For them, sav­ing and pay­ing down debt at the same time might be the best ap­proach.

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