Pay Down Debt or Save for a Rainy Day: Which Should You Do First?

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Rainy Day savings
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Millions of Americans have outstanding debt and limited savings. So when a rare bit of spare cash appears -- say, for example, a tax refund -- they face a tough question: Should they use it to pay down their debt, or save it in an emergency fund or for a long-term goal like retirement or buying a house?

The right answer is a bit more complicated than you might think -- it depends on the type of debt you have and what you plan to do with your savings.

But it's not hard to determine which is the smartest decision to fit your situation.

What People Are Doing With Tax Refunds

For many people, tax refunds represent their biggest fiscal windfall of the year, and this year more people will use their refunds to pay down debt rather than to save. According to a survey from dealnews.com, 44 percent of taxpayers getting a refund expect to use it to pay debts, compared to 34 percent who plan to save it. The results show a rising appreciation for financial responsibility: Only 22 percent said they would spend their tax refund.

To figure out whether you're better off saving a windfall or using it to pay down your debt, there are a few things you need to look at more closely. Once you have answers to the following questions, you'll be able to make a smarter decision.

Question 1: What Interest Rate Are You Paying on Debt?

From a purely financial standpoint, the more you're paying in interest charges on your debt, the more you gain by paying it off.

In general, you can break down what you owe into "good debt" and "bad debt" based on its interest rate and repayment terms. For instance, most credit-card debt gets treated as bad debt, because prevailing interest rates on credit cards are very high -- typically well above 10 percent, and often above 20 percent. By contrast, mortgage debt is often good debt, because rates right now are extremely low, and most people can deduct the interest they pay on their mortgages on their tax returns.

With some types of debt, though, the distinction isn't always as clear.

Some promotional car loan rates can be very low, for instance, while other sources can charge much higher interest rates. Similarly, student loans come in different flavors, with federally subsidized loans typically offering better rates than private loans.

Whatever you do decide to put toward paying down debt should almost always go toward the highest-rate debt you have so it will make the biggest positive impact on your finances.

Question 2: What Return Can You Expect to Earn on Your Savings?

The other half of the debt/saving question is how much of a return you'll earn on what you save. If you plan to put money into an emergency fund or rainy-day account at a bank or credit union, you won't get much income at all right now. That said, if you don't have any money set aside to help you weather an emergency, parking some of that extra cash in savings is an insurance policy against having to put charges on a high-interest credit card later.
If you're planning to invest your savings, however, the picture is much different. With the stock market having more than doubled over the past four years, those who bought stocks in 2009 rather than paying down debt have generally done much better. But looking ahead, it's unlikely that stocks will keep posting such strong returns, especially with the markets having recently set new all-time highs.

Question 3: Do You Have Extra Incentives to Save or Pay Down Debt?

In some cases, there'll be added reasons to make one choice over the other.

On the debt side, some lenders offer discounts if you make additional payments or pay off a loan early, giving you a financial incentive to put extra cash toward debt. Also, paying down debt can improve your credit score, which in turn can make it easier for you to qualify for cheaper financing in the future or to save money on insurance premiums and other expenses.

On the saving side, many employers offer matching contributions for those who contribute to retirement accounts at work. Combined with the tax savings from saving for retirement, an employer match can give you a nice boost for your savings dollars.

Look closely at whether you have any such incentives, and be sure to weigh them in your decision.

Find Your Balance

Of course, the decision to pay down debt or save doesn't have to be an all-or-nothing proposition. Splitting the difference can give you the benefits of both courses of action. In the end, much of the decision depends on whether getting rid of debt will make you feel more financially secure than having it hanging over your head, even with savings to offset it.


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June 07 2014 at 7:41 PM Report abuse rate up rate down Reply
Peter James

thanks for the great article, i learned a lot from it.

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January 13 2014 at 3:53 PM Report abuse rate up rate down Reply
junoflydog

"For many people, tax refunds represent their biggest fiscal windfall of the year, "..... WHAT ?!?!?! Since when did getting your money back become a windfall? If I give a waiter a $100 bill for a $40 meal, did I get a $60 windfall? The liberal slant is ridiculous.

April 12 2013 at 3:06 AM Report abuse rate up rate down Reply
threefromil

I would and did first save that 8 months of emergency salary Suze Orman talks about, because you will need cash if laid off. Then after that, hunker down. I bought a bunch of "save money" books (and there is the web now), and was able to cut our household expenses over $30,000. That was the majority of our take home. I eventually supported 5 people and a $21,000 yearly house payment on $46,000 a year.

April 12 2013 at 2:39 AM Report abuse rate up rate down Reply
mahrmach

It's the UNCERTAIN job market that have people paying down debt so they won't get stuck when all hell breaks loose.

April 11 2013 at 10:33 PM Report abuse rate up rate down Reply
mhwyman7

When a loaf of bread cost $100 it does not matter how much you have saved, you will die trying to get it home.

April 11 2013 at 9:35 PM Report abuse rate up rate down Reply
Craigermt

Intaxication. The euphoric feeling you get when you get your tax return dollars until you realize they were your dollars all the time, just the government got to use them for up to a year.

April 11 2013 at 8:39 PM Report abuse +2 rate up rate down Reply
idcsr1

save up a spare paycheck, then pay down your cards.

April 11 2013 at 7:35 PM Report abuse rate up rate down Reply
bluesideup777

I like the Obama method. Just keep spending then give the bill to your grandchildren.

April 11 2013 at 5:19 PM Report abuse rate up rate down Reply
Wm Good

There ought to be a required personal finance course required for both High School and College. It's amazing how many people can't manage money or simply don't have their spending priorities in order. Our government could also use a class or two in the same areas.

April 11 2013 at 12:32 PM Report abuse +5 rate up rate down Reply
2 replies to Wm Good's comment
Bruce

I graduated in 1971 and some of my siblings 9 or 10 years before me. They all say that this has been a big complaint form folks even then. Yet the government and the public school system say, “It’s not their job”. It’s the parent’s job to do this. (It’s funny how they don’t say this about religion though. They do everything they can to make the students disbelieve what they’re taught at home in this area). I’ve heard that some private schools do have a course in what a young person should know on how to live on your own, which covers this and other areas the schools feel are unnecessary for a normal life. Our government is the worst. It is a bunch of individuals who over spend and over borrow to keep themselves or their party in power. Some analysts say that soon the interest on what we’ve borrowed will be all we’re paying for. No individual would be able to borrow and spend this recklessly. We’d be cut off or jailed at the very least. So why does our government have the right to do this? (pg 2)

April 11 2013 at 5:15 PM Report abuse -1 rate up rate down Reply
Bruce

(pg 2 con’t) It’s because we the people love our entitlements. Personal responsibility is a conservative value and really “old fashioned” to the new educated liberal establishment of today’s America. We want the best of everything and we’re willing to sell our souls to get it. We have all these resources still in our land but the green movement has put the “kibosh” on using it. We want the cleanest of everything. So we spend more money to try to get it. We’ll hand our “green country” over to China or Germany or some other country to get the very best that we lust for. That’s liberalism ideology of today in America.

April 11 2013 at 5:16 PM Report abuse -1 rate up rate down Reply
1 reply to Bruce's comment
threefromil

Majority of the debt was accrued under "conservative" republicans. Reagan and Bush SR. tripled the 1 trillion debt that accrued from washington to Carter. Bush Jr doubled the $5.5 Trillion debt he came into office with. Now Obama has to charge a $3 Trillion carryover of interest on legacies from Bush and borrowing Bush and the other GOP did.

Obama has also increased federal spending the LEAST of any prez since Eisenhower by far, only 1.4%

http://www.forbes.com/sites/rickungar/2012/05/24/who-is-the-smallest-government-spender-since-eisenhower-would-you-believe-its-barack-obama/

Then the deficit. Fed deficit has dropped faster in last 3 years than in anytime since WWII before the fiscal cliff, per CBO.

http://news.investors.com/blogs-capital-hill/112012-634082-federal-deficit-falling-fastest-since-world-war-ii.htm#ixzz2PLwJpP4V

Instead of throwing Obama ticker tape parades for these achievements, all we hear are lies.

April 12 2013 at 2:35 AM Report abuse rate up rate down