The question of whether to save or to pay debt is an important one to a smart investor. We all have more financial objectives than cash to save. Often, deciding what to do with extra money can be a challenge. While the cost of debt can be prohibitively high, having insufficient savings might result to one accumulating more debt and wallowing under it’s weight. Economists note that the ideal situation would be to formulate a good mix of both debt and saving. Carrying an optimal amount of each is healthy so that they leverage on each other to give an investor efficient wealth management matrix. Let’s delve into some questions below that will help us bring our priorities into perspective.
What is the cost of debt?
Settling a credit card debt with an Annual Percentage Rate (APR) of 18% is equal to obtaining an 18% fixed return on a similar saving. If you compare with the stock market’s Average Rate of Return of 10%, the return on savings is a lot less. It, therefore, makes economic sense to pay off that card, else more money will be lost by holding onto debt and investing in the stock markets.
Do you have a buffer or emergency savings?
If your rainy day buffer is depleted or completely wiped out, it is critical that you revamp it using your extra cash. Economists advise that the fund should meet at least three to six month’s worth of living expenses. It is important to have this fund in place because lack of it may attract more costly debt out of desperation in case of emergencies.
Are you getting the full employer benefit from a pension plan?
Most companies offer pension benefits by contributing a percentile of the employee’s earnings, usually between 3% and 6%. Foregoing that benefit is like closing a door to free money, also known as fixed return. That is a deal too good to ignore.
Which debts should you settle first?
Would it be more prudent to settle the student loans or reduce expenses on the credit card? Pay off the mortgage or car loans? Defraying some debts, and not others, will benefit the investor by far. We will assess the best place to put the extra cash by using the steps below.
Assess what kind of debt you are holding
Money borrowed to purchase a home or pay school fees is generally seen as a good debt. The reason being that these expenses can help boost one’s financial situation at a later date. Additionally, mortgage interest and some student loans are tax allowable, thereby reducing one’s tax burden. It is not prudent to struggle to clear such debts so long as you can continue to raise and pay the requisite instalments as they fall due.
Think about a fancy meal at an expensive restaurant or a birthday gift for your child. That is a classic example of a bad debt. These do not improve the financial well-being of the individual. Other bad debts to consider are personal loans and credit card debts. They come with high rates of interest which is why they should be tackled first.
Find out what will offer the biggest financial boost
From a financial standpoint, it is a clever choice to first pay off the bad debt with the highest interest rate. Picture this; paying £500 towards a pounds £3,000 credit card bill with an APR of 18% will save you much more than paying a £500 bill at the rate of 6%. That said, if it will give immense peace of mind by wiping out the small bill completely, it is worthwhile giving preference to that smaller bill. After all small victories can bring incredible impetus to stay on course.
Think about the credit-worthiness rating
If you are planning to purchase a car or a house soon, it may be necessary to pay off any credit cards that are nearly maxed out. That is true because bringing down your utilisation ratio will have great effect on your credit score, which will qualify you to get lower interest rates.
In conclusion, here’s a caution. If you are swamped with a huge, high APR credit card debt, the temptation is to pay it off quickly. You may want to finance that by taking out home equity loans. That is not a smart move. Remember defaulting on your home equity obligations might cost your home. If you lose or quit your job, the entire sum may become due immediately or within a short period. If you fail on your obligations, stiff penalties may accrue.