What Should You Do First: Pay off Your Debt, or Start Saving?

In the class of 2018, about 69% of college graduates took out student loans to afford their tuition, according to the Federal Reserve. That means that the vast majority of graduates are carrying student debt. And students aren’t the only ones dragging debt around. Between student loans, home loans, auto loans, and more, 80.9% of baby boomers and 81.5% of millennials are in debt (source). If you’re carrying debt, it may be tempting to prioritize paying it off above all else. But it’s also imperative to start saving for your future early in life. So how do you know where to start? What should you do first: pay off debt or save for your future?

Why you should prioritize paying your debts?how is your FICO credit score calculated

Improves your credit

Your credit utilization ratio, also known as your debt-to-credit ratio, has a massive impact on your credit score. That means that if you’re deeply in credit card debt, it’s hurting your credit score.

Having a low credit score can make it harder to get a loan, get an apartment, and even get a job. If you’re struggling with a low credit score, paying off your debts sooner might make your life much easier.

Reduce interest payments

The longer you carry your debt, the more interest you’ll accumulate. And if you’re carrying high-interest consumer debt, that interest can add up fast.

If you have good credit you may qualify for a low-interest debt consolidation loan.

However, a debt settlement may be an option if you have bad credit or your debt has snowballed out of control.

Why should you save first?

Emergencies are expensive

Using all of your disposable income to get out of debt is a noble endeavor, but what happens when disaster strikes? If you have to pay off an emergency medical expense and don’t have any savings, you might have to finance the procedure with a personal loan. And that brings you right back to where you began.

Compound interest

And saving isn’t just about the present day. It’s crucial to start saving for your retirement as early as possible. That’s because saving money in a tax-deferred or tax-free retirement account lets you accrue a ton of interest over 50+ years. In other words, the sooner you can get some cash into a retirement account, the better.

To illustrate, let’s say an 18-year-old invests $300 a month for just eight years (a total of $28,800). She could retire with more than $1 million at age 58 even if she never invests another dime. If she waits till 65, the total would exceed $2 million.

Returns on a $300 investment

That impressive return on investment assumes a 10% annual return. Investors typically use the S&P a benchmark for the overall stock market, and the average return since its inception is around 12%.

Avoid prepayment penalties

Many loans charge prepayment fees — penalties for paying off your loan early. Why? Because when you pay off your loan early, lenders lose profit that they would have made in interest. If a lender charges expensive prepayment fees, it could reduce or even negate the savings you receive from paying off your debt early.

Investment opportunities

Plus, if you play your cards right, high-yield investment opportunities can net you more profit than you’d save in interest by paying off your debts early. Browse top brokerages to find out what kind of returns you can expect.

So what should you do first? Pay off debt or save?

Build an emergency fund first

To prepare for the worst (and prevent further debt), building an emergency fund should be a top priority. Your emergency fund should include enough money to cover your rent and expenses for three to six months. But don’t let saving for an emergency fund make you late on any of your loan payments. If you need help figuring out how much to put away each month, check out these helpful money management tools.

Follow the 7% rule

If you need to decide whether some extra cash is better spent on investments or on early loan payments, just follow the 7% rule.

The average return on the S&P 500 is 7% if you adjust for inflation (around 12% if you don’t adjust for inflation). That means that if your interest rate on your loan is lower than 7%, you could make more money on the stock market than you would save by paying off the loan early. Accordingly, if you’re paying more than 7% interest, you’d save more money by paying off that loan as soon as possible.

s&p 500 annual return

Take advantage of 401(k) matching

If your company offers 401(k) contribution matching, you should take full advantage. That’s because 401(k) contribution matching is a great way to maximize your retirement fund at little cost to yourself. You should try to contribute as much as your employer will match — typically 3%.

All things in moderation

In general, it will benefit you to save and make early loan payments. If you have any high-interest consumer debt, you should pay this off as early as you can. But you should also allocate some of your savings to kickstart your retirement fund. And it’s wise to invest early and often in moderate-risk, long-term investment funds, such as an S&P 500 low-cost index fund.

Getting started

Not sure where to start? These money management tools can help you set a budget and build an emergency fund. And these investment advisors can give you a leg up on the investment world. If you want a more personalized touch, consider finding an experienced investment advisor.