Should I pay off debt or save?

I have about $6,500 in student loans left, made up of three separate loans with 4.5% interest rates each. Thanks to some extra jobs, I've recently started a savings account and have about $4,500 now, gaining .9% interest. Should I continue pay off my loans and maybe up the payments a bit, or should I pay a couple of them off altogether and drain my savings down?

Answers

  • 10 out of 10 people found this answer helpful

    CFP®, MBA, MSFS Irvine, CA

    Make a list of all your debts.

    List them by amounts owed and the payment due in descending order.

    Create a budget for debt reduction.

    Make minimum payments on all of your debts except the smallest one. 

    Subtract the sum of the minimum payments from your total budget and apply the difference to the smallest debt. 

    This should allow you to pay off this debt in record time. Then take what you paid down on the smallest debt (after you pay it off) and apply it to the  next smallest debt on your list including the minimum payment you were making.

    Now you should be able to pay this one off in record time. Repeat the process until you have them all paid off.

    Hope this helps.

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  • 6 out of 6 people found this answer helpful

    AIF®, CFP® Pleasanton, CA

    Great question!  There are always three aspects to consider when paying down debt: 1) the math, 2) personal bias, and 3) everything else to consider.

    The Math

    In your situation, the math is pretty easy.  If you're paying 4.5% for the money and you're only earning 0.9%, it's costing you a net 3.6%. The math says you should pay off the loans.  

    A good example of where a loan makes sense today is buying a home.  You can get a 30-year loan with an interest rate of less than 4.0% today, but houses are appreciated 16% over the last year. In this case, the money costs less than what you're earning on it.

    Personal Bias

    Some people hate debt.  Sometimes their parents drilled it into their heads to avoid debt.  Sometimes they just learned from experience that they didn't like owing money to others.  Sometimes people are fearful being a slave to others.  If you hate debt, pay it off, especially since it's costing more than what you're earning.

    Other use leverage effectively to build wealth, which is what you're doing.  You're building up a savings program instead of paying off the loans.

    Think about how you feel about this topic and factor that into the decision.

    Everything else

    There is a lot to consider here.  Taxes are one aspect.  Student loan interest is tax deductible in many cases so you have to look at the after-tax cost of your loan.  It's too lengthy to explain here, but your 4.5% loan may be costing you less after you factor in taxes.

    Emergency savings.  You should have enough savings to cover 3-6 months of expenses for housing, food, taxes, loan payments, etc.  You should start accelerating payments to pay down your debt after you have enough in emergency savings.  If you don't have to worry about paying rent, mortgage, other loans, etc, come up with a plan to pay off debt aggressively.

    Here is an article I wrote that might help:

    Which loan should you payoff first – auto, home or HELOC?

    You can also search for "Snowball debt repayment plan" on the internet and find lots of resources.

    There is no blanket answer that makes sense for everyone.  I hope this gave you some ideas to formulate your own direction.

    Gary E.D. Alt, AIF®, CFP®

    www.MontereyPrivateWealth.com




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  • 4 out of 4 people found this answer helpful

    CFP® Santa Barbara, CA

    In almost every case, paying off debt first, before saving, is the right choice.  This is especially true in today's low interest rate environment where banks are essentially paying almost nothing in interest on savings accounts, CDs, etc.  It makes no sense to pay 10%, 15%, 20% or more in interest on revolving credit card balances while earnings 0.1% on a savings account.  All excess cash, once an emergency fund has been established with a minimum of 3 months of total monthly expenses, should be paid towards the highest cost debt until that debt is fully repaid.  At that point all excess cash should be paid on the next highest cost debt and so on, until all debt has been repaid.  The only exception to this would be (possibly) with auto loans and mortgages.  Today's mortgage rates are exceptionally low, and these loans are typically long-term in nature - at least 15 years typically, so those with excess cash and only a mortgage would want to begin saving and investing for retirement and other goals.

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  • 4 out of 5 people found this answer helpful

    CFP® Palo Alto, CA

    There are several factors to consider when weighing out debt-paydown versus savings and investment.

    The first one which often comes to mind is interest-rate and/or return on investment.  For example, if your debt is costing you interest at 4%/yr, does it make sense to pay that down when you have an investment or alternative which pays 5%?  It might not - of course, there are risks - will the investment which returns 5% keep returning that much?

    The second consideration, which may really be a refinement of the first, is taxes.  The interest on some debts is tax deductible and it's important to compare apples-to-apples here.

    The third consideration, also a refinement of the first, is risk.  The paydown of debt is risk-free return -- if you have a debt at 4% and you pay it down, you guarantee yourself the "return" of 4%.  If you have an alternative investment with a higher expected return, that's great but only if that alternative investment really pays off - as you know, most investments have variable returns - bonds can default, stocks go up and down, etc.  It's awfully hard to find a high-return investment which is not also high-risk.  On a risk-adjusted basis, paying down debt is often a great deal.

    Another related consideration with regard to alternative uses for your cash is whether or not you are maxing out your retirement savings options.  If your employer offers a 401k match, that's often the best return on your money you're going to get - it's like free money.  But it goes beyond just the match and blends into the tax considerations - retirement savings have tax benefits which may include immediate tax breaks, tax-deferral on growth, or even tax-free growth.  Don't ignore that!

    However, the final consideration I want to bring up is not a refinement of the "rate of return" one -- it's about liquidity.  And the result of this may be surprising - in that you may choose to pay more in interest than you get in return as a result of this.  One of the problems with paid-down debt is that if you pay it down and leave yourself without liquid assets - you could find yourself in a bind which costs even more than the interest.  This generally translates into the recommendation that most folks should have an Emergency Fund - 3-6 months worth of general living expenses - on hand in a way that you know for sure you can get that cash if you need it.  If you lose your job, you need a new roof, you have a major car repair, etc - there's no substitute for having cash on hand to cover those costs.  Paid-down debt is great, but cash on hand, which may have much lower returns, is essential.  Make sure you've built up an emergency fund before you focus too hard on paying down debt.  Once you have the emergency fund in place, then start weighing out the various other considerations listed above regarding rates of return, etc.

    There's no single answer which is right for everyone and your situation is unique.  Sometimes, paying down debt is the best thing to do, and sometimes it's not.  Weigh those various factors against your personal situation and do make sure not to ignore your emergency cash and liquidity!

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  • 3 out of 4 people found this answer helpful

    CDFA Mystic, CT

    I have always been a fan of paying down debt first, especially in our current interest rate environment. Just think about it for a moment. For every dollar you pay off in debt, you earn a rate of return equal to the interest rate on that debt.

    Having said that, it's also important not to completely drain your savings. It's important to keep SOME level of savings, and also have a credit card to fall back on in an emergency.

    If possible, I would leave your savings where it is, and take any excess income you have to increase your debt payments.

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  • 1 out of 2 person found this answer helpful

    San Francisco, CA

    This depends on a lot of factors, but a general rule of thumb is that you should pay off debt if the after-tax interest rate is higher than your expected after-tax return from investing. There is some certainty on the debt interest rate while there is little to no certainty when it comes to investments, so it may make sense to stick with the sure thing and pay down debt. What you don’t want to do is pay down too much mortgage debt which results in owning too few stocks during your working years. Your expected return from investing should be higher than current after-tax mortgage rates. Not having enough stock can seriously reduce your nest egg in retirement.


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  • 0 out of 2 people found this answer helpful

    CFP®, MSFS San Luis Obispo, CA

    First off ... congratulations on building up that savings stash! Hopefully, you feel good about it.

    David Meyers just gave an excellent, albeit lengthy and complicated response. As always, the answer to the question depends on a lot of variables for your case.

    My preference is to keep the concepts as simple and user friendly as possible.

    First step - Cash reserves. You never know what issues could pop up. Generally, I believe that if the cost of the debt is reasonable (and even with today's historically low rates, your school debt interest costs are pretty reasonable), then there is no rush to pay it off at least until you have built up 3-6 months worth of expenses in cash reserves.

    This is the "peace of mind so you can sleep at night" stress test. If you lost your job or had a sizable medical emergency, how would you sleep at night knowing that you didn't have the money to cover it because you paid down your school loan.

    Once you have those cash reserves in place, then all the other suggestions - especially those of the guaranteed rate of return that comes with paying down debt - would apply.

    Good luck .. and again, great job on saving money in the first place.

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