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Pay Down Debt or Save Money?

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This guest post comes from DR, the founder of the popular personal finance website, DoughRoller.net, a site dedicated to providing tips and resources about money. DR also offers personal finance tips at the U.S. News & World Report My Money blog and MSN’s Smart Spending blog.

One of the most frequently asked questions we get is whether it’s best to pay off consumer debt before saving or investing money. What makes this question so difficult is that there is no one right answer. What might be the best choice for one person, many not be the best choice for another.

So to help you make the best choice for your unique situation, let’s look at the three factors you should consider in making this decision, followed by some practical tips on applying these factors to your finances.

3 Factors to Consider

As you make the best choice for your financial situation, consider these three key factors:

1. Interest Rate on Debt

It goes without saying that the higher the interest rate you are paying on debt, the more likely you’ll want to tackle this debt first. But before you plow all your available cash into repaying a high interest loan, remember that there are alternatives. For example, you may be able to use a low interest home equity line of credit to pay off a high interest credit card. Likewise, you may be able to take advantage of credit credits with 0% balance transfer offers, which now last as long as 21 months.

2. Benefits of Investing

You’ll often hear some suggest that if you can earn a higher interest rate on investments than you are paying on debt, it’s better to invest the money. The problem with this approach is that it fails to take into account the risk of investing. There is zero risk in paying down debt. In contrast, most investments that can generate a higher return than the interest rate on your debt generally come with significant risk. So unless you can earn more from an FDIC-insured savings account than you are paying on debt, this comparison isn’t very helpful.

But there can be some benefits to investing that should be considered. For example, your employer may match some or all of your 401k contributions. If so, failing to take advantage of this benefit is leaving guaranteed money on the table. There are also tax advantages to investing in a 401k, IRA, and other retirement accounts that should be considered as you make your decision. For example, even with a school loan still outstanding, I recently opened a Scottrade account for an SEP IRA that allows me to shelter some income from taxes each year.

3. Emergency Cash

Finally, you want to consider how you would handle a financial emergency. Even with debt, unexpected expenses can and will arise from time to time. Without adequate preparation, these events will plunge you deeper into debt. So even while you are working to climb out of debt and invest for retirement, give some thought to how you would handle an emergency.

Applying these Factors

The place to start, I believe, is with your emergency fund. Even with high interest rate debt, it is important to have some money saved to handle the unexpected. Dave Ramsey suggests saving $1,000. While I don’t think this approach is best for everybody, the concept is sound. Set a realistic goal for an emergency fund and begin putting money in an FDIC-insured high interest savings account. Once you’ve reached your goal, you can begin tackling debt and investments.

The next step, which should actually begin now, is to evaluate the interest rates on all of your debt. The simple question to ask yourself is whether you can lower the interest rate. Whether it involves refinancing a mortgage, refinancing an auto loan, or lowering the interest rate on credit cards, finding lower rates should be a priority. Keep in mind that you may have high rates because of your credit score. If so, get your credit report and FICO score for free so you know where you stand, and then take steps to improve your credit history.

Once you have the lowest rates you can get, consider your investments. Investing early in your career is extremely important to obtaining a level of financial independence later in life. With a 401k, you can begin investing with very little money each month. As a result, there is a lot to be said of investing as soon as you are eligible for your company’s 401k, even if you do have a lot of debt to tackle. The key here is to realize that the best solution for you may be to invest a little and put the rest toward debt.

Finally, whatever you decide about investing, you need to prioritize repayment of your debt. Some suggest paying off the debt with the highest interest rate first. Mathematically, this will result in paying the least amount of interest and paying off your debt the fastest. Nevertheless, some suggest (including Dave Ramsey) that you pay off the lowest balance first. The idea here is that by paying off a credit card or other debt a soon as possible, it will motivate you to keep chipping away at the rest of your debt. In the end, do whatever works best for you.