One of the more common dilemmas in personal financial management is the tradeoff between paying down debt and saving money. Should I pay cash for a car or take a loan? Should I keep money in savings or pay off my credit card? Given that you are a unique person with a unique financial situation, the correct answer for me may not be the correct answer for you. There are, however, two primary filters that you should consider when making this kind of decision.
#1 – Math
Most people asking this kind of question are primarily asking about which choice is mathematically better. Will I end up with more money if I do A or B? The good news is that this is the easiest part to solve as well. In a nutshell, you should put your money towards the choice that has a higher expected interest rate. For example:
- You expect to earn 7% in the stock market and
- You will pay 5% on a car loan
In this case if you choose to invest extra money rather than pay off your car loan, you will end up with more money at the end of the day. Even if your goal is to pay your car off in three rather than five years, you are better off investing money for three years then cashing out and paying off the loan. You’ll still have extra cash left over.
Now, it’s a little more complicated than that because you need to factor in potential taxes or transactional costs that may eat into your total return. Likewise, your interest rate may be effectively lower, such as when you are deducting your mortgage interest. But the logic still stands. If you can figure out your net interest cost of your loan vs your net profit on your savings, then you are financially better off choosing the option with a greater interest rate.
(Also keep in mind that when investing, growth doesn’t always come in reliable way. Since 2000 the S&P 500 has returned anywhere from -37% to +32% in a given calendar year. The shorter the timeframe you’re working with, the less you can rely on stocks to deliver positive returns.)
#2 – Behavioral / Emotional
Even when the Math filter gives us a clear direction of what is “best” to do, it’s not always the thing we should do. Some people HATE debt. It bugs them, and weighs on them, and makes them less happy. Should that person really prioritize savings over debt because it’s the “right” decision?
No, probably not. Unless they really and truly need to squeeze every last ounce of return out of their money, why bother? Are you here to maximize your money, or is your money here to serve your life?
Similarly, you may have a hard time breaking the cycle of mismanaging credit cards. You’ve built up a credit card balance, you’re working hard to get rid of it, but then your car breaks down and the only way you have to pay for it is to add it back on to your credit card.
Even though it’s not the most mathematically efficient path, if you focus on building up a rainy-day fund first you can break the habit that’s making you fall back on credit cards. Good behaviors lead to wealth accumulation, not the other way around.
Like everything else, the best choice for managing your debt and savings is going to come down to your individual circumstances and personality. Too often people are focused solely on the math side of the spectrum. The math is important, but so too is managing your behaviors and feelings about money. Be sure to incorporate both when making your decision.