Debt vs. Savings: The Payoff Conundrum

Should I pay off my debt with extra income, or save it?

There will come a time in every person’s financial journey where they are faced with a question: should I be paying down my debts, or saving my money? Sadly, there is no easy or correct answer; it depends entirely on your individual situation and risk tolerance. In general, personal finance wisdom tends to go as follows:

1. Save up a small emergency fund ($1k or so)
2. Pay down your debt, starting with the highest balance or interest rate first
3. Build up your emergency fund to 3-6 months of living expenses
4. Save enough in your 401k to capture 100% of your company match
5. Save $5500/year into a Roth IRA
6. Maximize your 401k up to the limit ($17,500/year)
7. Utilize taxable vehicles for investment

The wisdom in this is pretty sound: with debt comes interest. Paying down interest-bearing debt is a guaranteed return, so unless your savings return is greater than the debt interest rate, it’s better to pay down your debt first. Makes sense, but is this always the case? I would argue not necessarily. Right now, I’m in a position where all of my consumer debt is gone; I don’t owe anything on credit cards or a car loan. So do I use my excess money to pay down my student loans, or save it up to provide a bigger cushion?

In true MBA fashion, my answer is both. I’m going to use some of it to speed up my debt repayment, while also saving a large chunk of it. Let’s take a look at each portion of this.

Debt Repayment
My student loans are spread across three different providers, each with a different interest rate (6.8%, 5% and 4.25%). Conventional wisdom would tell me to use all my money to hammer down the 6.8% loan and snowball it until they’re all gone. However, as we’ll get to in a second, I have other needs for some of that money. I pay $462/month on my loans. At that rate, one will be paid off in eight years, another in 14 years, and the last one in seven. If I increase my total payment to $1k/month, putting the extra $538 on the biggest loan, all three loans would be totally paid off in three and a half years. Much better than 14+ years!

This is where my risk tolerance comes into play. I have a modest emergency fund ($5k) but that’s about it. I don’t have much else in my savings account (note: this does not apply to retirement savings; I put 8% of my salary into my 401k and my employer puts in an additional 3.5%, in addition to a pension fund where I’m fully vested), which makes me nervous. My car is nine years old and has 137k miles on it. I have a trip to NYC coming up for the marathon, and Christmas is coming up soon. Finally, I have plans to go to Ireland next year for my mom’s birthday, her dream trip. If I put the $538 to my student loans, I would be able to save, conservatively, about $15k/year. This would more than cover my two trips, Christmas, random stuff that comes up AND build my emergency fund up to $10k. And that’s just in year one. By the time my loans are paid off, I would have saved over $50k in total, not counting any raises, bonuses or tax refunds. I have a low risk tolerance, so I’d rather have cash in the bank.

My plan does not exactly match up with the ideal scenario. I’d end up paying more in interest than if I put all my excess on my loans. But, conventional wisdom forgets one thing: life is lived now. If I didn’t save up the cash for the trip, I wouldn’t get to run a marathon across NYC. I wouldn’t be able to join my mom in Ireland for her dream trip and have that experience with her. Luckily I’m in a position to do both of these things without impacting other parts of my financial life. If I had no savings, lots of credit card debts and didn’t have as much excess income, I certainly wouldn’t be approaching things this way. But I have the means, so I’m going to do it.

There you have it. To answer this question, you need to evaluate where you are financially and what your priorities are. I am making the financially less sound decision to save more than I’m paying down, but I’ve evaluated the options and feel this best suites where I am. Each person needs to evaluate for themselves and make a decision they can live with, that does not put them in a financially precarious situation.

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