Q: Is it better to save or pay off debt?
A: With every client that I work with, we like to do a financial profile to see where they are at now and what do we need to do to get them to their goals. One of the questions that comes up often is, whether it is better to save your extra cash or pay off debt.
To answer this question, you must decide how your money can work best for you. Compare the money you might earn on other investments with the money you would pay on your debt. If you would earn less on investments than you would pay on debts, you should pay off debt.
Let’s assume that you have $1,000 in a savings account that earns an annual rate of return of 4 percent. Meanwhile, your credit card balance of $1,000 incurs annual interest at a rate of 19 percent. Your savings account thus earns $40, while your credit card costs $190. Your annual net loss is 15 percent, or $150, the difference between what you earned on the savings account and what you paid in interest on the credit card balance. It’s even worse when you consider the tax effect. The interest on the savings account is taxable, and you have to use after-tax dollars to pay your credit card bill.
In this instance, it would be best to use your extra cash to pay down the high-interest debt balance.
Now, let’s look at another example. Say you have a student loan of $1,000 that you are repaying at an annual interest rate of 5 percent. Instead of paying off the debt, you invest $1,000 in an investment earning a 7 percent average rate of return.
Here, your best strategy would be to keep the loan and invest the extra cash, because your net gain will be 2 percent annually, or $20–the difference between what you earned on the investment, less what you paid on the debt.
Personally, I try to encourage people to become debt free because you do not want to be a slave to the lender, especially in today’s economy where the rules seem to change often.
So make sure you have your financial affairs in order and a good way to start this process would be to contact me by e-mail at firstname.lastname@example.org or call me toll free at (888) 914-9909. I would be more than happy to review your financial situation with you to make sure your financial house is in order, and thank you for joining me this week for your retirement minute.
Until next week!
About the Author
John Bearss (Retirement Specialist)
John R. Bearss is a retirement specialist. He has been successfully helping clients nearing retirement generate lifetime income streams for 25 years. He can be reached by phone at (888) 914-9909.
Disclaimer: Investing involves risk. Always do your own due diligence and consult a trusted financial professional before making any investing or financial decisions. John Bearss is a retirement specialist. He is also a registered representative of and offers securities through SICOR Securities, Inc., Member FINRA, MSRB, SIPC, 6500 Poe Avenue, Suite 105, Dayton, OH 45414 | (937) 890.3101. Neither SICOR Securities, Inc., Lifetime Decisions Management nor their representatives provide legal or tax advice. Please consult your CPA or qualified tax advisor before making any decisions. Lifetime Decisions Management, Inc. and SICOR Securities, Inc. are not affiliated.