When I was up to my earlobes in debt in my early twenties, I knew I needed to change my money reality. I started reading personal finance books by David Bach, Suze Orman, Robert Kiyosaki and more and was well aware that living below your means and having a healthy savings cushion were smart, but I wasn’t following any of the expert advice.
At the time, I felt my income didn’t support both paying off my debt and socking away some cash in savings. The following question plagued me and I’ve come to find out it plagues many others who are in the digging out phase of wealth creation: Should I prioritize paying off my debt first or putting money into savings?
I’ll tell you what I did in a moment, but first, there are a number of questions you need to answer before you can know which direction to put your money:
- What is your debt snapshot? What type(s) of debt do you have, how much do you owe, to whom, by when, and what are your interest rates? Vagueness and avoidance are incredibly common when it comes to our financial lives. Answering the questions above in writing will give you so much clarity. After the initial shock of knowing the whole truth wears off, there’s actually a profound sense of calm and power that emerges. Once you know where you are now, you can chart your course to your desired location.
- What is your savings snapshot? How much cash do you currently have in your bank account? Do you have any money in reserve anywhere? If so, write down where it is, how much, and what (if any) are the interest rates. (For the sake of this exercise include all accounts like 401(k)s, IRAs, and money market accounts even though some of these would be dubbed retirement accounts and not savings. Knowing the full picture of your cushion will make you feel more calm even if that money won’t be touched for many years.)
- What is your minimum monthly debt payment? Look at all of your debt (or, as I like to call it, Invoices For Blessings Already Received) and total up the amount you need to pay on a monthly basis so that you’re paying the minimums on your credit cards, student loans, etc.
- What is your monthly spending total? Rounding to the nearest $100 or so, how much do you spend on a monthly basis? If you’re not sure, don’t worry. Grab last month’s credit card and bank statements and total it up, ideally breaking it down into categories. Moving forward, use a handy app like EasySpend to track your income and spending in real time on a daily basis. Be sure to include your minimum monthly debt payment total in your monthly overall.
- What’s your average monthly income? This one is really easy if you’re a salaried employee. If you’re a freelancer or a business owner, just look at the last six months of income and figure out what the average is per month.
- What’s your cushion? Now, simply deduct your monthly spending total from your average monthly income. I like to call what’s left over your financial cushion.
Now you know how much you actually have left over (on average) that you could be putting towards paying off debt or socking away in savings. Don’t make the decision about where to put your money until you’ve actually gone through and completed the steps above. So often we theorize about what we should be doing with our money without actually knowing the truth about our numbers. Don’t make this mistake. As my friend and mentor Barbara Stanny says: Clarity is power.
Now it’s time to decide where to put that cushion of yours. It’s a good idea to have 3 tp 6 months of living expenses in the bank and some people feel more comfortable having 12 months of living expenses saved up “just in case.” I like to call this a cushion rather than an Emergency Fund because a cushion is a soft place to land and we don’t want to be putting our attention on attracting emergencies.
Here’s where you have to get to know yourself a little bit: Imagine you had three months of living expenses in the bank. How do you feel? How’s your breathing? What would be different about your daily life? Now run through the same questions for six and 12 months.
Which one feels spacious and secure to you but not over-the-top conservative? That’s the one to shoot for. And now that you know your monthly spending total, write down how much you would need to have in the bank for your definition of a prudent savings balance.
Here’s the reality: the interest rates on your credit cards and some other debts are going to be significantly higher than the rate of return you can get on a savings account (which will barely keep up with inflation.) So, from a pure numbers perspective, it’s smart to pay off your debt, especially those with high interest rates, as fast as possible.
I made the choice to pay off all my debt before building my savings because I knew I had steady residual income that I’d built coming in every single week that had a very low chance of going away anytime soon. However, if you work as a freelancer or have unsteady income or fear that your job might be unreliable, it might feel better to split your monthly cushion and put half toward debt repayment (after the minimums are covered) and half toward your savings cushion. Even if what’s left over after your monthly needs are covered is only $50 and $25 goes toward debt and $25 goes toward savings, you’re taking action. The momentum of consistent monthly action will help you get where you want to be faster than you thought possible.
Money is a fundamentally subjective and emotional topic so there is rarely a cut-and-dry answer to any question. The key is to tune into your own reality and your own experience and make the choice that feels the most in alignment for you.