In a world that relies mostly on a credit system, it is very easy to fall into the much-dreaded debt trap. This happens when you rely on the utmost convenience of swiping that plastic credit card to pay for your purchases – without considering whether you can actually pay the bills or not.
Let’s say that you entered a store with clothes, shoes and bags on sale. You maxed out your card with all the items that you bought, thinking that you will be given ample time to pay for the total amount, anyway.
Once your billing statement arrives, you find out that the minimum amount required to pay is more than what you can actually afford. If this happens, your debt for this month will be rolled over to the next billing statement with additional interest.
The same thing happens if you continue paying just the minimum amount instead of the full amount indicated on your credit card billing statement. This ends up going on a vicious debt cycle that is very difficult to get out of.
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The Reality About Debt
The previous scenario is just one example of how debt can take over your life if not properly handled. When you spend more than what you actually earn, you would end up borrowing from your credit card or accumulating a number of loans which might be difficult to pay off later on. To give you an idea about how much Americans are in debt, here are a few statistics:
- For the year 2014, the average household credit card debt balance is $15,252.
- According to the Federal Reserve Bank of Saint Louis, the personal savings rate of bank account holders in the US is a mere 4%.
Financial experts recommend saving 10% to 20% of one’s monthly income for emergency purposes. So if an average income earner only saves 4%, what prevents him or her from setting aside the recommended percentage of earnings? Debt is the main culprit. Most people are hesitant to save while still in debt. This is with good reason, which we will talk more about in the next section.
Meanwhile, let us delve a bit deeper into the different types of debts that most people can incur.
- First is the high-interest debt, which credit cards definitely fall under. A loan or a debt like your credit card bills is considered high-interest, especially if you are charged 7% to 10% of your total debt amount as interest.
- Second, there are low-interest debts, examples of which are car loans or payday loans.
- Third, there are tax-deducible debts which include mortgages for homes, business loans, student loans and investment loans. For these, the interest is paid to the borrower in the form of tax deductions. This is a better type of debt to have because it is considered low interest, and you can easily build an investment portfolio while paying it down.
No matter which among these three types of debts it is that you have, you might be hesitant to save while paying them off. Find out what possible reasons people have in not saving while still in debt, and why you should do just the opposite – which is saving despite having debts.
Why People Are Hesitant to Save While Still in Debt
If your credit card billing statements start arriving and you find out that you have incurred more debt than what you can actually afford to pay, your first reaction might be to hold off adding funds to your existing savings account. Why do most people hesitate to save while still in debt? It’s all about the interest on your debts counteracting the amount that you can actually save.
Let’s say that you have a debt of $500 and the interest is $50. If you usually save $25 on your savings account every month that you receive your paycheck, this can easily be counteracted by the $50 interest that you’d have to pay. In cases like this where the interest on your debts is more than what you can actually save, it makes sense to hold off on adding the $25 to your savings account and simply use the money to pay off your debt’s interest. The end result is that you will skip on adding funds to your savings account, while deducting a specific amount from your debts.
The decision to hold off on savings while paying off your debts might make sense in some cases, but it’s still highly dependent on your personal situation.
In some cases, it’s perfectly fine for you to focus all your energies on paying off your debts without having to save. In others, you can save and pay your debts at the same time. If you’re wondering which decision is better, the answer is – it depends. You can definitely save and pay off debts at the same time; or focus on one thing at a time. But there are pros and cons to each decision.
Reasons Why You Should Save Despite Debts
If you’re torn between wanting to save while paying off debts and wanting to completely eliminate your debts first before saving, here are the reasons why you should go for the former option:
1. You would have nothing to fall back on in case of emergencies
The problem with paying off debts completely is that you will have nothing to fall back on in case of emergencies. Basically, you will end up relying only on your credit card in case you need a trip to the emergency room, or if the roof needs to be fixed. This is compounded by another bout of interest charges, which would have a snowball effect on your debts.
By trying to create that delicate balance between paying off your debts while saving will give you that extra assurance. Even a $2,000 savings account should be enough to see you through unexpected expenses or financial emergencies in the future.
2. You can add to your savings account while making minimum debt payments
Another reason why you should save while still in debt is that it is a golden rule to pay off at least the minimum amount on your credit card bills.
If majority of your debts come from credit card accounts, you should definitely make it a point to pay the minimum. If not, additional charges and probably a higher interest rate will be added on to your account. As you are making the minimum payments, you can slowly add funds to your savings account which you can rely on for future spending, instead of slapping your credit card with additional charges.
3. You can find a balance between investing and paying off debts
Let’s say that you already have an established amount on your savings account. If you are paying off your debts and saving at the same time, you can find that balance between investing and trying to be debt-free. You can even dabble in the investment industry to pump up your savings.
If you’re only left with the tax-deductible debts, you can easily put your savings towards the stock market or other forms of investment. Unlike stagnant savings accounts which only let you earn 1% interest on a yearly basis, conservative stock market investments will let you earn 4% to 5% returns – more if you are willing to take more risks with your money.
Again, it’s all entirely up to your personal situation if you’re deciding between paying off your debts while saving, or paying off all your debts before saving.
Perhaps a good exception of when you should go for paying off all your debts is when you have debts which are mostly high-interest in nature. If a person with a $10,000 debt is charged a 15% interest, the minimum monthly payment plus interest would be $225 per month. Out of the $225, only $100 would go towards the principal. The remaining $125 will be flushed down the drain because it is the interest charged by the bank.
If the borrower can only pay the minimum amount per month, the $10,000 debt plus interest will take almost thirty years to pay, and the total amount of interest could add up to $12,000. In this case, it makes more sense to pay off the debts first before attempting to save any amount as an emergency fund.
The Bottom Line
To sum it all up, it is possible for you to save or even invest despite having debts. There is no wrong or right decision as to whether or not you should save and pay off debts at the same time. It’s all a matter of deciding which option is right for you, depending on the status of your finances.
If you feel that your debts are all high-interest, you might want to put off saving for a while so that you can get a better grip on the principal amount of your debt.
On the other hand, if you have mostly low-interest debts, there is absolutely nothing wrong in saving while paying off your debts at the same time.