You’re on a mission to get your financial house in order — congratulations! But it can be hard to know where to start. You may have high-interest debt that’s been around too long, but you might be yearning to build financial security through saving and investing.
So — is it better to save or pay off debt?
The good news? There’s a simple answer. Once you know it, you’ll be able to improve your financial situation worry-free. We’ll also show you how to pay off debt while you save (and why you should do both), with examples.
Should You Pay Off Debt or Save?
Paying off debt can protect you from making high interest payments. But saving can help you earn interest, though usually at a lower rate than you’ll pay when you have debt. However, saving at the same time you pay off debt is proven to reduce stress, which can improve your financial wellness.
But there’s one caveat. Before you start working on both saving and paying off debt, take care of your most crucial financial safeguard — an initial emergency fund. That’s a small fund you can build up relatively quickly, equal to one month of take-home pay.
The steps below will help you see how to save money while you pay down debt.
Step 1: Assess Your Finances
Should I pay off debt or put money in savings? The answer depends where you stand financially. More than 36% of Americans have more credit card debt than emergency savings. Start by taking stock of your finances and by answering these questions:
Do you have an initial emergency fund equal to at least one month’s take-home pay?
An initial emergency fund can cover common unexpected expenses without using credit cards or loans. Natalie Taylor, CFP®, BFA™, financial planner, and speaker, says, “We recommend building this initial emergency fund before you start to pay off debt. Until that fund is in place, make just the minimum payments on your debt to keep your credit score healthy.”
To build that initial emergency fund, first determine your take-home pay for the month. If you bring home $10,000 monthly, save that much to start. Examine your budget carefully to find as many dollars as possible to aggressively seed that fund.
If you don’t have a budget yet, see our article on How to Budget as a Couple.
How much debt do you have?
Knowing how much debt you have can help you understand whether to save money or pay off a credit card. So — create a spreadsheet or write on paper exactly how much debt you have. List each creditor and the interest rate for each account. This will help you decide which one to tackle first.
Your debt list might look something like this:
Debt Account | APR | Remaining Balance |
XYZ Retail Store Card | 29% | $4,750 |
Travel Rewards Card | 26% | $2,200 |
Bank Credit Card | 17% | $600 |
Student loan | 4% | $12,000 |
Once you know how much high-interest debt you have, you can get to work on your savings and payoff goals.
Step 2: Prioritize Your Debts
Start by paying down high-interest debt over 7%. That 29% APR credit card is doing more financial damage to you than the 4% student loan. Prioritize your highest interest debt to make the most efficient progress possible. Alternatively, you might want to prioritize your lowest balance debt first to build momentum.
If you’re focused and methodical, tackling the highest interest rate debts first makes the most sense. If you’re worried about getting discouraged without tangible signs of progress, then attacking the lowest balances first may be a better approach for you.
Pay Low Interest Debt Last
If you’re fortunate enough to only have low interest debt, (generally less than 7%) then keep working on your emergency fund until you’ve fully funded it with three to 12 months of take-home pay.
At the same time, shift your focus toward funding your retirement savings, which will benefit you more in the long run. Look to save enough into your employer retirement plan to maximize the employer matching contribution.
Should You Pay Off the Smallest Debt First or the Highest Interest?
Pro Tip: Watch out for sneaky variable-rate debt that may look like low-interest debt one month, but change to high-interest debt a few months later. Check the fine print on your debts to see if any of them have a variable rate.
Step 3: Create Your Gameplan
The next step is to balance your funds between saving money and paying off debt.
After building your initial Emergency Fund equal to one month of take-home pay, split any dollars available for your goals equally between paying off high interest debt and continuing to build your Emergency Fund. Although you’ll likely be paying more in interest on debt than you earn in your savings account, building a fully funded Emergency Fund is your best defense against future debt, and the ultimate goal isn’t just to get out of debt, but to stay out of debt for the good. And that means building a fully funded Emergency Fund.
Best Practices for Your Emergency Fund
Here are a few tips to help you build an emergency fund that will help you save money and pay off debt — even in a crisis.
Use a High-Yield Savings Account (HYSA)
With rising interest rates, HYSAs are currently earning 3.5% to 4% interest, so they’re an easy way to give your funds a boost. Choosing a HYSA with a bank that’s different from your primary bank can make it easier to leave your savings untouched outside of a true emergency.
Once your account is open, automate a payment into it every time you receive a paycheck. This will ensure that you don’t forget to make a contribution.
Whether you contribute $100 per paycheck or $1,000, the fund will continue to climb — and earn interest — incrementally increasing your financial security.
Emergency Fund Size
Aim for at least three months of take-home pay if you don’t have any dependents, have consistent monthly income, and you don’t own a home. If you’re on your own and don’t have a mortgage, a three-month cushion should be enough to get you through an unexpected emergency or loss of income.
Save at least six months of take-home pay if you have dependents and/or own a home. More people to care for and a mortgage means more monthly expenses that you need to cover.
Build at least nine months of take-home pay if you’re self-employed or have inconsistent monthly income. Being even more conservative with your emergency fund is important when you don’t have a reliable income stream.
Save at least 12 months of take-home pay if you’re within five years of retirement. Once you move to a fixed income situation, the extra funds can help you weather potential medical bills or other unexpected expenses.
For more tips, see our article: How Much Emergency Fund Should I Have? Tips and Advice
Best Practices for Debt Payoff
Follow these tips to pay down your debt.
Stop Using Credit Cards Until Your Balances Are Paid
It can be hard to go on a plastic diet in what sometimes feels like a cash-free society. But — continuing to charge won’t help you pay down debt. Physically remove your cards from your wallet and turn off one-click purchase options from your favorite online retailers.
Best Practices for Saving
Besides your disposable income, look for opportunities to deploy big chunks of cash into your emergency fund, toward debt, or into saving for the future. These can include:
Windfalls: Bonus or commission checks, tax refunds, and monetary gifts.
Side gigs or overtime: Finding ways to earn extra income can move you forward faster. This might mean doing some consulting or some freelance work.
Step 4: Keep Moving Forward
When you achieve a fully funded emergency fund, take a moment to celebrate! It’s no easy feat, but your finances are all the safer because you did it.
And since you’re in the habit of saving money, keep going. The only difference is that now you get to choose a new goal that’s important to you, like buying a car, buying your first house, or working towards retirement when work becomes optional.
Take Your Debt to Zero
Getting to a zero balance on all your high-interest obligations is another celebration-worthy accomplishment.
Come Back to Plastic
If you have the self-discipline to pay your credit card bills in full every month, you can start using credit cards again. Used properly, they provide convenience and can earn cash back, points, travel benefits, and other perks. Making credit work for you (instead of the other way around) can be empowering.
Stay the Course, Conquer Your Goals
Focusing on improving all areas of your financial life at once aligns all your habits with increasing your financial freedom. So no — you don’t have to choose between paying off debt or keeping money in savings.
There may be times when you’ll have to rely on your emergency fund. At other times, paying off debt can free up cash flow for other goals. All the while, you also want to make sure you’re not taking breaks or waiting to invest for your retirement. By focusing on each of these goals simultaneously, you’ll be one step closer to financial freedom every month.
Monarch Money can help you achieve your money goals by helping you keep track of your finances in real time. Learn more.
