Saving Versus Paying Down Debt: It’s All About Risk, Interest, Access, and Cash Flow

by Kevin on April 7, 2011

It’s an age-old financial question: to pay down debt or to save extra funds for a rainy day? As with any personal finance question it really depends on your personal situation. That having been said here are some guidelines you can use to determine what is best for you.

Risk, Emergencies, and Stability

Having money put aside in an accessible account (a checking, savings, or money market account, usually) is a great thing to have when disaster strikes. I’ve written about emergencies and emergency funds for years because it is important to be aware of potential risks in your life.┬áBut is having that emergency fund worth not paying off that nagging credit card balance?

A big factor to consider is your situation’s stability. Consider these questions:

  • How stable is your work and thus your income? The less stable your position, the larger emergency reserve you must have.
  • Are you likely to be laid off? If so you need to be cutting costs and stocking up (and not just in funds, but that’s a start).
  • Do you work in an industry that is declining? A mature industry that is on its way out is more apt to have mergers/acquisitions and the associated layoffs that come with them.
  • Is a large percentage of your income based on commission? The more your income fluctuates, the more you need to have saved up.

A less stable and more risky life situation means you need more money set aside to handle those risks.

Interest: How Much Can You Earn?

Risk and stability aren’t the only factors to consider. You may have a completely stable employment and income situation. That doesn’t automatically mean you need to apply every extra dollar to your debt. You might be better off earning interest on those funds.

Earning more interest than you pay on your debts? Impossible, right? Not in some circumstances. If you have student loans that cost you 2% per year you would be better off finding a rewards checking account with a high interest rate to store your funds. Even after taxes earning 3% on your money is better than paying down debt with a 2% interest rate.

Unfortunately for most people cheap student loans aren’t their only debts. You might have a credit card debt with a 19% interest rate or a car loan with a 6% rate. You would be hard pressed to find a low (or no) risk investment that will beat 6%.

If you do have high interest debt then it not only makes sense, but is financially critical that you begin paying it down quickly. But don’t do so in a way that greatly increases your risk. The two sections have to be considered together. If you’ve got $5,000 to your name and $50,000 in debt then dropping every last cent toward your debt is going to put you at financial risk. You won’t be able to handle any emergencies that are thrown your way, and be forced to rely on credit (if you can get it).

Access to Additional Funds

That credit factor is the next thing to consider. How easy can you get access to funds? If you dump that $5,000 toward your debt and run into an emergency, can you access a line of credit to handle it or are you out of luck? Adding on additional debt is not a preferable thing to do, but it is better than not being able to pay what you owe at all. If you can access a line of credit in pinch, how much is it going to cost you?

How is Your Monthly Cash Flow?

Cash flow is the last factor you need to consider. Going back to the above situation — if you drop $5,000 on your debt, how quickly can you replenish those funds? If you’re only generating $100 per month in extra cash then you’re looking at 50 months — more than 4 years! — to build those funds back up. But if you’re generating $800 per month in extra cash it would only take you 5 months. It might be worth it to drop those funds toward the debt because you’ve got extra cash coming in every month.

A consistent significant positive cash flow every month is also a pretty good sign that you’ve turned your financial life around. You’ve either increased your income, cut your expenses, or done both. Keep up the good work and power through until the debt section of your net worth drops to zero.

{ 1 comment }

Dee April 7, 2011 at 2:49 pm

This was a great post, Kevin.

I’m in this situation right now, trying to decide whether to spread out debt payments or go for a huge lump sum. It’s been difficult weighing all of the factors, and overcoming my aversion to debt to do what’s best for my finances. I’m leaning toward preserving cash flow at the expense of remaining in debt a little bit longer.

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