Personal Finance: Debt vs Savings

Now that you’ve read Personal Finance: Where to Start you’re wondering – ok, I have my basic framework, now what? How do I apply this? What do I do next? Your next step is to start sorting through your finances to figure out how to best make your money work on your behalf and to decide how far you’re willing to go to meet your #1 goal. People tend to think about personal finance as debt vs savings vs investing. I would argue that savings overlaps with investing, but that will be discussed further below.

If you’re in a situation where you aren’t able to meet minimum expenses (i.e., food and shelter) then you either have to figure out a way to generate additional income or reduce expenses (or do both ideally). You have no other choices. There is no magic bullet. I’ll devote a separate post just for this situation because, unfortunately, it’s becoming increasingly common. For now, I’m going to assume that you have money left over after covering minimum expenses.

Debt is always your starting point.

There are many different kinds of debt, but the bottom line is that any type of debt means that you owe money to someone. Make a list if you need to – you want to know the following about each type of debt:

  • How much money do I owe?
  • What’s the interest rate on this debt?
  • How long do I have to pay it back?

You don’t need to make any decisions at this point; all you need to do for now is lay out the details of your existing situation so that you can easily see how much you owe in total.

Should I save or pay down debt?

This is a big question that comes up for most people at some point in their lives. Obviously, it varies greatly depending on the specifics of your situation, but what you need to ask yourself in order to make this decision is: Where will my money work the hardest for me?

You have a limited amount of money and need to divide it between a number of competing interests. Money is just a tool to finance the things you need and want in life, which is why you want to focus on the best way of making that tool work for you. The “best” way is the one which is most aligned with your #1 goal but also generates a reasonable return.

For example, assume that after paying minimum expenses (food and shelter) you have $1000 and need to allocate this between (1) credit card debt of $3500 which has an interest rate of 19%, and (2) an empty savings account. Where you allocate your money depends on your #1 goal and your overall personal situation.

If your #1 goal is to eliminate debt and you have options for emergency funds (e.g., family/friends, or a line of credit with a 5% interest rate), then you might decide to put all or most of that $1000 onto your credit card debt. Let’s assume that you put the entire $1000 onto credit card debt but had an $800 emergency – take that $800 from your line of credit and even though it’s technically new debt, you’re still coming out ahead because you’ve eliminated $1000 @ 19% interest and only owe $800 @ 5% interest.

If your #1 goal is to build savings to alleviate anxiety because you have no options for emergency funds, then you might decide to split your $1000 between the credit card and your savings account. Maybe you’d be most comfortable with $800 of savings, so go ahead and pay down only $200 of your credit card debt. In this case, you want the minimum savings that you’re comfortable with because if you put the entire $1000 into savings, your money isn’t working for you at all. With the entire $1000 in savings, you’re barely making any money from it, plus you’re losing money because of the outstanding debt+interest.

Your money works hardest for you when you’re able to get the highest rate of return from it.

How do you find the highest rate of return?

A key to managing your own finances is being comfortable enough with underlying concepts to decide which direction is best for you. Getting the highest rate of return from your money is simply figuring out which of your options keeps the most money in your hands instead of someone else’s. To ensure we all have the same starting point, I am going to define an investment as a way of making your money grow.

Going back to the example above, you can start to see how saving your money is a type of investment. The word “investing” is generally only associated with stocks or real estate but using my definition, investing includes savings accounts (because they earn interest) or even taking courses so that you can get a job with a higher income.

A lot of finance decisions can be reduced to the question of: which option keeps the most money in my hands long-term? Long-term is key here, since what you’re ultimately trying to achieve is your #1 goal. Underlying this question is deciding how far you want to go to achieve your #1 goal.

Deciding how far you want to go is part of your overall thought process. Let’s assume you have $1000 to allocate with a #1 goal of building up $5000 of savings to alleviate the anxiety of having no emergency support options. Your savings account has 0.5% interest, so from a strict dollar-perspective, you keep the most money in your hands long-term by putting the $1000 towards your credit card debt (credit card return = $1000 @ 19% | savings return = $1000 @ 0.5%). But that doesn’t help your #1 goal.

Your ultimate decision is driven by how far you’re willing to go to achieve your #1 goal – maybe you’ve been burned so badly in the past that having that $1000 in your savings account would make a huge difference to your anxiety/quality of life and you’ll be earning enough in the future that you’re willing to pay more interest on the outstanding credit card debt. Then go for it. It doesn’t matter what I think or recommend because I’m not you. Just make sure you think through the decision long-term so you’re prepared for the future, not just for today.

You’re the one in charge. Talk things through with other people if you need to but remember that ultimately this is your life and you have to live with the consequences of your financial decisions.