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.

Personal Finance: Where to Start

At some point it’s there, either in the front of your mind or in the back of your mind. You should be doing something about your personal finance situation.

They talk about it on tv. The internet is full of articles, blogs, and websites devoted to it.

But it’s daunting. There’s too much information and you don’t know where to begin. It’s a big deal because you know you need money to pay for things but this just adds to the anxiety because what if you screw it up? Maybe you’re already screwing up.

Take a deep breath. Forget everything you’re thinking. We’re going to start from the beginning.

Don’t even think about the word “finance” or about money. Really, just ignore anything that has to do with money for now. Instead, think about what kind of life you want. Just drift for a bit.

Is there a type of stress that you want to remove from your life?

Did you experience a bad situation that you never want to go through again?

Maybe you have something you always dreamed about doing?

Any ideas what you envision for your life five or ten years from now?

It could be anything really. Don’t rush this, it’s likely to be a gradual thought process. Days, weeks, months…a few minutes here and there…

Think of this as your foundation; it’s not only about what you’re thinking but also how you’re thinking. I know it may seem strange, but stick with me. There’s a reason why I’m telling you to do this.

Identify what’s most important to you.

That’s what this thought process does. After you do it for a while, you might start to realize that a lot of the things you want have the same underlying driver. Or you might start to realize that you keep looping back to the same things when you think about what you want.

Make sure when you’re thinking about these things that it’s for a longer time frame. I suggest five to ten years – you can’t get caught up in what you want now or what your plans are for next year. Don’t worry, you’re not locked in to anything; the things you want are going to change over time. But because you’re trying to identify what’s most important to you, it’s likely going to be something big and anything big will take time to achieve (like five to ten years).

Now comes the hard part. Pick out one thing that will get you closest to the life you want. It could be anything.

You’d be happiest staying near your family who live in an expensive city which would mean having to increase your income?

You want to experience as much of life as possible and travel the world so you have to figure out how to fund your activities?

You feel scared that you won’t be able to afford food and shelter and would feel most secure with a steady, reliable income stream?

You worry constantly about being in debt and would be happiest if you could save more?

Your personal finance decisions should be driven by what’s most important to you. Of course, life happens unexpectedly and sometimes you need to make a choice which runs counter to your long-term goal, but the more you’re able to keep your #1 goal in mind, the more you’ll be able to stay on track to reach that goal.

Once you figure out what matters the most to you personally, you’ll have a framework for deciding what to do financially.

It’s easy to become overwhelmed or derailed with personal finance because most things in our life require money and the cost of living has exceeded wage gains for most people, so we’re off-balance to begin with.

Which is why you have to figure out what’s most important to you and focus on it when making decisions. There are so many financial choices you can make that if you don’t have a strong starting point, you can easily wind up doing something that makes no sense for your long-term goals.

Again, it’s ok if you have a good reason for making a choice which doesn’t fit with your long-term plan. Maybe your ultimate goal is to focus on saving but you wound up having to pay for an unexpected medical bill; that’s completely understandable. But maybe your cell phone is a few years old, slow, kind of ugly, and you want the newest iPhone but technically your old phone is still usable…keeping your savings goal in mind could remind you that you’d rather be debt-free a month sooner than buy a new phone right now.

This is the most important lesson in personal finance – always focus on personal before finance.