For most of my adult life, I’ve been buried in debt – student loan debt, personal lines of credit and credit card debt. I didn’t grow up in a financially supportive family and have been on my own since moving out at 16. I’ve been working full time in a variety of different jobs since then, and I paid my way through college by working full time while studying. Although I’ve always tried to stick to a budget, several setbacks and “reckless” spending (i.e. more than a few shopping sprees) have led me to my current situation – over $60,000 in debt before the age of 30 and no real savings.
I’ve consolidated my debt in the past few years and have started to aggressively pay it down now that I’ve advanced in my career and am making a decent salary. However, I’m not sure how to go about saving (and eventually investing) while I am still in so much debt. I want to do both, but does it make sense to start saving when interest is still accumulating on my debt? Is it better to do one at a time or do both at the same time?
-Aspiring Saver Buried in Debt
First off, I want to acknowledge how far you’ve come from the days of setbacks and shopping sprees! Some of the most difficult work we take on is the internal work required to change our perspective and our behavioural patterns, in particular around finances. It takes courage and commitment to transform yourself from a spender to a saver and the fact that you’re asking me these questions tells me that you’re on your way to financial fulfilment.
Deciding how to prioritize saving and paying off debt is one of the most common questions I am asked, so know that you’re not alone in your uncertainty! I wish there was a simple, straightforward answer for you but, like most personal finance questions, the answer is “it depends”.
To me, it depends on two key factors: the math and the motivation.
Do the math
I often say that paying down debt and saving to invest are two sides of the same coin. While it might seem like an either/or decision, paying down debt essentially has the same effect as saving for the future. To understand what I mean by this, we need to look at how both of these options affect your net worth.
Let me explain.
Your net worth is a formula that represents your current financial position. It looks like this:
When your assets are more than your liabilities, you are in a positive, or “surplus” financial position. When your liabilities are greater than your assets, that’s a negative, or “deficit” financial position.
I’m going to show you an example of how a net worth formula might look for someone working to pay off debt, but before I do, I want to remind you that net worth has ZERO relation to your self-worth, or worth as an individual. The words “positive” and “negative” can be emotional triggers, and I know for a lot of people seeing their net worth as a negative number can feel awful. Try to look at your net worth number as simply a data point, similar to the “current location” coordinates on your GPS. In order to figure out how to get to where you’re going, you need to know where you’re starting from.
Now, let’s get to that example.
Deep breath! We did it. We calculated the starting point in the journey to being debt free. The ultimate destination – financial freedom, or retirement – might be a really big number, so let’s try working with a short term goal. For example, let’s say your first milestone is reaching a small surplus net worth. There’s two ways to accomplish this:
One way to increase your net worth is to decrease your liabilities. That means paying off the $60,000 in debt. Your new net worth formula would look like this:
The other way to increase your net worth is to increase your assets, or, save $60,000. If you accomplished this, your new net worth statement would look like this:
As you can see, whether you pay off debt or save to invest, you are creating the same effect in your net worth. This is why I say that it’s not exactly an either/or decision, because no matter which option you choose, you’re moving yourself in the same direction. The difference is the speed in which you get there.
The formulas above ignore one major factor that affects the rate at which your debt shrinks and your savings grow: interest. A dollar of debt is not always the same value as a dollar of savings, depending on the interest cost of your debt and the interest income of your savings. A rule of thumb here is to compare the interest rate on your debt to the interest you expect to earn on your savings and allocate the money to whichever is bigger. That will get your net worth growing faster.
Let’s consider two kinds of debt: credit card debt that costs you 19.99% in interest per year and a mortgage that costs 4.5% per year.
Given that interest earned in savings accounts is typically 1% or less, you’re almost always better off paying off your debt—unless you decide to invest your savings! On average, the stock market returns somewhere between 6-8% per year. If you’re willing to take on some financial risk and be able to leave your money invested for at least three to five years, investing might provide the bigger financial result.
In the examples above, you’d be better off paying towards your credit card debt rather than investing: 19.99% saved versus 6-8% earned. On the other hand, investing would likely leave you better off financially than paying off your mortgage faster: 6-8% earned versus 4.5% saved.
You might be wondering how fixed income investments, like GICs, fit into this equation. Since these products involve less risk, they produce less reward – you can expect somewhere around 1-3% in annual returns. It’s less likely you’d be better off financially by choosing to invest in fixed income versus paying off debt, but there may be a few circumstances where these products might make sense for you.
To summarize, when doing the math you want to first understand that paying off debt and saving are two sides of the same coin. Then you want to look at the interest rates and allocate your cash flow to whichever is bigger – the cost of the interest on your debt, or the income generated by your savings and investments.
Understand your motivation
A sound decision always begins with logic, but don’t discount the importance of doing what feels right to you. You can do the most precise calculations, but if your plan doesn’t motivate you to follow through with consistent action, you might find yourself spending money that you intended to use to pay off debt. A soulful, heart-centred answer to your question requires you to dig a bit deeper and ask yourself what’s really important to you when it comes to your finances.
Some people value freedom from debt, and having any of it – no matter how low the interest rate – can cause massive anxiety. If this is you, by all means go ahead and throw whatever money you have at your debt, regardless of the investment income you could create. Even though you’re passing up an opportunity to earn more money by investing, you’re aligning your cash flows with your values and that is the type of decision that will make you feel good about your money.
However, it sounds to me like your heart wants to see some growth on the asset side of your net worth equation. If building up some savings while you’re paying off debt is going to make you feel good and motivate you to stick with your aggressive repayment plan, then I encourage you to do it. Just make sure you understand exactly how much your debt is costing you in interest, and how much more interest you are going to pay by paying it off a bit slower.
I don’t know exactly how much interest you’re paying, but let’s assume a high-interest scenario. Paying off $60,000 of debt at 19.99% interest over five years instead of four years will cost you an additional $7,000 in interest, and with the lower debt payments you can watch your savings grow by $250 per month while you pay down your debt. (I used this calculator to do that math). You’ll be worse off financially by paying it off slower, but that might feel like a cost worth paying to see your savings stack up. Only you know what feels right for you!
Balance your head and your heart
As you can see, there’s a few things to consider when deciding whether to pay off debt or save and invest. It’s important to look at your options from both the logical and the emotional perspectives, and be honest with yourself about what you truly value and what will motivate you to stay committed to your financial goals. The answer is both simply logical and deeply personal, and there is no one right answer.
Since you’ve already reached out for help to consolidate your debts, I encourage you to reach out for help again – this time to calculate the cost and benefit of your options so that you can make a truly educated, intentional decision about how to move forward.
And remember, no matter which path you choose, both options will get you to the same destination – your debt-free day. Call me when you get there and we’ll celebrate!