holding a piggy bank

Should You Save Money or Pay off Debt?

In this article, I tackle this important question: “Should you save money, or pay off debt?” You should really do both, but I want to share with you the best way to do that.

When to save money

Saving money is something you should always be doing, really, but there is still a certain way it should be done.

Whether you are in debt, or not, saving is going to be something that you do on a regular basis.  The only thing that should change is how much saving you do.

If you are in debt, the goal should be to get out of debt.  But if you don’t have any money saved, that’s not going to work.  And here’s why.

When you have debt, you are going to be responsible for paying that debt each month (at least whatever the minimum payment is).  But if you have no savings, how are you supposed to keep from going further into debt when an emergency happens?  That’s why you need to save a little bit up front, while you’re making your minimum debt payments.

Technically, you are paying debt off and saving at the same time (at least at first).  This is what you have to do in order to keep from going further in debt, but the priority still needs to be to get that debt paid for as soon as possible.  The little bit that you save up will be for any emergencies that might happen while you are making those minimum payments.

Say the initial amount of savings you need is $1000.  First, you gotta get focused.  You gotta get serious about getting that money saved as quick as possible.  To do that, you might need to cut your lifestyle a bit, get an extra job, work overtime, whatever it takes to get that money saved up as quick as possible.

In the meantime, you continue to make your minimum payments until your $1000 is saved.

Once you get it saved, you now have a small emergency fund.  This will keep you from continuing to use those stupid credit cards, thus worsening your debt situation.  You have to stop that, and that starts once you have a cushion of cash saved.  Then it’s time to turn your focus towards paying off all the debt.

When to pay off debt

A lot of my “money philosophies” are influenced by Dave Ramsey.  And what Ramsey recommends you do at this point is called the debt snowball.  Here’s how it works.

Remember, we’ve been paying the minimum payments on everything up to this point, so this debt snowball will start to make sense in a second.  Yes, we are going to keep doing that, but we are going to start focusing on paying any extra money on one of the debts.  This is what you wanna do.

Just like when you were saving up all your extra pennies to save that starter emergency fund, now you need to take that extra money and start throwing it towards your smallest debt.

You’re not worried about interest rates or anything like that; you’re only concerned with the smallest amount of debt.  Yes, mathematically, that may not make sense, but we don’t care about making sense at this point.  We care about paying off everything as soon as possible.  Just remember, 20% interest on zero dollars is still zero; we need to get things to zero as soon as possible, and the debt snowball will make that happen.

When you start getting small wins here and there, and start freeing up more and more money by paying off debt, something magical happens that defies all logic and math.  Something happens psychologically and you start paying everything off before you even have a chance to worry about a silly interest rate.  Remember, 1% and 20% are the exact same number on zero dollars.  Get to zero as soon as possible; that’s the name of the game.

At this point, you are still paying your minimum payments on everything except for the smallest debt:  you are throwing everything you have left towards that one.  Once it’s knocked out, you move on to the next smallest, then the next, and so on and so on, until all debt is paid for.  That’s the debt snowball.  It “snowballs” as you go because as you free up money from your smallest debt, you add that to the minimum payment of your next debt.  Now the amount of money you’re paying towards the next debt continues to grow until you are completely out of debt.  That’s how you want to do it.

Once you are completely debt free, now it’s time to really start saving.

When to really save money

Initially, we saved $1000 to fund any emergencies while getting out of debt.  This was the starter emergency fund.  Now it’s time to save the fully funded emergency fund.  Dave Ramsey recommends this amount to be around 3-6 months of expenses.  In other words, the amount of money you could live on with no income at all.

By the way, most of these concepts are outlined in Dave Ramsey’s book, TheTotalMoneyMakeover. I would highly recommend it; it completely changed the way I think about money.

When you save your fully funded emergency fund, it’s actually easier than your starter emergency fund.  That might sound crazy, but it’s true. That’s because you are completely out of debt, so you have a lot of your money freed up. You can fully fund your emergency fund in no time.  If you want to speed the process up, you can always do like you did initially by getting an extra job or whatever.  It’s not going to take long to get this money saved; it’s usually ten to fifteen thousand dollars for most people, but it could be more or less depending on your situation.

Also, if you work towards reducing your cost of living, by living a modest and frugal life, you might be able to cut out a lot of your expenses. This will make your “cost of living” even less, allowing you to not have to save as much.

Ramsey recommends 3-6 months of expenses based on what he’s learned from other millionaires.  This is how you stay out of debt for good.  Once you pay that crap off, you never go back.  This allows you to start building some serious wealth.  You have a pile of cash for emergencies that keeps you from having to borrow money if you are ever unemployed for any reason. This keeps you out of debt for good.

This is what millionaires have done in their own lives; they don’t borrow money.  They didn’t get rich by borrowing money, and you’re not going to either.  Yes, it could happen, but that’s an exception; not the rule.  Most millionaires did not borrow their way into wealth.  Millionaires just don’t do that, and you shouldn’t either.  If you want to be rich, do what rich people do.  Ninety nine percent of them will tell you not to borrow money.

When you finally have your fully funded emergency fund, it’s time to take it to the next level.  It’s time to start investing.

Should you invest money?

Once your emergency fund is fully funded (3-6 months of expenses saved), you should start investing.  By the way, congratulations!  Getting out of debt was one of the best investments you’ll ever make, but it’s time to take it to the next level.

You might be asking yourself, “Do I really need to invest?” And the answer is, “Yes, if you care about building wealth.”  You’re not going to build wealth in today’s economy unless you invest.  The days of letting your money sit in a bank and earn decent interest are long gone.

If you work for an employer, chances are they offer some sort of 401(k).  If you are contributing to that, you are investing, and that is a good place to start.

Most employers will offer a match of some kind, and you’ll want to take advantage of the match (it’s money that is being invested for you).  Generally, if you are in debt, you want to avoid investing because you want to free up as much money as possible to pay off debt.  But at this point, you should be debt free.  If your employer offers a 401(k) match, start contributing to at least the company match (you’ll want any extra money going towards a different investment vehicle).

Most millionaires did not inherit their wealth; they became millionaires by saving and investing.  They avoided debt and lived simple lives.  They basically lived a modest and frugal life, and that is illustrated beautifully in the book TheMillionaireNextDoor.

It’s important to note that millionaires generally invest 15% of their income towards retirement.  This is a benchmark worth serious consideration. But if we are only investing in 401(k)s up to the match, we’ll need another investment to make up the difference.

Say your employer matches 4% of your contributions towards your 401(k); that leaves you with 11% to invest elsewhere if you are to hit the 15% standard.  That’s where a Roth IRA comes into play.

If your household income is $50k, then you should be investing $7,500 towards retirement (15% of $50k).  Here is an example of how the numbers play out if your employer matches 401(k) contributions at 4%:

  • $2,000 towards 401(k), which is 4% of $50k
  • $5,500 towards Roth IRA, which is 11% of $50k
  • $7,500 total towards retirement, which is 15% of $50k

At the time of writing this, you are allowed to max out a Roth at $6000 a year, so these numbers would not be at risk of falling short of the 15% benchmark.  However, if you were to fall short of the 15%, then you would want to think about increasing your 401(k) contributions to make up the difference.  The goal is to hit that 15% mark.

The reason you want to focus on a Roth first is because of how the taxes are handled.  A 401(k) grows tax deferred, while a Roth grows tax free.  This simply means that you could shield millions of dollars from taxes with a Roth. Your growth will be close to the same; you just won’t have to pay taxes on the amount you withdrawal if it’s a Roth, whereas you would on your 401(k) withdrawals.  It just makes much more sense from a tax perspective to fund as much as you can towards Roth.

Lest you think investing is not going to make you a millionaire, let me remind you that $200 a month invested in mutual funds (401(k)s or IRAs) will turn into $1.5M over a 30-40 year period (according to S&P 500 historical returns).

By the way, $200 a month is probably no where near your 15% goal, so becoming wealthy is clearly within your means. But you have to be intentional with your money, and you do that by getting out of debt and saving and investing accordingly.

What’s the point?

You might be asking yourself, “What’s the point in all this?”  And the answer is to become wealthy.  If that’s not your goal, then there is no point!  But I imagine that if you are asking yourself, “Should I save money or pay off debt?”  You probably care about winning with money.

The point is this:  to be able to retire one day; to be financially independent; to leave a legacy for your children; to give a bunch of money away; to make the world a better place; to be able to make a difference. In order to do any of that, you have to start winning with money. Once you are intentional about paying off debt, saving and investing, you will have a chance to do all of that.

This is the very reason why I live a simple and frugal life. This is why I live on less than I make and avoid debt. This is so I can invest as much as possible and have a chance to retire with millions.

Final thoughts

The idea that saving or paying off debt are mutually exclusive behaviors seems confused to me.  These two things are really the same.

It seems to me that when you pay off debt you are saving.  It could also be the case that when you are saving, by living below your means, you might be using the extra money to pay off debt.

No matter how you look at it, paying off debt is saving, and saving is paying off debt.  They can be done separately, but they should never be done without the overall goal of investing in mind.

Perhaps the greatest investment of all is getting out of debt.  Once you do, you are able to invest like never before, setting yourself up for a promising future.