How To Decide Whether To Sock Funds Away Or Pay Off Debt

When you get a hold of a large chunk of cash — say, from a bonus, tax refund or item sale — those with the self-control not to blow the funds have to decide whether to save it or pay off debt. While there are other options available, such as investing or donating the money, saving vs. debt reduction is one of the tougher quandaries to decipher.

Go Banking Rates suggests making tough financial policy decisions in advance of receiving the windfall. For instance, if you’re short of your reserve fund goal, it’s a no-brainer to use the new money to fill up that account before you do anything else with it.

For hoarders, though, no reserve fund is ever high enough, and those hyper-savers can end up negating their savings interest rate by shelling out interest on balances that fall too slowly. On the flip side, those who are obsessed with getting rid of their debt can end up cash-poor if they suffer setbacks.

There’s no universally correct way to juggle debt and savings, so it’s up to you to allocate the funds depending on your income stability, savings needs and debt load. You should be OK as long as you put some critical thought into your decision.

Saving Money Vs. Paying Off Debt: Which Is More Important? [GoBankingRates]

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  1. Extended-Warranty says:

    If you have credit card or personal debt, you should be paying it off.

    Finance people will come in and tell you about the possible 1-3% you can make by investing instead of paying off debts. I’m pretty sure I know more people with debt problems, rather than not having enough investments.

    • bendee says:

      It depends though – if you have a 4% mortgage but not a lot of savings, it might make sense to put it into savings, even with a 1% interest rate. Once you have enough of a buffer to withstand major emergencies and unemployment, then begin to pay down debt.

    • castlecraver says:

      I know several people with debt problems too, but to a man they ended up that way because some unexpected circumstance hit (lost job, medical problem, legal issues, etc) and they had no emergency fund.

      • sponica says:

        or the emergency outlasted their emergency fund…no matter how hard you try a 3 to 6 month fund can not be turned into an 11 month fund (says the person who looks at the 130 dollar savings balance, remembering it was over 3k)

    • mindaika says:

      If you lose your job and have $0 in savings, being able to brag to your friends about how you paid off your student loans early isn’t going to do you a whole lot of good.

  2. Tim says:

    Bigger question: how much of the windfall should you spend?

    Seriously, if you get a windfall, especially if it’s because you did something good, you should spend a good chunk of it.

    • obits3 says:

      Most people should not spend their “windfall” as fun money. A bonus and a tax refund are the same – they are both compensation for labor (that “refunded” money was your labor tax overwithheld). They should be considered the same way you would consider a paycheck.

    • ledbetse says:

      I don’t think so, Tim. By what rationale is spending it a good idea?

    • hoi-polloi says:

      If you’re normally very frugal or on a very tight budget, I wouldn’t begrudge someone doing something nice for themselves. Indulging in a reasonable purchase, a good dinner out, or a massage may be well and good, but spending “a good chunk of it” sounds like a pretty shortsighted decision.

  3. obits3 says:

    I think the key for most people is not interest savings vs investments. Most people should be looking at interest savings vs liquidity. If you don’t have an emergency fund, then pay enough to service the debt and save the rest. Once you have an emergency fund, start paying off the debt.

    • FatLynn says:

      Exactly! I have a mortgage at 5%, and my savings account earns, like, .25%, but you know what? If I pay down the mortgage, and then have an emergency, I can’t just take the money back from my lender.

  4. dush says:

    How to decide? Just think critically about it.
    It’s up to your own individual circumstances.

  5. Loias supports harsher punishments against corporations says:

    I say have enough cash to cover any emergency that can not be covered on a credit cash (paying rent, taxes, anything that requires cash or check). After that, put everything into your credit cards and/or anything with a bad interest rate.

    You might as well drop your credit card balance if, when an emergency does happen, you’d just have to put it on the card anyway. At least this way you are reducing your paid interest.

    • obits3 says:

      It also depends on where you are at in life. My mom is hopelessly in debt credit card wise and barely makes enough money to cover the bills to live. I have advised her to just let the credit cards go (as there is now way in 30 years that she would be able to pay them off).

  6. comedian says:

    Before we became entirely debt free last year my wife and found great joy in looking back at articles from before the current debt-fuled worldwide financial crisis telling people that it was foolish to pay off a mortgage when money was cheap to borrow and the market was doing well.

    Sure, paying off our mortgage only returned about 2.5% per year after taxes, but (other than opportunity cost, loss of liquidity & potential to get “stuck” in a house if you want to move) it is an entirely risk free “investment”.

    Paying off a 24 month 0.9% car loan early was a bit harder decision, but given that the same money was only earning a pre-tax 1% in an online savings account, that too seemed like a good idea.

    • aphex732 says:

      I can understand the house, but you’re ignoring inflation regarding the car loan. If you have an interest rate of less then 1%, you’re beating inflation by just paying off the loan as slowly as possible.

  7. vliam says:

    saving vs. debt reduction is one of the tougher quandaries to decipher.

    At the current interest rate levels?
    Not so much…

  8. Bugley says:

    ” … so it’s up to you …”

    Is it tim–µ to updat–µ th–µ Consumerist tag line, “Shoppers bit–µ back”?

  9. sponica says:

    I’ll probably split my tax refund b/w my savings account, one of my credit cards, and buying glasses so I can drive safely at night again

  10. Buckus says:

    Hmmm…pay off debt you’re being charged 12% on, or save it an earn, what, 0.25% (that’s a quarter of 1 percent, which is what most savings accounts are paying). No brainer here.

  11. BurtReynolds says:

    I saved rather than pay off student loans at 3 and 3.25% because having a decent savings cushion was worth doing. Also I was still paying substantially more than my “payment” while saving, so I was at least cutting off some of the interest.

    • hoi-polloi says:

      When a CD matured a while back, my wife and I looked at the interest rate if we rolled it over for another few years. It was quite a bit less than the interest on my remaining student loans, and it was only part of our emergency fund. We decided to knock out the student loan debt and then apply that monthly payment amount to rebuilding. That strategy worked for us, especially due to our relative stability.

  12. FatLynn says:

    The rule of thumb that I like is to have an emergency fund = one month of expenses for each point of unemployment. I know, though, that I am a bit of a hoarder, and I could pay down my mortgage early if I weren’t so obsessed with having emergency cash on hand.

    • yellowdog says:

      Me too! My emergency fund NEVER has enough, and I don’t know that it ever will. I’m too afraid of job loss to stop my regular contributions to savings, even though I’m earning a pathetic rate of interest. Call me a cash hoarder too, I guess.

  13. maxamus2 says:

    Seriously? Pay off your dang debt. I’m quite sure you will just run that debt up again anyway.

  14. dolemite says:

    My problem is…we’ve finally built up a decent chunk of an “emergency fund”/savings, but it’s sitting in a savings account earning 1/10 of 1%. Most savings accounts, even high yield ones or money market is paying around .1% or .8% (in contrast to 5% years ago). You can hardly find any that pay even 1%. It’s hardly worth me even moving it between accounts and keeping up with new login/tax forms/junk mail to open up an account somewhere for a .5 or .6% interest difference.

    • FatLynn says:

      I like I-series bonds. They don’t earn a ton, but they earn more than 3% right now, and they are liquid. Even if you have to cash them in before 5 years are up, you only lose one quarter’s worth of interest, and you still come out ahead, as compared to earning .5% in a savings account.

    • blueg3 says:

      It depends on how much risk you’re willing to weather. You can buy bonds or bond funds (I don’t personally the think I-series is a great boon compared to regular US bonds) for a better return with some risk. You should probably adjust how much you save accordingly: if it seems like a bond fund could lose up to 20% of its value, your should save 25% more in it than you would have saved in cash.

  15. lovemypets00 - You'll need to forgive me, my social filter has cracked. says:

    When I started to pay off debt, I also had a small emergency fund of $1000, ala Dave Ramsey. But I soon learned that $1000 wasn’t nearly enough, and thank God I didn’t cut up all my credit cards or close my line of credit with my credit union. I had one emergency that was over $2K, and had I not had a credit card to use, I would have been SOL with no car to drive to work (23 miles away and no public transportation).

    Now I’m down to a parent plus loan, ~$7800. Instead of hammering away at it, I’m paying more than the minimum, but putting any extra money into savings instead. I hope to avoid the debt down, debt up, rebuild emergency fund yo yo that I experienced over the last few years.

    I guess I could have asked for a loan from the bank of Mom and Dad, but I try to avoid that at all costs because I want to feel like I’m at least semi responsible for myself.

    • sponica says:

      once my credit cards get paid off I’m not closing them down….and to be fair they’re only maxed out because I had to keep my car working during my prolonged unemployment. oh how I wish they were maxed out bc I went to Vegas or someplace fun

  16. ponycyndi says:

    When I was in debt, I always did a 3-way split between debt, savings, and spending (either a large needed purchase, or something more frivolous), with the largest amount going towards the debt, and an equal but smaller amount for the other two.

    Now that I am not in debt (except for a mortgage) I do a 3-way split with the largest going to savings, and smaller amounts going towards large, needed purchases and something frivolous like a nice meal or two.

    Always including the needed purchases keeps me from going into debt again or drawing money back out of my savings.

  17. MeowMaximus says:

    Always pay off debts first. The peace of mind is worth it, and the few bucks you will make on the investment wont add up to much.

    • meltingcube says:

      The only debt I have is a car loan which I owe $16k on still. I feel much better putting extra money into a savings account rather than paying down on the vehicle.

      • LMA says:

        Why would you incur debt on something that inherently depreciates? At least a house (if you are an intelligent buyer, don’t buy above your means or when we’re atop a bubble, live in a region with tons of employers, etc) can go up in value. That never happens with cars. Since I bought my first car nearly 30 years ago, my rule has always been “only buy a car you can pay for with cash, maintain it scrupulously and drive it until it’s done.” That first car was mildly used at $4k. Drove it until it rusted out on me in ’92 and bought a my first new car, a Saturn, for $13k. Two years later, someone rear ended me on the highway, so I bought another Saturn with the insurance money and an extra $2K. Drove that until ’06 when I bought my Prius for $25k. Never paid a cent in interest, which of course means all the money I didn’t spend on interest became savings for the next car down the line.

  18. crispyduck13 says:

    A lot of the comments here keep bringing up interest as the motivater for saving vs paying off debt, but I wasn’t aware that was the main reason to save. Article after article (and common sense) instructs us to build up at least 3 months living expenses as an emergency fund. MANY people do not even have this small luxury and are living paycheck to paycheck.

    I’m currently working on building up my own emergency fund. Knowing that I wouldn’t immediately go into default on my mortgage and student loans after suddenly losing my income is worth the $300 a month in interest I’m paying on various unsecured debt. Once I get it to where I’m comfortable and less stressed out I can then focus on paying down debt aggressively.

    I guess it comes down to what would make you sleep better at night, and that’s a very personal thing.

  19. aciddeath says:

    I believe the most difficult part of this dilemma is evaluating your situation.
    I am a single male employed stably full time, health insurance, renting a house for $1,000 with $23,000 of federal student loan debt at 6.8%
    I have about $1,000 emergency fund (used to be $5k, figured I might as well put that into my debt).
    So naturally for me, it makes sense to pay off my debt as aggressively/quickly as possible.

    The small emergency fund does make me a little nervous but I have a single 0% apr for 12 months credit card with no balance currently so I feel I am at least minimally covered incase “s!#% hit the fan”

    On the flip side if I was saddled with credit card debt, a mortgage or otherwise my ideas about repayment of my student loan (and savings) would be completed 180′d. I would not want to lose my HOME so I would certainly make sure I had at least 6-12 months of mortgage payments saved (or in the process of BEING saved).

    …back to my IT bubble….

    • sponica says:

      the nice part about student loan debt (and I’m guessing you have Direct Loans based on the interest rate) is that when you’re unemployed you can go into deferment…if your loans were subsidized while you were in school, they remain subsidized in deferment.

      my direct loans aren’t in deferment because the IBR on them is 10 dollars a month and I can afford to pay that, but I did put my Perkins Loans into deferment.

    • impatientgirl says:

      You need a bigger emergency fund. 3mths

  20. Starfury says:

    I found out we’re getting a merit bonus…usually about 2 weeks pay before taxes are removed (40%) and also the company is matching 9.5% of my salary from last year into my 401k plan. I figure with that little bump to the 401k I won’t feel guilty about spending the bonus.

    Most likely it’ll be going to pay for a checkup on my car…125k miles and I’m sure it needs something done to it.

  21. Such an Interesting Monster says:

    Like most things in life a balanced approach is likely best. Save a little, spend a little, and send a little off to pay down your debt.

    • sponica says:

      yeah…while I enjoy growing my savings account, I also like to go on vacation, drink fancy beer, and whatnot. granted all these things are on hold til I get a new job

      if i ever do purchase a house, it will be a smallish house…if I end up with more kids than house, well that’s how my parents and grandparents grew up. (I blame a lot of the palatial college dorms on the fact that most of these kids never had to share a room growing up and get to college and don’t understand how to share a room)

  22. Not Given says:

    I say put $1k + 1/3 the balance in an emergency fund, the rest can be paid toward debt. That can keep you from having to charge minor emergencies to a credit card.

  23. impatientgirl says:

    1st give yourself a 3 month emergency fund to only be used if you lose your job
    2nd pay off small debt
    3rd pay off large debt
    4th invest and save
    5th pay off mortgage

    and done.