Which Is Better: Saving Money or Paying Down Debt?

By Wendy Connick Markets Fool.com

IMAGE SOURCE: GETTY IMAGES.

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In a perfect world, everyone would have no problem living within their income; we'd all have little to no debt and plenty of money set aside in savings. In the real world, that's a depressingly rare circumstance. Stuff happens -- your kid breaks a leg and runs up a huge medical bill, the car dies, the roof flies off the house in a storm, and suddenly you have no savings and a mountain of debt to worry about. If you're in this situation, then you have plenty of company.

So should you be focusing on saving money or on paying down that load of debt? There's no one-size-fits-all answer, because it depends on how far you've gotten in the trek to balancing your personal budget. Regardless of your situation, here are seven steps that will get you well on your way to financial security.

Step 1: Run the numbers

The first step in digging yourself out of a financial hole is to figure out where you stand right now. You need to know exactly how much money you have (checking accounts, savings accounts, retirement accounts, investments, the old piggy bank sitting on your closet shelf, etc.). You also need to know exactly how much money you owe (credit cards, car loan, student loan, mortgage, unpaid bills, the $10 you borrowed from Bob at the office, etc.). If you're paying interest on the money you owe, which is likely, write down the interest rate next to the amount due for each debt.

If you're surprised by any of these figures, then you should start monitoring your finances more closely from now on. In any case, with this information in hand, you're ready for step two.

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Step 2: Build a micro-savings account

If you have literally nothing in savings, then your top priority is to build yourself a small cushion. That way, when a crisis rears its ugly head, you won't have to sink yourself even deeper into debt to deal with it. Ideally, an emergency savings account would hold enough cash to pay for at least three to six months' worth of living expenses, but if you're shouldering a ton of debt, then you may not want to commit that much to savings yet. For now, save just enough to see you through a minor financial emergency, like a vehicle breakdown or a big dental bill.

Exactly how much you set aside is up to you, but if you have a lot of high-interest debt, then $1,000 or so is a reasonable goal at this point. Until you've saved that amount in an account that you can access on short notice, just pay the minimums on your outstanding debts.

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Step 3: Cut back on interest

Pick up that list you made in step one and highlight the debt on which you're paying the highest rate of interest. This is likely to be credit card debt, which means the interest could be very high indeed -- north of 20% for some cards, especially if you're behind on payments. If you owe a lot of money on this account, then you won't be able to pay it off instantly. However, there might be a way to reduce that insane interest rate or even get rid of it entirely.

If you have some room available on another credit card, see if you can get a balance transfer offer to move the high-interest debt -- or at least a portion of it -- to a card with a lower rate of interest. Depending on your account history and credit rating, you may even be able to get a zero-interest balance transfer, which could give you several months' worth of extra breathing room.

A balance transfer won't solve your debt problems, but it will buy you some time to pay down the debt without being constantly set back by high interest charges.

Step 4: Pick a payment plan

When it comes to paying down debt, there are two major schools of thought. One says your top priority should be paying down the highest-interest rate debt first. The other says you should start by paying off the debt with the smallest balance. The latter is the "debt snowball" approach popularized byDave Ramsey. The reasoning behind the debt snowball approach is that getting rid of one of your debts quickly will give you a psychological boost and make paying off the rest feel easier.

If you're feeling overwhelmed by your debts (which is very common), then start out with the debt snowball approach. Every debt you pay off will mean one less lender breathing down your neck.

If you can handle the pressure and stick to a strict repayment plan, then paying off your highest-interest rate debt will save you the most money in the end.

Step 5: Implement your plan

If you've chosen the debt snowball approach, then you'll want to pay the minimums on all but your smallest debt. On the smallest debt, pay as much as you can every month. If you've chosen the high-interest rate approach, pay the minimums on everything but your highest-interest rate debt, and pay down that particular debt as fast as you can.

There's one exception to both of these plans: If you owe money to the IRS, then pay the tax man first. The IRS can get extremely scary when it comes to collections, so you'd be wise to pay off your debt to the IRS first and then move on to the highest-priority debt per your plan of choice.

Step 6: Switch back to saving money

At some point, you'll have paid off your high-interest debts (which probably includes all your credit card debt) and will be left with mostly fixed-interest loans, such as your mortgage loan, student loans, and possibly your car loan. At that point, you can switch your priority back to building an emergency savings account, which will help you to stay out of debt in the future. Exactly how much you should save will vary depending on your situation, but three months' worth of expenses would be the absolute minimum. Many experts these days recommend setting aside enough money for six months' worth of expenses or even more -- especially if you live in a one-income household or you're not entirely confident in your job security.

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Step 7: Celebrate

You've cleared your high-interest rate debt, reduced your debt load significantly, and funded an emergency savings account. You should be extremely proud of yourself! You're not done yet, but you're past the worst of it, and you've put yourself on much more solid financial footing.

Now you can safely split your extra income each month. Part of it can go toward paying down your remaining debt, and part of it can go toward other savings goals -- namely, funding your retirement accounts. And don't forget to set a little money aside each month to spend on something fun. You can afford it now!

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