When you have limited cash, what's the best thing to do with it? Find out if paying off your debt is the best use of funds.
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Most of us have only a limited amount of money coming in each month -- and lots of things we want to do with it. This means you have to prioritize where your money goes among spending on needs, wants, and competing financial goals.
If you're in debt, chances are that repaying what you owe is one of those financial goals. But you'll have to decide if it's the primary goal you want to send all your spare cash to or if there are other things that may be better to do with your limited funds.
It can be difficult to determine if paying off debt is always the best thing to do with your money, as the answer depends on many factors including the interest rate you're paying on the debt, whether the debt is tax-deductible, and what other potential uses there are for your money. Here are a few key considerations to help you decide whether your spare cash should be going to debt repayment or to something else.
Making all your minimum payments always comes first
When you owe money, you have an obligation to pay as promised. If you don't, you could do serious damage to your credit score and could find yourself facing collections activities including lawsuits, wage garnishment, foreclosure if you don't pay your mortgage, or repossession if you don't pay your auto loan. You'd also likely owe late fees and could trigger a penalty interest rate.
Because of the dire consequences of not complying with your repayment agreement, you should always put your money towards making at least minimum payments on what you owe before you do anything else with your cash. It would make no sense to allocate money to savings or retirement while falling behind on your essential bills. So you really only have a decision to make about what to do with extra money if you have any extra after sending in minimum payments.
If you find you have no wiggle room in your budget at all, you may wish to look into refinancing or consolidating your credit card debt. If you could reduce your interest rate and monthly payment through consolidating and refinancing, you could make debt payoff easier and have more extra cash to pay down principal or use for other things.
The interest rate matters
The interest rate on your debt also makes a huge difference when it comes to deciding whether to prioritize debt repayment or to prioritize other things. If you're paying a fortune in interest, then paying back your debt becomes a much higher priority. If you have credit card debt at 20%, for example, you should really focus on getting that debt paid down because it's costing you a lot of money.
But some debt is at a very low interest rate. If that's the case and there's a very strong chance you could earn a better return on investment by putting your money into safe investments than by paying down your debt, it makes little sense to put any extra money toward debt repayment.
For example, if you have a mortgage at 4% but could likely earn 7% or 8% by investing in the stock market, you'd be much better off investing than you would be if you paid off your mortgage early.
Having an emergency fund is important, too
If you have no emergency fund, saving up to create one could be a better use of your money than making tons of extra payments towards your debt. This may seem like bad advice -- after all, why would you want money sitting in a savings account earning no interest while you pay 10% interest on a personal loan or 15% interest on a credit card?
There's a simple answer, though: Emergencies are inevitable. And if you don't have the cash when an emergency occurs, you're probably going to have to go right back into debt to cover the unexpected costs.
If you've been seriously working on paying off your credit cards and you suddenly have to charge $2,000 for a major car or home repair, this is going to zap your motivation and likely make debt payoff much harder in the long run. You'll also find you're constantly trapped in a cycle of paying down debt and getting back into it, which makes it hard to make any real progress.
While you should eventually have an emergency fund with three to six months living expenses saved in it, you don't need to save that much before allocating extra money to paying high interest consumer debt. Instead, pay the minimums on your debt, save about $500 to $2,000 (depending on your income) and then switch over to using your spare cash to pay off your debt ASAP. Once you have paid your high interest consumer debt in full, you can then work on building a bigger emergency fund.
Tax breaks make debt payoff less of a priority
There are a few types of debt you could get tax breaks for. You can take a tax deduction for up to $2,500 in student loan interest each year, provided your income isn't too high. You don't have to itemize to claim this deduction. You could also take a tax deduction for interest on mortgages up to $750,000 (or $1 million if you purchased your home before Dec. 16, 2017).
If you're able to take a tax deduction for the interest you're paying on your loan, then it makes much less sense to prioritize debt payoff over other things such as investing your money or saving for an emergency fund. This is especially true as your mortgage and student loan interest rates are likely pretty low and you could usually get a better return on investment by putting money into the market than by paying debt early.
You don't want to pass up free money
When you have access to a workplace 401(k), it's common for this account to come with a company match. For example, your company may match 100% of contributions up to 3% of your salary, or 50% of contributions up to 4% of your salary.
If you're able to get access to matching funds for your 401(k), it's almost always a good idea to prioritize contributing enough to earn the full match before making any extra debt payments. Doing this could give you a 100% return on investment if your company provides a dollar-for-dollar match, which is far more valuable than the savings from early debt repayment even on very high interest debt.
Should you pay off your debt early?
As you can see, there are lots of considerations when deciding if paying off debt early is the best thing you could do with your spare cash. You'll need to evaluate the type of debt you have, whether you could earn a better return on your money by investing, and whether tax breaks mean paying off your debt isn't really worth it. Only by assessing the specifics of your situation can you make the right choice for your financial needs.