Why you should build your savings BEFORE paying off debt

Why you should build your savings BEFORE paying off debt

When people find themselves in a lot of credit card debt, they tend to think it’s best to financially prioritize those debts and pay them off as quickly as possible. Credit card customers will put all of their extra income toward their balances in the hopes that, with enough hard work, they can climb out of their financial hole in the next few months. Now, this course of action sounds logical enough — in order to minimize interest and get yourself out of debt, there’s nothing to do but pay that it off, right? — but, as crazy as it sounds, it isn’t the best way to get yourself out of credit card debt. In reality, the key to a bright financial future is actually saving money before you start to tackle your outstanding balances. Here’s some advice on how to save money so that you can confidently tackle your high-interest credit card balances:

Our Recommendation

First thing’s first: we recommend having at least one month of expenses saved in a high-yield savings account before doing anything else. High-yield savings accounts are online accounts that offer extremely competitive interest rates — typically between 1.5% and 2.05% APY — meaning that the money you put into the account will mature at a steady pace. With this savings account as your emergency or rainy day fund, you won’t have to rack up more credit card debt when the unexpected transpires. If, on the other hand, you were to skip this step and devote all of your money to paying off your balance as quickly as possible, you’d have no choice but to turn to your credit card in an emergency situation. This financial pattern, of creating one debt to pay off another, is called the debt cycle, and it usually keeps building on itself as long as you don’t have any savings set aside. To break the debt cycle, then, and finally get out of credit card debt once and for all, you should first build up some savings.

Set an Objective

To figure out how much to put into your rainy day fund, you need to calculate how much you typically spend in one month — this should include fixed expenses, minimum debt payments, and discretionary spending. Take a look at your past three months of expenses and use this monthly expense calculator to figure out the average amount of money you spend each month. Once you’ve figured this out, you’ll know how much, exactly, you should put into your savings account before you can turn to eliminating your debts. Having a month’s worth of expenses in your savings account will give you the wiggle room you need in an emergency situation.

Tricks of the Trade

Setting up a savings account is a financially sound move, but it’s also a bit of a mind trick. By setting up a savings account that’s separate from your checking account, you’re less likely to dip into your rainy day fund while it continues accruing interest — the money that’s there isn’t really yours until you actually need it. This practice fosters financial prudence by convincing you to limit your spending to what you have in your checking account. What’s more, you can set up an automatic transfer from your checking account or your paycheck so that you don’t forget to save. This article goes deeper into explaining why a savings account is a critical financial tool.

When you’re figuring out how much, exactly, to put into your savings account every month, you should aspire to follow the 50/30/20 rule. This rule tells you to devote at least 20% of your monthly income to long-term goals, such as savings or paying off debts. So as long as you’re at this stage in the process of breaking the debt cycle, most of that 20% should go directly into your rainy day fund. But don’t count yourself out if that number seems out of reach. Even a little can go a long way: if you put $20 a week into your savings account, you’ll have over $1,000 saved up within a year.

In the Meantime

While you’re focused on building your rainy day fund, try not to stress out about the interest that’s accruing on your credit card. The sooner you have money saved up, the sooner you’ll be able to start chipping away at your debt without having to look back. So as long as you’re setting that money aside, only worry about paying the monthly minimum on your credit cards. Setting up automatic minimum payments will allow you to focus on your savings without triggering any burdensome fees.

Next Steps

Now that you have a month’s worth in expenses set aside, you can redirect most of what you were putting into your savings toward paying off your debts. How, exactly, you pay off those debts is another matter entirely: two popular approaches, the snowball and avalanche methods, each have their own unique benefits and followings. We cover the pros and cons of both methods, and how to decide which is right for you, in this article.

While you’re focusing on eliminating your debts, try not to forget about your rainy day fund. About 20% of the money you’re putting toward long-term goals should still go into your savings account. This way, your rainy day fund will keep growing, and you’ll have an even better safety net as you continue tackling your debts.

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