Thursday, March 24, 2011

Saving or Paying Off Debt

I think many people in debt run into this situation often where they have to examine whether their excess income is allocated to savings or paying off debt. As you go through your debt pay off adventure, you find your debts start to decrease. Perhaps, some of the urgency of paying off the debt dissipates as you watch the balances decline. Or perhaps, due to a change in life circumstances you find yourself feeling more vulnerable financially and feel the need to save more. Or maybe you’re fed up and tired of the debt hanging on you and want to pay it off as quickly as possible even though you’re savings is far from adequate.

As I’ve done research on the topic. Here are some of the approaches:

Save small and focus like mad on paying off debt
This is a view advocated by financial gurus like Steve Ramsey. He encourages people to save up a small amount like $1,000 to cover any small emergencies and then throw all your money at your debts. It has worked for many people. It keeps the intensity of the debt pay off high. You get an automatic positive feedback as you see large debts whittled down at great speed. It may have been a great strategy during the boom economy but it is hard to imagine a person or family right now for whom 1,000 in savings would be adequate. Many people are unemployed or facing potential layoffs. Few jobs are secure and those with some security often face pay cuts or reductions in benefits. Would you want only 1,000 between you and the abyss of financial insecurity? My other issue with this method is that having money in your savings account often provides people with a peace of mind that they otherwise wouldn’t have. Personally, I find that having 5,000 or more dollars in the bank gives me the feeling of security that my family can meet most immediate or short-term challenges.

Save big and then pay off debt
Others are now advocating that you save up anywhere from 3-6 months or more of your basic living expenses before you tackle debt
. For most people, especially young people just learning the basics of personal finance, this can seem daunting. It is hard making sacrifices with the goal of saving for some amorphous emergency that you can hardly foresee. I imagine that many people might simply give up on it all before they’ve even reached the 3 month savings goal.

Save some and pay off some debt
Here is my own personal finance strategy. Somewhere right in the middle. I think that every person needs to weigh their own personal situation, which may include factors like these:
· job security
· other sources of income in an emergency
· need for savings to meet personal financial security needs
· need to pay off debt

Here is how I analyze my own situation as we transition to a one income family:
Job Security—fairly high
for my husband. He has tenure. It is unlikely that he will be laid off in the next few years.
Other Sources of Income---low. We do not have many assets we could sell or other sources of income. I’m looking to improve that in the coming years.
Need for savings to meet personal financial security—high. As a one-income family, we need to have a sufficient cushion to meet our needs. The budget will be fairly tight, which is even more of a reason to have a healthy savings
Need to pay off debt---moderate. We have some lingering credit card debt that we would like to dispose of as quickly as possible.

In our situation, we have two factors that indicate we should focus on debt repayment: job security and need to pay off debt. However, the other two factors more strongly indicate that we need to beef up our savings first. My personal goal is to get our savings up to four months of living expenses. Instead of focusing entirely on savings, I’ve determined that the first $400 of income after expenses will be allocated to savings and the next $100 will go to debt. It will keep us focused on savings but allow for additional debt payments when we have extra money. When we have less than $400 of income after expenses, it will all be allocated to savings.

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