Paying Down Debt Vs. Saving
If you’re managing debt, you’ve likely wondered whether it makes more sense to pay it off or save. This is one of the most common questions I get from new clients—and one I’ve asked myself on my own financial journey.
A few years ago, when interest rates were historically low, the answer was more straightforward. Today, with higher rates, the decision is more nuanced. But the core framework for making an informed choice remains the same.
Step 1: Establishing a Surplus
Before deciding whether to pay down debt or save, you need a cash flow surplus—money left over after covering core expenses. If that’s not your current situation, check out my Top Tips video for starting to find some room to save.
Step 2: Optimizing Savings vs. Debt Payoff
Once you have a surplus, the goal is to deploy it wisely to maximize your financial growth. I call this process savings optimization—but that doesn’t necessarily mean putting all extra cash into a savings account. If you have debt, your best move might be elsewhere.
Step 3: Understanding the Tipping Point
Debt interest can erode your wealth faster than savings can grow it. If you’re carrying high-interest debt, this is especially true. So how do you decide whether to prioritize savings or debt repayment? While your personal situation plays a big role (and working with a financial planner helps), here are key guidelines to get you thinking in the right direction.
1. Maximize Your Employer Retirement Match
Before aggressively paying down debt, check if your employer offers a match for contributions you make to your employer-sponsored retirement plan (401(k), 403(b), 457, TSP, etc.). This is essentially free money, and it’s often one of the best ways to grow your wealth.
For example, if your employer matches 50% of contributions up to 6% of your salary, contributing 6% means your employer kicks in an extra 3%. That’s an instant 50% return, even before your investments start working for you. This kind of return is nearly impossible to beat, making it a top priority.
Action step: Check with HR to confirm your match and make sure you’re taking full advantage.
2. Pay Off High-Interest Debt
Once your employer match is secured, the next priority is tackling high-interest debt (typically 15% or more, such as credit cards and personal loans). This kind of debt aggressively erodes net worth and should be eliminated as soon as possible.
Check out my video on YouTube for strategies on debt reduction!
Step 4: Evaluating Lower-Interest Debt vs. Investing
We all know high-interest debt is bad. But what about lower-interest debt? Here’s where things get tricky.
Consider the time value of money. Investments grow over time through compounding, and historically, the S&P 500 stock index has provided an average return in excess of 10% annually (of course, past performance is no guarantee of future results). If your debt interest rate is lower than that, it may make sense to invest rather than accelerate debt payments.
Example:
Employer match = 50% return (top priority)
Credit card debt at 20% interest = negative 20% return (pay this down next)
Student loan at 5% interest vs. potential investment return of 8% = Investing may be the better move
This is where working with a fiduciary financial planner helps. The right balance between paying down debt and investing varies based on factors like income stability, risk tolerance, and financial goals.
Need Help Deciding?
If you’re wrestling with this decision, let’s chat! Email me at jhowe@gencapmgmt.com for a free consultation. We’ll look at your numbers and figure out the smartest way forward.
Until then, take care!
John
