Should I Save or Pay Down Debt?

Last Updated Jun 18, 2010 3:12 PM EDT

Our financial goals include both personal savings and debt repayment, but which should take precedence?

Reilly, a recent college grad from Arizona State University, recently asked me:

Is it better to keep as much cash in savings as possible, or keep less in savings and pay down debt? I just started a new job making $50,000 a year. I have $4,500 in savings and $9,000 in credit card debt.
There's no clear-cut answer to this type of question. Pure mathematics says it makes sense to pay down debt first, since your debt likely carries a higher interest rate than any savings account these days. But the math doesn't always speak to what is "personally and financially secure." If you were to lose your job tomorrow, wouldn't you have regretted ignoring your savings account? Ideally, we want to be able to save and pay down debt without sacrificing too much.

In Reilly's situation, he has a job (congratulations!) and a decent bit of rainy-day savings. His debt load, on the other hand, worries me. The total is quite high ($9,000) and the interest is around 15%. Here's my prescription, starting with how to deal with the debt.

Step 1: Pay More Than the Minimums
Using your take-home pay, budget for at least $300 a month to put toward your credit card debt. That's about $100 above the current monthly minimum. At that rate you'll recover from debt nine times faster. So, instead of being debt-free in 27 years, you'll be out of debt in 3 years.

Step 2: Take Advantage of Surprise Cash
To see your balance shrink even more rapidly, put half of any and all surprise money you receive toward your debt. If your boss gives you a $500 spot bonus, put $250 toward the debt. Same goes for birthday and holiday gift money.

Step 3: Keep Up With Saving
Keep up the good work by automating your savings, putting 5% of your take-home pay each month (approximately $150) into a personal checking account. Your current $4,500 should help cover a little less than two months of living expenses in case of an emergency. You want to eventually get that up to at least six months.

Step 4: Live Within Your Means
The only way this plan can work is if you don't rack up any additional debt. Yes, you can still use your credit cards - but only for the necessities that you know you will be able to pay off in full at the end of the month. So spend only what you can afford to.

In two years' time, an aggressive commitment to paying down debt, coupled with consistent, autoamatic savings, can help Reilly achieve a zero dollar balance on his credit card and an additional $3,600 in savings.

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    Farnoosh Torabi is a personal finance journalist and commentator. She is the author of the new book Psych Yourself Rich, Get the Mindset and Discipline You Need to Build Your Financial Life. Follow her at www.farnoosh.tv and on Twitter at @farnoosh.

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