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A reader named Cierra asks:
“I really want to get out of debt, but I also know that I should be saving money. Is it better for me to pay off a maxed-out credit card or to build up my savings?”
Whether it’s better to get out of debt or save money is a question that most of us have struggled with. It’s like asking whether it’s better to exercise or eat right. We actually need to do both, but we don’t always have enough money, time, or motivation.
So how do you know which option will make the most of your money when you need to choose between getting rid of credit card debt and saving? I’ll discuss each choice, so you know what’s best for your financial situation and give you an action plan to follow.
Benefits of Getting Out of Debt
First, let’s talk about the benefits of getting out of debt. If you’re a regular Money Girl reader or podcast subscriber you already know that debt can be dangerous. Every dollar you owe a creditor is a dollar that you can’t save or invest to build wealth for yourself. It’s a drain on your financial resources to have too much debt for your level of income or to pay high interest rates.
But not all debts are created equal. Some come with low interest rates and built-in tax deductions that make their net cost relatively inexpensive. Mortgages and home equity loans are at rock bottom rates right now—and the interest is deductible when you itemize on your taxes. Student loans also come with tax deductions or credits up to a certain amount (regardless of whether you itemize), depending on your income.
Plus, financing a home that’s likely to increase in value over the long-term or paying for an education that will help you earn more over your lifetime are smart investments in your future.
However, other debts, like credit cards and auto loans, don’t come with tax breaks and can be very expensive—especially if you don’t have excellent credit. Financing consumer goods isn’t wise because they almost never appreciate in value—instead, they depreciate the moment you take them out of the store. So getting rid of consumer debt with double-digit interest rates should always be a top financial priority.
How to Raise Your Credit Score
Cierra mentioned that her credit card is maxed out, which means that her balance is bumping up against her available credit limit on the account. That’s a red flag that will cause her credit score to plummet.
When your credit score drops, it hurts your overall financial health and gives you fewer choices. For instance, if you have good credit, you can consolidate credit card debt and save a bundle by getting a lower-rate personal loan or a no-interest balance transfer credit card. If you have bad credit, these money-saving remedies won’t be an option.
Quick and Dirty Tip: To maintain or raise your credit score, never charge more than 20% to 30% of your available credit limit. For instance, if you have a $10,000 credit limit, don’t let your balance creep above $3,000—even if you pay it off in full by the statement due date each month.
Related Content: Credit Utilization—What It Means for Your Credit Score
Having good credit is also important because it affects other parts of your financial life, like the quotes you receive for insurance, whether you can open utility accounts, rent an apartment, and even get a job. So pay special attention to whittling down credit cards and lines of credit that have high balances relative to your credit limits.
Benefits of Saving Money
Now, let’s consider the benefits of saving over paying down debt. Let’s say you have a credit card balance of $5,000 at a 26% interest rate. You racked up this expensive debt because of an unexpected emergency when you didn’t have any cash.
To avoid this financial pitfall, it’s critical to have at least $1,000 dollars in an FDIC-insured bank account. The reality is that you should have a minimum of 3 to 6 months’ worth of living expenses in the bank—and maybe more depending on your career and family situation. This is how you’d get through a tough time if you lost your job or business.
But having $1,000 is a good goal to accomplish before you begin paying down credit card debt. Without some amount of emergency savings to fall back on, you could easily get into more credit card trouble and fall deeper into debt.
Your Personal Finance Action Plan
Here’s a 5-step action plan to help you know the right financial moves to make when you’re not sure whether to save money or get out of credit card debt:
Step #1: Stop making new charges to your credit card so you don’t increase your balance.
Step #2: Always make minimum payments on your credit card so you maintain a good credit score.
Step #3: Max out employer matching if you have a workplace retirement account—but don’t contribute more while you’re concentrating on getting rid of credit card debt.
Step #4: Build up an emergency fund of at least $1,000 to $2,000 so you have cash to fall back on.
Step #5: Increase credit card payments as much as possible each month by cutting your expenses ruthlessly.
Once your credit card is paid down to a low utilization ratio, you could make minimum payments and then funnel extra money into savings. Or, if you already have a healthy emergency fund, you could continue paying down your credit card so you wipe out the balance completely.
Using your financial resources wisely is like a balancing act. You have to protect yourself by accumulating enough savings, while satisfying your creditors at the same time by making timely minimum payments.
Then, attack your most expensive debts first so save the most interest. Your credit card debt will be under control in no time and you’ll have a cash reserve to keep you safe.
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