Photo by db*photography

A recent Yahoo! Finance article weighed the benefits of paying off debt versus putting your money into savings.  You can read the original article by clicking on the following link:

Should You Pay Debt Before Saving?

Clearly, there is no one-size-fits-all answer to the question.  The logical approach favors paying off high-interest debt before putting money in savings.  After all, the difference in interest rates makes this approach a no-brainer.  Why tie up money for 1.25% in a savings account when you could pay off a credit card with a 16% interest rate?

Donna Fox, author of the book “From Credit Repair to Credit Millionaire,” says low interest rates on savings accounts make paying off debt first a better choice right now.

“People get into trouble with debt and finance when they start letting emotions vote on their outcome,” says Fox. “So they feel better if they have a cushion in their savings account, even though for most people it’s not the financial savvy thing to do.”

She cites the example of someone who has $10,000 in savings (earning 2 percent) and $10,000 in credit card debt (at a rate of 9 percent). Anyone pleased with this situation is misguided, Fox says.

“This is like investing your $10,000 in an investment you know will lose 7 percent a year … and being happy about it,” she says.

Sure, this makes sense, from a strictly logical approach.  You could look at one extreme, where you’d apply all of your extra money toward your outstanding debt, and put nothing in the bank.  But would you really feel secure having nothing in your savings account, even though you’re paying down your debt at a higher rate?  True, the debt may disappear faster, but you would have the uneasiness of having nothing in your savings.  What would you do when an emergency happens, and you have no emergency fund?

The other extreme has you paying the minimum payment on all of your debts, and dumping the rest into savings.  Although you’d have enough cash to cover emergencies, it would make paying off the debt a lifelong endeavor.  Clearly a compromise can be struck that doesn’t optimize either side, but creates a proper balance.

Having a stash of emergency cash is more important in today’s economic times of tight credit, says Sarah Place, president and CEO of Place Trade Financial, a full-service, discount brokerage firm based in Raleigh, N.C.

She suggests socking away six to 12 months of easily accessible cash to cover any unexpected expenses. Access to such money is especially important today, when many people have found their home equity line of credit has been reduced — or even canceled.

Place acknowledges that it’s difficult to tell people to save “in an environment where they are earning a fraction of a percent of interest on their savings” while being charged “usurious loan shark rates of over 30 percent on their credit cards.”

Only you can determine the proper size of your emergency fund.  The shakiness of your job will be a factor in the number of months of expenses that you can cover.  An interesting piece of advice was given regarding 401(k) contributions:

Michael Rubin, president of Portsmouth, N.H.-based Total Candor, a provider of financial education, advocates paying down debt before saving. However, he cites exceptions to the rule. In particular, he urges a “save first” approach in situations where a person’s employer matches contributions to the company retirement plan.

“The guarantee provided by a matching program is even more valuable than repaying credit card debt, so one should always maximize the match first,” says Rubin, who is author of the book “Beyond Paycheck to Paycheck: A Conversation About Income, Wealth, and the Steps in Between.”

Or, you could follow Dave Ramsey’s Baby Steps, which have helped many people get their finances under control:

1. $1,000 to start an Emergency Fund
2. Pay off all debt using the Debt Snowball
3. Three to six months of expenses in savings
4. Invest 15 percent of household income into Roth IRAs and pre-tax retirement
5. College funding for children
6. Pay off home early
7. Build wealth and give!  Invest in mutual funds and real estate

The strategy that I used was a balance.  I funded my 401(k) first, and threw the remaining funds at my credit card debt each month.  When that was paid off, I started on the mortgage.  Once that was paid off, I did a little dance of joy, and started saving in earnest.

Find which strategy fits your goals the best, and follow that one.  Don’t be afraid to change it up as you go along.  This isn’t a science, it’s an art.

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