Is it better to pay off debt, or save?

When it comes to paying off debt or saving money for emergencies, retirement and other goals, your priorities will depend on several factors. These include the types of debt, their interest rates on your debts, your disposable income and your long-term goals. You can weigh your options, depending on how much debt you have left to pay off and how much money you already have in the bank.

Building an emergency fund

Do you feel like you have too much debt and not enough savings? If so, you might want to prioritize saving—even though you’re still in debt. That’s because repaying all your debt as quickly as possible may not help you feel more financially secure. For example, if your bank account balance often falls close to zero, it could derail your debt repayment efforts. Instead, saving money for a rainy day will help protect you from surprises.

Everyone should build an emergency fund—enough savings to cover at least three to six months of essential living expenses. These are the funds you’ll rely on if you can’t work, or if you can’t get to work without fixing a car that suddenly won’t start.

But when you’re paying off debt, you might feel like you can’t afford to set aside emergency savings. Paying more than the monthly minimums on your debt might leave you with little to nothing left to save.

Opinions differ on how to prioritize emergency savings versus debt, but one option is to save up either $500, $1,000 or one month’s worth of expenses first, then start paying extra on your debt. When you’ve paid off your highest-interest debt—like a credit card with a 24% APR—you’ll have more room in your budget for savings.

Your next step might be putting half of your former highest-interest debt payment toward increasing your emergency savings and the other half toward your next-highest-interest debt. This way, you’ll be making progress toward a three-month emergency fund. You can’t just stop paying debt altogether to focus on savings, because late fees and extra interest will put you further in the hole. Finding a balance is important.

Saving and investing for retirement

Once your emergency savings are fully funded, saving starts to go hand-in-hand with investing. Keeping your emergency fund in a checking account, savings account or CD (certificate of deposit) helps keep that money readily available if you should need it. The downside: Those accounts usually don’t pay enough interest for your savings to keep up with inflation.

When it comes to your retirement, you don’t want your savings to just keep up with inflation; you want to beat it. You also want to make your money work for you. That’s where investing becomes important.

Sometimes, saving and investing makes more sense than paying off debt. Once the interest rate on your remaining debt is below 6%, you may want to pay off that debt on schedule rather than making extra payments. Why 6%? Historically, that’s the average annual return of a balanced investment portfolio of stocks and bonds (though past results never predict future ones).

As an added incentive, the tax advantages of investing through retirement accounts like 401(k)s and IRAs can help your money go further over time than it would by paying off debt early.

Plus, you can only contribute so much each year to retirement accounts. Every year you don’t contribute is a missed opportunity to save. With many workplace plans, you also miss a chance to earn matching contributions—i.e., free money—from your employer. And thanks to compounding, the earlier you save, the more your investments could grow over time.

Prioritizing debt repayment

When prioritizing debt versus savings, the interest rate on your debt is a key consideration. The higher the rate, the more you stand to save by paying off the debt.

But also consider the type of debt. A debt can be “secured” or “unsecured”. A secured debt is backed by an asset, also called collateral. Auto loans and mortgages fall into this category: Both allow the lender to repossess the asset if you stop paying the loan. In other words, they can take what you bought with the loan and sell it to get their money back.

An unsecured debt isn’t backed by anything except your promise to repay it. Credit card balances and many personal loans are examples. If you stop repaying these debts, you can expect to hear from the company’s collections department. Eventually, the creditor might sue you if you don’t pay up.

Debt can also be “stable” or “revolving.” Car loans, personal loans, student loans and mortgages are examples of stable (aka installment) debt: You borrow a fixed sum up front, but you can’t borrow more. By contrast, revolving debts are ones you can pay down and then run up again. These include credit cards and home equity lines of credit (HELOCs).

Unsecured and revolving debts often have higher interest rates, so you might want to prioritize their repayment. It depends, however, on your situation. If, for instance, your credit card has a 0% introductory interest rate for 15 months and your auto loan has an 8% rate for six years, paying down the auto loan first can make sense. Even though it’s a stable, secured debt, the car loan is more expensive.

Be careful, though: For this strategy to work, you must also be able to pay off your credit card before the introductory rate expires (and the interest rate shoots up). If you want to save money on your car loan, look into refinancing at a lower rate.

Paying down credit card debt

There’s almost no better way to reduce your expenses and save money than unloading credit card debt. Introductory offers are not the norm; credit card interest rates typically range from 10% to 30%.

Ridding yourself of this high-interest debt offers returns that few investments can match over multiple years. Even though the S&P 500^® has long-run average annual returns of 10%, most people should only expect to earn about 6% a year on average because they’ll hold a mix of investments (including bonds) that lowers their overall risk (and expected returns).

As you pay down your credit card balances, your credit score may increase. This might qualify you for a lower-interest card or personal loan. You could transfer your high-interest balances to the lower-interest option, and pay down your debt faster.

Paying down student loans

Look at refinancing if you have private student debt at interest rates higher than today’s averages (anything above 4%, in most cases). But think twice before you refinance federal student loans.

The reason: Federal student loans come with hardship protectionsopens in a new window that private student loans don’t. These include income-based repayment plans, deferred payments due to economic hardship, and complete discharge of the loan if the borrower dies. The only way to refinance a federal student loan is with a private student loan, and private lenders may not have as robust ways to help struggling borrowers.