my two cents

Should I Pay Off My Debt or Start a Savings Account?

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Dear Charlotte,

After years of living paycheck to paycheck, I am now making enough to start saving more aggressively (read: at all). I currently have a monthly car payment of $168, which does not have a large impact on my monthly budget. It’ll take about $4,000 to pay it off entirely. Over the holidays, I received a sum of $7,000 from part of an inheritance. I used about $3,000 to pay off the rest of my credit-card debt. Now I’m wondering what to do with the remainder: pay off my car or put it directly into my barren savings account? I’m leaning toward establishing my savings, but which is the smarter move?

Congratulations — you have advanced to a new financial level: one with surplus cash. It feels good to have your head above water, doesn’t it? The first time I got a paycheck that exceeded my expenses by a noticeable margin (thanks to a new job), I had a clouds-parting, “phew, I made it” feeling; technically, I’d been fine before, but now I had options. (Being the regular dumb 20-something I was, I exercised those options at Zara; don’t do that.) The point is, this is a big moment, and there’s a difference between using this windfall as a cushion versus a springboard. You want to do the latter.

You’ve done right by your extra money so far. Hitting “pay full balance” on your credit-card statement (every month!) is priority No. 1, because high interest rates make that debt compound quickly. But beyond that, the order of operations is less clear. More funds bring more options, but they also call for multitasking. While living paycheck to paycheck is a slog, your goals are straightforward: stay up to speed on the bills right in front of your face. Once you have a few bucks left over, your strategy involves more than one priority at a time.

Looking at pure math, you get a guaranteed “return” if you shovel all $4,000 toward your debt, because you’ll save the interest on future payments you won’t have to make. However, I don’t know the APR or other terms of your loan, and it’s worth digging into those numbers to calculate exactly what the interest will amount to between now and when it’s all paid off. It could be a relatively low sum — the national average for a 60-month auto loan is only 4.21 percent — in which case, your money (or at least a chunk of it) might be better off elsewhere. “The mathematical answer is not always the best answer,” says Megan Ford, a financial therapist at the University of Georgia. “You also want to consider your financial stability, past money patterns, and other individual factors.”

For example: Since you have zero savings, any emergency expenses would kick you right back into credit-card debt, which carries much heftier interest rates than even the sleaziest auto loan. So from a risk standpoint, it’s wiser to use this money to jump-start an emergency fund. “Even if you have outstanding loans, I’d recommend keeping a lump sum of cash in savings, because if you lose your job or something awful happens, you’ll still have to meet your monthly bills,” says Pari Hashemi, a certified financial planner at Wells Fargo.

The golden rule is to have at least three to six months’ worth of living expenses socked away, liquid, but let’s be real — that’ll take a while to reach. Dedicate a portion of your inheritance to setting it up now (make it a high-yield savings account, which you can find online), and then automate a regular deposit so that your income gets siphoned in bit by bit from here on out.

Be aware that an emergency fund is not just “oops” money. “It can quickly become a ‘draw from it when I need it’ fund, so I suggest writing down exactly what situations you’d classify as ‘emergencies,’ and pull from those funds only in those cases,” says Ford. “I also recommend creating an additional savings account (or two) for other savings goals, like general savings and vacations — really whatever is important to you should be earmarked.”

Better yet, divvy your money between all of the above — and then continue to do so. Now is your chance to lay a foundation for multiple financial goals going forward. “This is an exciting time,” says Ford. “Dream a little about things you want to afford someday.” Meanwhile, take a hard look at the patterns you already have — if you are often surprised by your bank balance, this is an opportunity to get better acquainted with your habits (and try to set judgment aside). “You can’t assess your saving ability without a solid knowledge of your expenses, current and anticipated,” Ford continues. “Knowing what you want and what it will take to get there will create the basis for a better monthly plan — and one that you’re more motivated to stick to. This plan should involve a close review of where your money is going and a reminder of what you’re saving for.”

When I first had “extra” money, I was lousy at this (see above re: Zara). The prospect of squirreling away my cash for long-term prospects — particularly multiple ones — seemed daunting and dull, and reviewing the various vacuums where my money was already disappearing just made me depressed. I wanted more control, yet I felt paralyzed by what that would take. It took a few catalysts for my behavior to shift — and in your case, this inheritance will surely be one of them — but houses are not finished in a day. It took me years to wrap my head around the different areas that I needed to construct simultaneously: an emergency fund, a long-term savings account, a solid 401(K) plan, an investment portfolio, a “backup” fund to make sure I never carried a balance on my credit cards — and the list is still growing. It would great if there were a financial magic wand that could transform our situations instantly, but the reality is that it takes intentionality, focus, and consistency,” says Ford. “Financial changes rarely work with the snap of a finger. Work to remain adaptive, and if something isn’t working, take it in stride — it’s just a sign that an adjustment is needed.”

Should I Pay Off My Debt or Start a Savings Account?