Top Tip For Saving: Pay Off Your Debt First

Paying down debt is no fun, but it’ll help you in the long run

We’ve written at length about our golden ratio for budgeting, the 50/30/20 Rule. A quick explainer: this budget allocates 50% of your net income to paying for your fixed costs, like housing and food; 30% goes to your “wants,” like Netflix or concert tickets (RIP); and 20% goes to your goals, including meeting savings goals and paying down debt.

This ratio can be useful because it helps provide a consistent but flexible framework to keep perspective on reaching your financial goals. Of these three categories—needs, wants, and goals—the first two are pretty self-explanatory. But how do you design more focused financial goals?

We’ll give you our two cents here, but remember, financial goals are incredibly personal; no two people will have precisely the same goal and the same means to achieve it. Your financial goals have to come from you after your own careful consideration.

Pay Down Debt First

For many people, paying down high interest debt first can be a smart strategy.

There are of course some different schools of thought on this, but we feel pretty strongly that there are few circumstances where saving and not paying down your debt will benefit you more in the long run than paying down your loans or credit card debts ASAP.

This is because, while possible, there are generally few circumstances where you will earn more on your savings than what you’ll have to pay back in interest on what you’ve borrowed.

Meaning, your return on investment (or interest earned on savings) would have to outpace the compounding interest assessed on what you owe.

At best, your savings and returns will likely be gouged by your debt; at worst, they could likely be totally cancelled out.

People may feel that saving is more fun than paying off debt. We get it! We all want to be “grown ups”; we want to save money and reach our long held financial goals.

But in our opinion, one of the best things you can do to improve your financial health is get rid of that big dark cloud of debt.

While you’re paying off your debt, you could ask yourself if you are able to save and invest even a few dollars every month—because the sooner you build the “investor” habit, the easier it could be to continue building wealth using that strategy going forward.

Exceptions to the Rule

There is always at least one exception to every rule! This is finance y’all. Read the fine print!

If you’ve got low interest debt on a larger scale that can be paid off over years, you can probably balance your debt payments with more aggressive saving.

Namely: debts like student loans and mortgages.

The reason this circumstance may be different is because what tends to get you on “bad” debts (like credit card debt from buying things you don’t need or have the money for) is the accumulation of compounding interest charges.

Looking at student loans in Canada, a fixed interest is assessed at the prime interest rate plus 2% (at the time of writing this blog, this is a total of 5.95%). So, on your principal balance of $30,000 today, you’re paying at most 5.95%. This is very different from 19% interest, even on a smaller principal balance.

The same can apply to most mortgages. Mortgages are often hundreds of thousands of dollars, and with an interest rate (hopefully) below 5%, it is more typical and acceptable to make fixed payments and pay off that bad boy over the next 10, 20, or 30 years rather than trying to pay it down more quickly, like you might with a credit card.

Paying off your student loan debt or your mortgage can take a really long time, and with more manageable interest rates, you could be more likely to profitably pay these off with your monthly minimum payments while also allowing your savings enough time to meaningfully grow over the course of years.

So if you fall into one of these categories—at least in Canada—it’s probably reasonable for you to make the agreed upon minimum payments (set by the Government of Canada or your mortgage lender) while diverting other income into your savings.

You Should Generally Spend More On Paying Down Debt

Reminder: this is different for everyone. You know your finances best and how much you can comfortably allocate to these goals.

But here’s the deal: minimum payments on credit cards aren’t enough. This is insane, right, because your minimum payment could already be hundreds of dollars per month.

But making your minimum payment doesn’t really impact your principal balance, it only manages your interest—which can keep you in debt. If you are only making minimum payments, you will have that debt for years—even with balances as low as $1,000.

This is the point. Credit card companies make more money when it takes you longer to pay off debt, so they don’t want to encourage you to make big, effective payments. There are online credit card interest calculators that can help you get an honest view of how aggressively you need to act to pay off your debt (while staying within your means).

Then, set your plan and stick to it. If paying down your debt effectively uses 15% of your net income, but allows you to save 5% every month and quash that debt in 2 years instead of 10, then so be it.

Title this financial goal “You know I had to do it to ‘em”. Pay off your debt. Once it’s gone, maybe buy yourself a lil treat (because that was hard, and you deserve it)? Then, get into the fun stuff: savin’ yer money, and getting on the path to financial freedom.

This email is provided for informational purposes only. It is not intended as investment advice and isn’t meant to suggest that a particular investment or financial strategy is suitable for any particular investor. If you’re unsure about an investment or a financial decision, you may wish to obtain advice from a qualified professional. It’s important to remember that past performance is no guarantee of future results.