Should you save cash or reduce debt? This is a tough question for anyone to answer, especially if you're committed to frugal living on a fairly low income.
Should I Save Cash or Reduce Debt?
We all know what we should be doing to ensure our financial security. We should have a healthy emergency fund, an ample retirement account, college savings plans for our children, and no debt other than our mortgage.
Unfortunately, very few people in America can say they meet all of these criteria. In fact, surveys have concluded that between 40 and 60 percent of Americans are essentially living from paycheck to paycheck.
CreditCards.com reports the following startling statistics regarding debt levels:
- Average outstanding credit card debt for households that have a credit card was $10,679 at the end of 2008.
- In 2007, before the recession even officially began, 14.7 percent of families had debt exceeding 40 percent of their income. That number is undoubtedly higher today.
- As of July 2008, 28 percent of Americans felt it was becoming more difficult each month to pay off their credit card balance.
Deciding whether it's more important to save cash or reduce debt isn't easy, because every family has a different financial situation. A single mother with small children and significant credit card debt is in a totally different financial place than a middle-aged couple looking at retiring in a few years. On a similar note, paying off a low rate car loan is obviously not as much of a priority as paying off a credit card that is charging 20 percent interest each month.
Some of the factors you should consider when deciding your personal financial goals include:
- The amount of credit card debt you currently have and the interest rates on your credit cards.
- The amount of other debt, such as a mortgage, student loans, car payment, or money borrowed from family members.
- Your current savings.
- How secure your income is.
- Your personal feelings about your family's economic security.
Arguments in favor of saving cash include:
- You won't be tempted to accumulate more credit card debt in the event of an emergency if you have the cash available to pay needed expenses.
- If you've been using your credit cards as an emergency fund, saving cash means you don't need to worry about what will happen if your credit card company reduces your credit limit or changes the terms of your agreement.
- In some cases, you could make more money by investing your money than you could paying off your debt.
Arguments in favor of reducing debt include:
- The high interest on credit cards costs you money each month you carry a balance.
- Paying off credit card debt is a huge psychological relief for most people.
- Reducing debt may boost your credit score, which could be important if you want to buy a home or make a similar large purchase in upcoming months.
The Compromise
For many people, the best solution to the "save cash or reduce debt" debate is to compromise by trying to achieve both goals simultaneously. Work on building up a small emergency fund while you're paying down debt. If you have $100 extra at the end of each month, devote $50 to debt repayment and $50 for your emergency fund. If you have only a small amount of high interest debt, you may want to devote $75 each month to paying off the high interest debt first and then work on building your emergency fund while paying only the minimum on your lower interest debt.
How much of an emergency fund should you have? Ideally, you want to have enough cash to cover three to six months worth of essential living expenses. As an initial goal, however, financial experts such as Dave Ramsey often recommend trying to save $1,000 for emergency expenses. This is a small enough amount to be manageable for most families, but large enough to pay for an unexpected illness or a car repair without causing you to accumulate more credit card debt.
