Opportunity costs. It’s an odd sounding term but an important one that’s rather simple to explain: with every choice that you make, there’s an alternative choice that you give up; with every choice that you give up there is a potential loss or gain for that decision. Essentially, there are pros and cons for every decision you make in life, and the same holds true when making choices with your money. You have only so much cash left over at the end of the month, which means that every dollar you spend or put toward your debt is one less dollar you’re saving.
It’s the very idea of opportunity cost that makes this question so difficult to answer: “Should I pay down my debt or save up for the future?”
It’s a common financial conundrum with no one-size-fits-all solution: everyone’s financial circumstances are different, and there’s no perfect solution for anyone. So when deciding whether or not to focus your money repaying your debt or saving up for the future, consider asking yourself the following questions:
1. What is my return on investment for paying down my debt versus saving or investing my money instead? Your return on investment, or ROI, depends on one critical calculation: your interest rates. The first step to determining your ROI is to compare the interest rate or APR on your debt – your credit cards student loans or any other type of outstanding debt – to the returns you could earn by saving or investing your money instead. Let’s say for example you have an outstanding student loan balance of $10,000 with an interest rate of 6.8%. Because that’s debt, it means you’re effectively getting a negative 6.8% return on that $10,000. Compare that rate to the return you could earn by putting money into a savings account (less than 1%) or by investing your funds (historic returns around 5% over the long-run). The math is obvious: focusing on paying down your debt seems like a logical choice.
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2. Do I have any savings to get me through a financial emergency? Don’t rush off and throw all your extra cash toward debt quite yet! The last thing you want is for a financial disaster to throw off your financial plans. You should always be prepared for a possible financial emergency, like suddenly losing your primary source of income. If you don’t already have at least $1,000 saved up for a just-in-case scenario, you should focus on putting some of your money away into an emergency fund.
3. What is my top financial priority in life right now? Everyone has a different debt burden and different financial goals, which means everyone has different financial priorities, too. If your debt is holding you back from achieving your goals, like changing careers, then paying down your debt may be a bigger priority for you than saving for the future. If on the other hand your goal is to buy a house in the near future and you have a reasonable interest rate on your outstanding debt, you may want focus more of your energy toward saving money.