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Saving money or paying off your debt, what is more important?

Akshata Kamath
Akshata KamathNov 07, 2022 | 17:13

Saving money or paying off your debt, what is more important?

(Illustration: Seemon, DailyO)

Saving money and repaying the debt are both important. But you need to have an emergency savings fund to take care of random expenses that pop out of the thin air. Once that is taken care of, pay off your debts because otherwise they eat away your income and delay your process of becoming debt free and your ability to be wealthy.

We may have to take up debt for a lot of things in our life - maybe we need that credit card to go on that dream vacation to France or we want to buy a dream home for our parents and a home loan seems to be the only option. 

First, understand your net worth: Your net worth comes from substracting your liabilities from your assets. Now the best way to increase it is to increase your assets and reduce your liabilities. But when we take a debt (say we want to get educated at Oxford or we need a car at home and want the bank to fund it at the moment), we increase our current liabilities. Though getting educated and having a car are extremely valuable, it doesn't count as ''assets'' while counting your net worth.

So when you are a student and you take your first loan, your net worth becomes negative. In common terms- 'you are broke' because you have no assets but only financial liabilities. 

Say you start working at a great firm in some years and you start saving some part of it as cash. When you do this, you actively increase your assets. But this doesn't mean that you are reducing your liabilities. You are just increasing your assets while your liabilities stay the same. So until your saved-up assets in cash equal your loan liabilities, you will continue to have a negative net worth, even if you are on a well-paying job. 

Are you in the same general boat? If you are like the general public and have decided to go through the same trajectory in this order:

  • Getting educated on student loans and getting a job
  • Eventually paying off part of your student loan debt and building your savings
  • Then getting married and getting a home mortgage and
  • Then having kids and everything that follows later on.

Then it is very likely that you might be in a debt trap and feel confused about saving and repaying your debt. 

Here's what you can do: Either follow a set plan which looks like below or evaluate in terms of the opportunity cost. 

1. This is a step-by-step plan you can follow in this order:

  • Save for a basic emergency fund,
  • Pay off all your debt (except your house mortgage) using the snowball method (from smallest to largest),
  • Increase your savings fund and maintain it at 5-6 months of normal monthly expenses and
  • Then pay off your home mortgage and save for retirement.  

Saving first for a basic emergency fund helps you manage random expenses that come out of thin air and helps you keep your monthly budget in control. Since you cannot predict emergency expenses, providing for them is your first no-brainer step. Once that is settled, paying off debts in ascending order helps you reduce your liabilities and over time, helps you become debt free. 

Paying off smaller debts also increases your confidence levels. Once you pay off debt, it makes more sense to refill your emergency funds up to the amount of 6 months of expenses. This helps you navigate major life changes comfortably.  

But, why pay debt first before creating a 5-6 month saving fund? You might want to feel very safe and secure and want to create a big savings fund to cover 5-6 months of expenses. If you do so by keeping the money in your bank or in cash, you literally receive only 6 to 8% as interest. 

But when you take on a debt of say Rs 300,000 for 3 years (be it by way of a credit card or a car loan), you are essentially agreeing to pay at least Rs 3,40,000 to the bank later on. If you don't receive any other financial inflows from this loan, then the longer your loan period, the longer you will see a net cash outflow. Hence here, it is better to pay off debt as soon as possible and be debt-free. So that eventually you can use your income to invest in retirement funds and build wealth. 

2. Evaluate the opportunity cost: Say you take on debt and just like businessmen, you use it in a way to generate additional net cash inflow. Here, since you are leveraging others' money at a lower interest rate and investing in a place to make money at a higher rate, you can benefit from the interest difference and the profits.

If your credit card debt costs you 13% and you had the option to either repay it or save it in a fixed deposit or in stocks where the growth is 10%, why would you not pay your debt? Repaying your debt means you save on the 13% interest whereas you get only 10% when you save it- so why not pay your debt, save 13%, and get it over with? Also, how long will you be okay with having a negative net worth? 

Last updated: November 07, 2022 | 17:14
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