Find Better Interest Rates, or Pay off Debt? How to Balance Savings vs. Debt

If you're struggling with debt, you probably don't have much in the way of savings. If you do have debt--particularly high-interest consumer debt--as well as a hefty savings account, conventional wisdom says you may be doing something wrong. Your debts are almost certainly costing you more in interest payments than your savings or investments are earning in interest yield. On balance, you're losing money on your savings, even if they seem to be generating a handsome return.

It's true that in a healthy economy, financial advisers recommend that their clients eliminate debt with what financial guru Dave Ramsey calls a "laser-like" focus. That is, this approach says to put every dollar you can towards your debts (unless you have debt with freakishly low interest rates or other very favorable terms). How do you do this? Abandon all luxuries and niceties and pay down that debt with all the frugality you have in you.

But particularly in a recession or bad economy, it can make sense to build your savings account--at least a little bit--before paying down debt.

Why You Might Choose Savings Over Debt Payments

When the economy takes a nose dive, it's more critical than usual to have even an emergency fund--even a relatively small sum such as $1,000. This is enough to cover many bad surprises: a car repair, a minor home repair, the immediate expenses associated with an accident or injury. It's there to help you break the cycle of credit card debt, where you have no savings at all and any unexpected expense goes on your credit account.

Once you've saved $1,000, only then should you put every cent into debt repayment. And once you've knocked off the debt, you can build up a real emergency fund in your savings account, with three to six months of living expenses. Retirement savings come after that on the priority list.

Why is that $1,000 cushion so important? Living without a savings cushion is a financially precarious position. You might be a layoff away from financial collapse. At worst, if you lack sufficient insurance or have too much debt, a serious accident, car failure, or other mishap could force you into collapse even if you hold onto your job.

In a fragile economy, then, there's virtue in building up a substantial emergency fund before fully paying off your debts. That emergency fund can give you something credit doesn't: ready money to weather any emergency, without adding to your debt. It's your most flexible option--and if your job is at risk or your health is uncertain, it is a necessity.

Diminish Debt or Start Saving: You Can Do Both

If you're in a relatively stable position, you might want to consider a hybrid approach. If your job is stable--say, you have tenure at a university, or you're covered under a union contract with protections against layoffs--a hybrid approach might serve you best. Keep paying off your debts, but split your extra money between debt payment and savings. This way you'll build up your savings account more gradually but still be paying down your debt.

Splitting your funds requires discipline. You won't get the emotional thrill of seeing your debts vanish as fast as you would if you were focusing only on that goal. You also won't build up savings as fast as you would were you out of debt already and only putting money into a savings account.

But doing a bit of both gives you some of the best of both worlds. You'll pay less interest overall than you would if you just let your debts sit till you'd built up your emergency fund. You'll have more savings faster than you would if you'd waited to save until your debts were paid.

The most important thing is simply that you start. Shop around and compare savings rates. Online banks often have the best savings account rates, though you shouldn't take that for granted.

Once you open your new account, you can start building that $1,000 emergency fund. Put money into your high interest savings account every time you get paid, as regularly as you pay rent or your mortgage. Whether you then apply that money to pay off your debts faster or sit on a growing nest egg, you'll be in better shape than you were before you started saving.