You sent us your money questions, and we asked Michelle Singletary, The Washington Post’s award-winning personal-finance columnist, to share her answers. Below you will find the fourth of a five-part series of Q&As; check back each week for the next installment.
Q: What should I prioritize during the pandemic: paying down debt or adding to my savings account?
A: In good and bad economic times, many people struggle with prioritizing how to allocate whatever is left over after they pay their essential bills.
They wonder whether they should focus just on saving for a financial emergency or throw all the extra funds toward paying down their debts, figuring they can save later.
But debt vs. saving isn’t an either-or situation. You must do both — pay down debt and save.
Here’s why you can’t favor one over the other.
Life will happen. Without saving for an emergency when a major financial shock happens — and it will — you’re likely to use debt to bail yourself out.
Only 39 percent of Americans could handle an unexpected $1,000 expense such as a car repair or emergency room bill by tapping their savings, according to a recently released survey from Bankrate.com.
With no savings, 38 percent of Americans would need to use their credit cards to cover the financial emergency, borrow money from family or friends or take out a personal loan.
If you’re constantly adding to your debt because you don’t have a rainy-day fund, you’ll make little progress in shedding that burden. It’ll be like getting stuck in quicksand. You can struggle to get out, but you just stay stuck.
Debt distracts you from future financial goals. If you’re only managing to make the minimum payments on your debts, you’ll likely delay investing as much as you should for retirement or saving for your child’s college education.
The fear driving you to save may be costing more than you realize. I run a volunteer financial program at my church. During one of our sessions, a woman asked me: “Should I pay off debt or continue building up my savings account?”
This is how the conversation went:
Me: How much debt do you have?
The woman: I have about $10,000 in credit card debt.
Me: How much do you have saved?
The woman: I have $15,000 in my emergency fund in a savings account.
Me: And how much is the interest you’re paying on that credit card?
The woman: I’m paying about 15 percent.
Me: How much interest are you earning on your savings?
The woman: I’m getting about 1 percent.
(This was before the pandemic. Currently, the average savings account pays 0.07 percent annual percentage yield, which is the rate of return earned on a savings deposit or investment, factoring in the effect of compounding interest. Many of the biggest banks pay less than that, according to a recent survey by Bankrate.com.)
This woman was so fearful of facing an emergency that she didn’t really comprehend how much she was paying in interest in exchange for the security of her savings.
I told her to pay off her credit card and then take the money she was applying to the debt to build back up her savings.
Now, there’s a caveat to this advice.
If you are facing a layoff or furlough, you should hold on to your savings. If you lose your job, it may take you longer to find work than you think, especially given the economic uncertainty of the pandemic.
However, if you are as sure as anyone can be these days about your job security, don’t stockpile money in a bank account while holding on to high-interest debt.
So, how do you do both — save and pay down debt?
Let’s say after paying for housing, transportation, food, etc., you have $500 leftover in your budget every month. Take half of the money and put it toward your debts. Save the other half until you reach $1,000 to $2,000, which would cover a typical financial shock. Stop saving at this point and direct all the extra funds toward paying off the debt. I like a 50/50 split because it’s simple. But you can adjust the split if you want to be more aggressive in either saving or getting rid of your debt.
Again, if you’re concerned about the security of your job, building up your savings account until you have at least a few months’ worth of expenses accumulated should be a priority. Then stop and aggressively attack the debt. This way, if you become unemployed, you’ll have less debt to manage.
Whatever you have left in your budget, make saving for financial emergencies and freeing yourself from the burden of debt twin goals. Like a mother who has two kids, both should get your attention.