Have you ever been in the position to ask yourself if you should pay off a debt like a credit card or save that bonus, you just got for a rainy day? Many people who live paycheck to paycheck are put in that position around the holidays and when they get a raise, get recognition for a job well done, or a better job. Nevertheless, just how much and when should you pay off debt instead of save that money? There has to be a secret formula somewhere. Most credit advisors will tell you to save at least three months worth of pay, but most would like to see you be frugal and have a years’ worth stashed away.
[Read: Should You Use 401(k) to Pay off Credit Cards]
Questions about Paying Off Debt That Only You Can Answer
Well, to help you determine what to do; you need to ask yourself some questions that you need to answer honestly.
- Do you already have a savings account in place for emergencies?
If you don’t, then you need to seriously consider starting one. The reason should be obvious. You cannot rely on having credit or loans available if you already have debt. If you decide to go to savings:
a. Find a separate bank for your savings account.
b. Start small if you have to, but start.
c. Pay yourself first. (percentage of your paycheck, every paycheck)
d. Forget you have that money in savings.
When you have at least three months of income stashed in a savings account, then you can rethink the whole ‘pay off debt’ idea. Having cash at your disposal for emergencies is important.
- Just how much is your debt hurting your wallet?
Now it is time to crunch some numbers. Don’t worry, it won’t take a math genius. Just list your debtors and the amounts owed.
a. Credit cards
b. Auto loans
c. House mortgage
d. Student loans, etc.
Now that you have all that on your list, put their interest rate beside each of them. If you are not sure, this would be a good time to look that up. You need to know these types of things to get control to pay off debt. When you multiply the amounts and the interest rates together, you will have how much interest you are paying each year for that debt. Now add all those interests together.
Example: Auto Loan: $8,793.64 x Interest 3% = 263.8092 or $263.81 a year
That is how much your debt is costing you over and above the actual debt itself.
It doesn’t look like much until you add it up with all the other interest. Now here is your next question:
- How much would that savings account be earning you?
When you get to that golden number of three months worth of paychecks, you will have to decide what you want to do with it, if anything. By this time, you should already have a habit of putting money away in the account, so that shouldn’t stop, but there are other options that could give you a better return on your money if you choose to use them. You need to determine if it is worth keeping your money where it is at the low-interest rate that it is giving you back a return (usually less than 1%) or putting it in a CD or money market account. Check the rates. Multiply them out as you did for the credit and interest.
Now just simply compare the two. Would it make a difference to pay off debt, even if it were only a portion, but a decent portion, or keep saving? Now just keep that in mind as I pose the next question here:
- What does your financial future look like?
This can be short-term or long-term. Are you looking for that tax return, a bonus check, or that gift from your parents? Maybe you are being considered for a promotion or you are about to start a better job with better pay.
Sure, you can celebrate, but don’t just let it go to your head. You will have some financial flexibility to maybe pay off debt and save, all at the same time. That would definitely put you in a much better position. Now the last question you will have to ask yourself and this one, I promise is the fun one:
- What is that Big Financial Goal in the sky that you want?
I am talking about your dreams. What do you want to be able to do without worry of financial ruin? Maybe you want a dream car, your own business, a home, or the vacation you always wanted.
Whatever it is, you want it, and it would be so nice to be able to go and get what you want without worries of debt hanging over your head.
[Read: 10 Financial Fees You Should Never Pay]
Deciding When to Pay off Debt
Now, this is where you decide when, how, and how much you want to apply and use to pay off debt. If you have answered the above questions honestly, and went through the few steps, you have a good idea what needs to be done. You can either go one-step at a time or mix it up to fit your finances. Maybe mix up the questions a bit. That may get you going. I would start with “Just how much is your debt hurting your wallet?” That one is a revelation!