Should you set aside money for your savings if you have debts you need to pay? My straightforward answer is YES.
But wouldn’t it be wise to pay all your debts first (specially credit card debts) and then work on your savings afterward?
By doing this, you’ll pay less on interests and you’ll get to eliminate your debts faster.
Yes, that is true. But personal finance is not all about money, interest rates and figures; it is also about mindsets, positive habits and personal rewards. My answer is based on these principles.
Let me explain further through an example.
Let’s say you currently have P20,000 in credit card debt which accrues an interest of 3% per month.
Furthermore, your monthly earnings and necessary expenses leaves you with P5,000 net savings at the end of the month.
By using that amount to pay your credit card debt, you’ll surely be debt free after 5 months, and you would have paid a total of P964.50 as interest.
Now let’s say you only use P4,000 to pay your debt and save the remaining P1,000. This plan will eliminate your debt within 6 months.
Alternatively, you can choose to pay all your debts by the end of the fifth month. With this plan, you would have paid a total of P1,273.63 in interest fees.
From a mathematical point of view, Plan A (pay debt, no savings), is the better choice. But if you take into account human nature, Plan B (pay debt, save money), will clearly have more advantages from a psychological point of view.
Why and how?
- The reason why you have debts may be because you don’t know how to save. Plan B trains you to save money which will help you avoid bad (and ugly) debts in the future.
- You’ll have money in cases of emergency. Thus, helping you avoid getting more into debt.
- Your debt is being eliminated AND you see your savings growing. That’s two positive affirmations that rewards you psychologically and motivates you to continue.
Previously, I mentioned that your emergency fund can be alternatively used as an investment fund. If we take that principle into practice here and invest the monthly savings on a low risk opportunity, then you’ll have the best financial scenario.
Even though you paid more interest fees, your net worth in Plan C would be P486.83 higher than in Plan A after 5 months. (Can you see how I got to that figure?)
Of course this is assuming that you will invest your savings in something that will allow it to grow by 10% every month – like using it as working capital for a simple sideline business.
The key to making Plan C (pay debt, invest savings) work is to grow your savings / investment at a rate higher than the rate accrued by your debt.
To conclude, do remember that all of us have different financial situations and different mindsets when it comes to debt. But in most cases, the thing that suffers most when we are struggling with debt is our morale.
Thus, in the end, it doesn’t really matter if you do Plan A, Plan B, Plan C or any other plan. What’s really important is we find a way to eliminate our debts through a plan that gives us more confidence, self-worth and the motivation to have financial control of our lives.
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