When your boss decides to give you a raise or bonus, how do you decide on where exactly that money should go? Most of us would find it intuitive to save the extra cash, especially if we don’t have expenses reserved for the months ahead. For others, you might choose to put this money towards large but necessary expenses made regularly, like your car loan. Paying heed to these huge figures, it’s obvious that allocating extra cash towards one of the many car loans of America can help tons in your journey towards becoming debt-free.
Indeed, giving priority towards paying off debts with high interest, such as credit card bills, is a clever decision since you need to avoid paying less interest in the future. However, paying off debt doesn’t always have to take priority over building up your emergency reserves, as a professional wealth advisor advises.
If you are at a crossroads between building up your savings and paying off your car debt, here are some tips to help you make your decision.
Reasons to save, instead of paying off your debt
Based on the current research of economists, it is advisable for you to set a target of $2500 in savings if you currently don’t have much but want to get started. This amount is sufficient to make you feel relatively secure, according to the researchers’ findings, as well as cover the cost of possible emergencies so that you avoid having to turn to credit. Opt to save this money in a savings account that promises you high returns, one that comes from an online bank as they typically offer better interest rates than traditional banks.
After you’ve paid off the debts with high interest, send the leftover funds as additional savings towards your emergency fund. A good amount would range from three to six month’s worth of your paycheck, but remember that it’s important to save according to what puts your heart at ease. For instance, those who work on a smaller scale and may have different income streams coming in may prefer to get half to a full year’s worth of monthly expenses reserved safely away. For those with steadier jobs and income, they might not be too frazzled about having slightly lesser money saved into their bank account.
Many factors, including your credit score, will determine the interest rate of your car loan. Although the average rate to loan a new car is 5.7%—this number is sufficiently low for you to still feel safe about saving extra cash instead of paying off your loans. Furthermore, consistent and punctually made payments can increase your credit score (although bear in mind that this should not be your main focus, especially if the debt that is quickly paid off could end up saving money on interest.)
If you already have a significant amount in your emergency reserves and deciding between paying off your debt versus making investments for when you eventually retire, go for the investment. Calculations will eventually favor making an investment, with the assumption that you have a low-interest rate for your auto loan. The stock market has been shown to return about 10% on average, even though experts expect this number to decrease down the road.
However, take note that you would have to make an “opportunity cost” between your loan and the potential return from your investments. For instance, if the car loan has an APR of 2% and the potential investment of your extra money gives a return of 6.1%, you would lose 4.1% in surplus returns.
Reasons to pay off your debt, instead of saving extra money
You may have heard the phrase “debt is bondage”, and it’s true. Once you go into debt, you’ll find it extremely difficult to extricate yourself from it. Furthermore, debt has a tendency to pile up, resulting in what is known as a cycle of debt When you fall into the pitfall of debt, it often becomes near impossible to achieve financial freedom. Not only will you have to support yourself, you still have to pay the bills.
With that said, psychological relief is a pretty good reason to prioritize paying off any debt over building up your savings.
Putting extra money into outstanding balance can help to reverse the negative psychological impacts of being in debt. Furthermore, paying off your debt will allow you to allocate your funds to other pursuits, such as investments.
Naturally, paying off your debt also lifts a great burden off your shoulders. Not only will the burden on your shoulders gets increasingly smaller when you see the debt amount decreasing rapidly, but once the debt is fully paid, you also get to feel a rewarding sense of achievement.
Another useful tip would be to start paying off the smallest debt first, a method known as the snowball technique. It is technically more effective to use the avalanche technique, which is paying off the higher interest debts first since the interest builds up much quicker than lower interest debts. That saves more money on interest in the long run. But research has shown that people tackle debt more successfully when using the snowball method. It’s because when you swiftly complete one payment, it builds momentum for you to tackle the next payment.
We all know ourselves best, and what we ought to do for our financial lives in a way that is secure and most guaranteed for success. Getting loans and having to pay off debts may be a hassle, but most of us will be in debt for a significant part of our lives; it is in fact normal to be in debt. What’s not normal is to find yourself in increasing debt. In the end, only you can know with certainty what your financial status is and how you want to manage it. If you realize that you’re heading down a slippery slope of debt, then it’s better to put money towards debt rather than risk further debt or losing your car or home. But if you’re doing just fine balancing your current debts and you think you’re in a position to start saving and making investments, then that’s not a problem either.