When parents start living on a budget and begin making financial progress they often start by paying down their debt rather than putting that money into savings. While it’s not the worst thing to do with additional funds, putting it into savings will get better results.
3 Reasons why most people go for debt reduction over savings
1) Paying off debt will make me happy
This isn’t true. A lot of people subconsciously believe they will be happy once they pay off their debt. But that isn’t true. Debt doesn’t make us unhappy jus like money doesn’t buy happiness. It’s our thoughts about debt that make us unhappy.
Debt has a very bad reputation in our culture. Many view it along the same lines as sin! When the credit card statement comes the balance it’s perceived as a reminder of all the things “they’ve done wrong.” It’s those thoughts that make them unhappy, not the debt.
2) I’ll have more money if I pay off my debt
Again, this isn’t correct. If you owe $6,000 and pay it off at $500 a month how much money will you have in 12 months? ZERO, you will have gone from a negative $6,000 to $0.00.
If you put $500 a month into savings for 12 months how much money would you have at the end of the year? $6,000! Yes you’d still have the debt, but mathematically you’d have more money if you were to save it. Not only will you have more money but paying off your debt will be easier, discussed in the next section.
3) It’s measurable
When people first start working on their finances they get excited about achieving a goal. They like to plan out which expenses they will cut and how much they will apply towards their debt each month. While this is fun to think about, it usually only lasts a couple months. It usually falls apart when an unexpected life event happens (maybe the dishwasher breaks) and they have to use debt to get out of the situation.
If making a plan and setting goals is your thing, considering putting the same amount of work and analysis into the goal of saving X dollars within the next 12 months.
Benefits of establishing a savings account before paying off debt
Have you ever had a savings account, one with a balance of $15,000 or more? Most people haven’t.
If you had that much in savings how would you feel? Stop and ask yourself that question, how would you feel if you had $15,000 in savings right now? Most would feel great. But, just as debt doesn’t make us unhappy, a savings account can’t make us happy. It’s our thoughts about that money that make us happy. But these are good thoughts, thoughts that server us, thoughts that come easily.
These thoughts can create feelings which will drive better actions and produce better results. For the following psychologic reasons, creating a significant ($15,000+) savings account, before paying off debt, produces better financial results.
1) You feel financially strong
This has two positive results 1) The desire to protect/take care of those funds 2) The desire to get stronger.
2) The ability to rely on your own resources
When life’s unexpected expenses come up, you’ll have the resources to pay for them using your own funds. Using credit cards or other debt is like running to mom and dad for a loan. It deny’s us the ability to live without relying on others.
3) Less likely to use debt
If we are relying on debt to buffer life’s unexpected expenses (the dishwasher breaks) it’s easier to keep using it for discretionary items. If we are already in debt and keep using it and don’t feel like we are making progress, then why not use the credit card to buy something fun?
A savings account gets us out of the habit of using credit cards/debt.
4) Work on your financial goals on your own timeline
Most people want to save for a house, go on a family vacation, or save for their kids’ college. If the first part of the plan to achieve those goals is to pay off debt then they don’t get to start working towards those goals for 2-3 years.
This is frustrating, slow and economically not the right idea. Rather than wait two years to start saving for a house why not start this month! The results are faster, it feels better and provides a greater sense of motivation.
Yes, you may need to pay off some/all of the debt before buying a house, but once you’ve made good progress on the savings side, the debt side usually comes along naturally.