Like many Canadians you may have accumulated more credit card or bank debt than you would like. Perhaps you’ve seen your personal savings account dwindle and your debt levels rise. Now you are facing a financial dilemma: should you pay off debt or restore your savings?
When To Pay Off Debt First
Paying off debt should be your first priority if:
- you are already struggling with your bill payments
- you are only making minimum payments on your debts
- you have high interest debts like credit card debt
- debt payments take up more than 36% of your income (use our debt-to-income ratio calculator to calculate your ratio)
If your monthly debt payments are higher than you can afford on your income then you need to get these debts under control. You need to deal with the emergency and if you can’t pay your bills each paycheque then that is your emergency. There are ways of dealing with your debts including budgeting and focusing on eliminating credit card debt that will help you pay off debt faster. If you need help, consider contacting a not-for-profit credit counsellor or trustee in bankruptcy for advice. Both can help you with alternatives to avoid bankruptcy.
If your debts bear a high interest cost (credit card debt for example) then paying off this debt first makes sense. One option may be to refinance your high interest credit card debt with a debt consolidation loan at a much lower rate. This will reduce your overall loan payments creating extra cash flow that you can put into savings.
If you are loosing sleep, or stress over your debts is affecting your personal relationships, then you may want to focus on a plan to pay off debt until you are feeling more comfortable. If you are trying to improve your credit score you may want to make paying off debt your number one priority for a while.
When To Consider Saving
It’s an alarming finding, but Canadian’s are heavily reliant on credit for unexpected emergencies. A recent study by Hoyes, Michalos & Associates, an advisor at Moneyproblems.ca, showed that 92% of Canadians would need to rely on some form of borrowing to come up with $2,000 for an emergency. If your debts are manageable, you should set aside extra cash flow towards an emergency fund rather than pay off debt faster. This is a temporary priority until such a time as you build up a large enough emergency savings. Typically advisors recommend that you set aside enough funds to cover six months of expenses. This is particularly important if you have experienced income loss in the past due to economic factors and are concerned that this may happen again. You should also set aside enough funds to cover off unexpected events like a car repair or small house repair.
The best approach is a balanced approach. Have a long term plan to pay off your debt, ensure you have an adequate emergency fund and focus on your savings for the future. And once you pay off your debt, keep them paid off.