“Do not save what is left after spending. Spend what is left after saving.” – Warren Buffet
Whenever I sit down with people who are wrestling with debt, the question inevitably comes up: should I be saving or paying down debt? It’s a question that has been debated back and forth, and yet, there’s no universally agreed upon answer.
Partly this is due to the fact that each person who asks this question has their own unique set of circumstances, challenges and goals and so the answer will vary greatly from person to person. What works for one won’t necessarily be the best option for someone else and each person you ask will have their own perspective to share. Some personal finance experts argue that it makes no sense to allocate money for savings when it will earn a lower interest rate than you’re paying for your debt. Interestingly, while this argument definitely makes sense from a mathematical point of view to pay off debt, from a psychological perspective it doesn’t always work quite so well.
One thing I know for sure, both from my own financial journey and from my interactions with clients, is that psychology is a powerful factor when it comes to managing money and building wealth. It’s also a factor that is frequently overlooked when it comes to financial planning and debt management.
When getting rid of debt, it’s important not only to come up with a plan to get rid of the debt, but also to alter your financial psychology. This helps to prevent you falling back into the same cycle of debt that got you into trouble in the first place.
Human beings are creatures of habit; we tend to repeat the same patterns and actions and, when it comes to money, our subconscious thoughts and beliefs drive the majority of those habits.
Often, when I talk about the fact that moving from debt into financial stability, and ultimately, into wealth and financial freedom is a psychological culture shock for the brain, people laugh. However, if you stop to think about it for a moment, it makes sense. Most of us have daydreamed about what it would be like to win the lottery and be financially set for life, but the truth is that a very high percentage of lottery winners go broke within a few years of winning the lottery (as do a high percentage of professional athletes). If someone is not psychologically equipped to handle the reality of having wealth, if they have negative beliefs about money and rich people, or they lack faith in their own ability to hold and grow money then they will instinctively (and unconsciously) find ways to get rid of their money. For example: through philanthropy, unrestrained generosity to friends and family or uncontrolled spending.
Similarly, when it comes to debt, if you have adjusted to the reality of living paycheque to paycheque and never having quite enough for everything you want or need, then being in a position of surplus can be really hard to adjust to.
It’s for this reason that I think, when it comes to the question of whether you should pay off debt or save, you should actually do both.
I’ve already mentioned that from a mathematical perspective it doesn’t make sense to have money in a savings account earning 1.5% when you could use it to pay down debt that’s costing you 19.9% or more. However, if you consider that you’re starting your debt elimination journey in a negative situation financially, then building a small amount of savings reduces your reliance on using credit to cover future unexpected expenses or to bail yourself out in an emergency. It also reduces the risk that you’ll put energy into paying down debt only to be discouraged when you find yourself running it back up again when something unexpected hits (which it always does!).
Additionally, it gets you into the habit of saving and, more importantly, of not spending the money in your savings account unless absolutely necessary. When you have gone for a long period of time with no savings you get used to spending every penny, and as silly as it sounds, it can be a hard habit to break once you move into a place where you have a surplus.
Finally, saving allows you to see yourself making positive progress financially in a tangible way. If you think of debt as a hole you dug yourself into, then when you’re paying off that debt you’re essentially filling in the hole. However, it can be hard to appreciate how much of the hole you’ve filled in, because all you can see looking into it, is what’s left of the hole. When you’re saving, you’re accumulating money and it becomes easier to see that you’re making progress. Psychologically, that’s a huge motivator and so it makes it easier to keep going towards the debt-free goal.
What I’ve found works well for many people is to start their debt elimination journey by first deciding how many debt-busting dollars they can commit each month to their goal and then allocating half to paying down debt and half to building savings. Once you have caught up on any past-due bills and saved $1000 for unexpected expenses, then you can allocate a larger percentage of your debt busting dollars to debt, and a smaller percentage to savings. If you treat your saving dollars like a bill payment then it makes it easy to build a solid savings habit as you reduce your debt. Once you’re out of debt you can build on that savings habit by increasing your monthly savings amount and that allows you to build real wealth over time.
When it comes to debt busting and wealth building there is no “one size fits all” solution. The trick is to take a look at your own situation, the habits and circumstances that led you there and the goals you have for the future, and then formulate the best plan for you. My one suggestion would be to not always rely solely on the math, but to always factor the psychological elements into your debt busting equation.