Paying Debt Off Vs. Cash Reserves

When you're on a tight budget, paying down debt can feel like a catch-22. If you don't spend extra money on your debts, you may never pay them down. If you don't save money for emergencies, you may not have enough to handle the next emergency without putting it on plastic.

Pay Down Debt

"Pay debt off" -- enthusiasts say it's simple economics. If you carry a credit-card balance with a 16 percent interest rate, paying off $500 is the equivalent of investing $500 at 16 percent interest. Paying off debt reduces your monthly payments, which frees up more money. Having less debt also improves your credit score, something saving money can help you with. After the debt is gone is the time to start saving.

Cash on Hand

Supporters of saving cash counterargue that having a financial reserve for emergencies is a necessity. The minimum reserve is three months' worth of living expenses, and six months is better. That way, even if you lose your job, you can still make mortgage payments and stay current on your credit cards. When you plan to buy a house, saving cash is even more necessary: building up a substantial down payment will impress lenders more than having a lower debt burden.

Interest Rates

Look at your personal finances before deciding which approach to follow. When you have a half-dozen high-interest credit cards to pay off, reducing debt should be a top priority. If your big debt is a large but low-interest student loan or a zero-interest credit card, saving money for emergencies may be more practical. The size of your current emergency savings matters too: If you have no cushion, building one is more important than if you have five months' worth of income in the bank already.


One option, if it works for you, is to save some money for emergencies while using the rest to pay down debt. Even if you have high-interest debts, developing some sort of cushion is important, because it lets you cope with emergencies without adding more debt. You can divide your money each month -- some to debt, some to saving -- or divide them by time: save up a minimum three-month cushion, then pay off your high-interest debts, and then go back and increase your cushion to six months.

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