Saving vs. Paying Debts

We live in a world with so much information on money management and financial planning available, but the majority of us are still clueless about our finances! With Malaysians owing almost RM25 billion of credit card debt (as of March 20101), it is becoming more important for them to realise the importance of saving money and paying off their debts. However, given our limited income, how do we find the balance between the two? Do we equally split the money we have or focus more on one?

This is an important decision to make because while having a savings account is a way to plan for the future, becoming debt-free is an excellent strategy for creating long-term financial health. At the end of this article, you will be able to identify steps you can take to assist you in finding the balance between saving and paying debts.

Step #1: Build a Safety Net

Before you decide whether to save or settle your debt, the first step that you need to take is to build an emergency fund. This should be your first savings goal, ahead of saving money for your house, children’s education and even retirement. Regardless of whether you are a newbie to saving or already have a basket full of money, having an adequate amount tucked away in an emergency fund will give you peace of mind knowing that your safety net is in place.

An emergency fund is important because it can keep you from falling into debt when financial emergencies strike; including job loss, health emergencies, automobile repairs and home repairs. Remember that this money is not for vacations, large purchases or other “wants”.

So how much should you save? Most financial experts recommend that you save about three to six months’ worth of your living expenses. As your income grows, add to the account so that you always have six months of living expenses set aside. Finally, always replenish your emergency fund once you have used it. It may feel overwhelming at first, but once you are back on your feet after an emergency, start saving again.

Step #2: Reduce Your Debts

Once you have your emergency fund established, it is now time to shift your attention to the hole in your pocket: DEBT. Given your limited income, you will have to use part or all of the money you would have continued putting aside for your emergency fund to pay off your debt.

What about your savings, you may ask? Well, adding more to your savings while you have debts does not make much sense. Most debts have much higher interest rates than those of standard savings accounts at banks. Therefore, you will lose more money on the debt than you will gain from the savings account. In other words, if you have debt, then your savings have already been spent!

For example, let’s say you have RM6,000 in a savings account earning 2% per year and RM3,000 on a credit card debt at an interest of 18% per year; how much money would you have after five years? Zero – you would lose all of your savings and still owe RM200 because your debt would have grown to RM6,800, while your savings only added RM600.

Another option is to invest the extra money instead of automatically paying off your debt. Find an investment product that may give your high returnand use the profits you earn to settle your debts. However, please note that investing your money comes with potential loses, depending on the risk level of the investment product of your choice.

Even if you choose to invest your money, your main goal is to settle your debt. Therefore, which debt should go first? The general rule of thumb is to pay off the debt with the highest interest rate such as credit card debt, personal loans and car loans. Leave the housing loans and education loans for last as these usually have lower interest rates and are considered as “good debt”. In any case, the credit card debt must be the first to go. At the end of the day, always remember to compare the interest rate of your debt with that of your savings and/or investing returns.

Step #3: Build a Nest Egg

Once you have settled your main debts, you can once again start focusing on increasing your savings. Set aside a certain amount of money every month to be put into your savings account (also known as the “pay yourself first” principle). If your employer allows automatic monthly salary deductions, do it so that you will not forget to transfer the money.

Furthermore, now is when you should start looking into investing your money, i.e. making your money work for you. You can tap into your savings and invest in investment products to help you generate income. Which investment product you choose will depend on your investment objective and risk tolerance. Last but not least, you should always monitor your investments to ensure it is relevant to your expectation.

With the three steps mentioned above, you can now begin finding a balance between saving your money and settling your debts. Do remember that saving, investing and settling of debts are all long-term activities that are linked to your lifestyle and other financial commitments. Achieving the balance between the three, more often than not, involves changes to your lifestyle and that is never easy. However, if you want to live your life to the fullest, finding that balance between saving your money and paying off your debts is the key. To further assist you, here is a simple illustration of the whole process.

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