Should you pay off your debts or add to an emergency fund first? It’s one of the most commonly asked financial planning questions. Recently, we read a blog post by Donald F. Dempsey. He’s a fee-only Certified Financial Planner® practicing in South Burlington, VT at Dempsey Investment Management, LLC.
Mr. Dempsey answered some questions we had about whether it was wise to pay debts or save money first. Here are his responses.
Q: From a purely math point of view, it’s almost always better to pay off debts before putting money into savings. Yet, you’ve written that there are exceptions. Why is that?
Mr. Dempsey: The first few exceptions are in the article about not missing out on matching contributions. Also, I think it is important to have some money in savings, so you can more easily handle the ups and downs of your cash flow.
Q: One of the areas that could be an exception is accumulating an emergency fund. Is there a psychological advantage to having an emergency fund (as opposed to having available credit)?
Mr. Dempsey: I think there is a definite psychological advantage to having cash. It just feels safer. The important part is not viewing that as fun money.
Q: Another exception to repaying debts first is putting money into retirement accounts. Why is that?
Mr. Dempsey: One is the matching and another could be tax reduction for someone in a 25% tax bracket or higher. Reducing current income is important. It really comes down to a variety of reasons why a planner may recommend one person paying off a debt while another client with the same debt and interest rate may be advised to not pay it off. Age, income, overall ratios, and job security are all variables. There is a whole host of reasons. It is all about balance, risk, return, etc.
Q: Is there any advantage to repaying debts and saving at the same time? Perhaps a 50/50 split?
Mr. Dempsey: I think that is what I’m talking about above. Hedge your bets a little. Get a match, reduce your taxable income, and save for a rainy day while paying down debt. For a young person, I’m not likely to recommend aggressive payment towards a mortgage at 3-4%, but I would suggest targeting a credit card at a higher rate. For an older client who has enough in cash or bonds to pay off a debt at 3-4%, I might make the recommendation as I can’t get 3-4% guaranteed without some risk or locking up the money.
Q: On repaying debts, is it always best to repay the highest interest rate debt first? Or are there situation where a person might want to pay a secured debt (like an auto loan) before an unsecured debt (like credit cards)?
Mr. Dempsey: I probably don’t run into the situation where someone is skating so close to the edge to worry about that. Typically, I’m going after high interest rates and maybe targeting smaller balances first. For example, $5,000 at 10% might be a priority over $10,000 at 12% for extra money. Get the small one paid off and then move onto the next. Then you can double up on the 10k and so on. I think there is some psychological reward to doing it this way.
Q: Is there anything that you tell your clients when they’re deciding whether to repay debts or save first?
Mr. Dempsey: I go over all the items we discussed above. There is no one rule. It is not always a simple math answer.
Gary Foreman is a former financial planner and purchasing manager who founded TheDollarStretcher.com website and newsletters in 1996. He’s been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and he’s a regular contributor to CreditCards.com.