Paying off debt vs. saving: Where to focus first

You work hard for your money and do your best to make it work hard for you. With multiple financial goals to manage, you may wonder whether it's better to pay off debt or save up your money.

In an ideal world, you'd likely try to balance both—each goal is critical for your financial future. But depending on your situation, you may have to prioritize one over the other.

Here are some ways to determine whether to save money or pay off debt first.

All debt may feel like a burden, but it doesn't all carry the same weight. You likely have various interest rates and types of debt, and certain investing choices may offer advantages that outweigh others. It may make sense for you to put more toward saving than paying down debt if:

Generally, low-interest debt has a rate that's less than the going rates for mortgages or student loans, which tend to be some of the lowest to promote access to homebuying and education. As noted by Equifax and Business Insider, experts put this cutoff at about 6%.

It's certainly a best practice to always pay the minimum due on a debt, but what about "extra" money? Is that better off going to low-interest debt or savings?

Thrivent financial advisor Colin Mildred notes that paying extra on low-interest balances can cut overall interest charges and eliminate payments sooner, which can feel rewarding—but you can also advance your financial goals by using the extra money in other ways. He points out that it may make more sense to put those additional dollars in an investment that provides a higher return than what you're paying in interest.

Say, for instance, you locked in a car loan at an amazing 3% annual percentage rate (APR) for 48 months. At the same time, you notice certificate of deposit (CD) rates are up to 5% annual percentage yield for a 12-month term. Depending on your wider financial picture, it could be a good move for you to save with the CD for a time rather than aggressively pay down the low-APR loan.

Having money set aside for emergencies is something most financial experts will recommend. The typical goal is to save enough to cover three to six months of your usual living expenses that you could rely on if you needed to. (Think an unexpected medical bill or costly home repair.)

Choosing to save for this rather than paying extra on your debts can be wise because having cash on hand may keep you from accumulating more debt. If you have enough money stored up—especially if it's earning interest in a high-yield savings, money market or other investment account—you may be able to avoid borrowing or running up credit card bills if you lose your job and don't get another right away.

If you have an employer-sponsored retirement plan, like a 401(k), you could gain long-term benefits that outweigh only using your money to pay down debt:

• Tax advantages. You can contribute to a traditional 401(k) with pre-tax dollars, which reduces your taxable income for the current tax year. Plus, you're not taxed on any earnings as your money grows over the years until you withdraw it.

• Compound growth. The earlier you can put away even a little money, the better. Investment compounding means you can grow money on top of money as the earnings are reinvested. “The sooner you start saving, the more time your investment has to grow,” Mildred says. “Every year, even every month you wait, is one less opportunity to reap the benefit of compounding.”

• Employer-matched dollars. Some employers offer to match your 401(k) contributions up to a percentage of your salary. This can effectively double your contribution at no extra cost to you.

Mildred advises that paying off debt shouldn't come at the expense of saving for retirement, especially if your employer is chipping in as much as you are. When there's matching available, "it's like leaving free money on the table if you don't contribute to your 401(k)," he says. "It's important to do as much as you can to get the free money."

In addition to saving for emergencies and retirement, diverting some money to save for large purchases you'll need can help you avoid taking on more debt in the future. Money that you plan to use for major purchases at least five years out could be invested in short- to intermediate-term savings and investment accounts so it has time to potentially grow.

Here are some options to consider:

Funds placed in a money market, CD or high-yield savings account can earn a fixed interest rate that adds up and compounds over time. Current rates are some of the highest seen in over 15 years. However, review the interest rates in comparison to the interest rate of your debt to prioritize if one of these options makes sense.

Review current rates from Thrivent Credit Union

With the potential to grow earnings faster than interest in CDs or high-yield savings accounts, mutual fund investments can help you reach goals that are a few years out. Per The Balance, the 10-year annualized return of the S&P 500 Index as of Jan. 18, 2022, was about 13.34%. However, market fluctuations happen and will affect the overall return, especially after major market downturns. In fact, the 15-year annualized return as of that same date was 8.08%. Just be sure to invest in line with your risk tolerance, knowing that you could lose money on your investment.

See mutual fund options from Thrivent Funds

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How to evaluate good vs. bad debt

Not all debt is bad debt. Certain types of good debt can build your stability and creditworthiness, helping you reach your financial goals. Learn about the different types of debt, how it shapes your credit score and how you can strategically control your payments.

Compare types of debt

As important as saving is, sometimes overwhelming debt can make it difficult to save while managing monthly expenses. If this sounds familiar, you may want to prioritize debt repayment before focusing on saving.

Understand, though, that you don't have to pay off all your debt before you save. As mentioned, not all debt carries the same weight, so take time to learn the differences between good debt vs. bad debt.

Here's when to consider paying down debt ahead of saving:

If you have high-interest debt rather than the low-interest kind, you should aim to pay it down as quickly as possible and keep it down. As noted, low-interest debt is generally less than 6%, so any loan or credit card that charges you 7% or more is high-interest debt.

The reason it's better to pay down debt rather than save in this case is that high-interest debt often has rates that let the balance grow faster than you can keep up with. It makes it very hard to gain ground on your debt if you're doomed to spend more in interest than your money could make in savings or investment account gains.

"We live in a world where you can push buttons and have stuff at your door the same day," Mildred says. "Consumer debt, usually because of the interest rates, will likely grow faster than most investments."

Credit card companies in particular consistently set their rates to be a certain amount higher than the prime rate, commonly reaching 20% and more. The U.S. Securities and Exchange Commission goes so far as to say "virtually no investment" will earn enough in returns to match your credit card's high interest rates.

So if you have high-interest debt, consider paying more than the minimum payment to keep accumulated interest from spiraling out of control.

For some, debt comes with a mental and emotional cost that can feel too heavy to bear. If you're facing large debt balances that make it hard to sleep at night, you might choose to pay down the balance to a more manageable amount before shifting toward your savings goals.

This may mean you're missing out on growth opportunities, but that may be worth it to you. Just remember that building savings can also bring you peace of mind by protecting you from needing to take on more debt in the future.

The best way to tackle multiple money goals, including lowering debt while also building savings, is to map out a plan. By creating a spending plan, also called a budget, you're taking account of your money and controlling where it goes. This can give you confidence that you'll be financially secure down the road.

These budgeting basics can help you create a strategic plan to balance your savings and debt repayment:

• Track income and expenses. Use mobile or online budgeting apps to understand how much money you have coming in each month and where it goes. You can start with Thrivent Credit Union’s BalanceWorks® tool.

• Maximize discretionary income. When you subtract your expenses from your income, you'll have a monthly amount that can go toward building savings and paying down debt. Maximize this number by decreasing unnecessary expenses.

• Set spending guardrails. Self-imposed spending limits can help ensure your money goes where it needs to go. A common practice is the 50/30/20 budget. With this plan, 50% of your income goes toward bills and needs, 30% toward wants and 20% toward goals, like saving money or paying off debt.

• Check in regularly and adjust when needed. Compare your actual spending to your plan to see if you've veered off track. If so, make adjustments to your budget, such as shifting how much you put toward paying off debt vs. saving.

Setting financial goals is only the first step. Having a strategy is what makes the goals achievable over time. Whether you want to pay off debt or save for future goals—or both—you can create a plan based on your resources and personal situation. Working with a financial advisor can help.