6 Considerations When Determining if You Should Pay Off Debt or Save for the Future

It can be challenging to know where to start if you've never managed money before. Should you pay off debt or start saving first? Do you need to create an emergency fund? It is normal to feel pressure to pay off debt because, for some, having significant debt can be very stressful.?But, quitting unhealthy spending habits and saving money can not only help reduce financial stress, but greatly increase your overall mental health. ?

Save Money or Pay Off Debt?

How do you decide whether to save money or pay off debt first? Though it seems like a straightforward inquiry, the response isn't always obvious. Savings or debt repayment? In an ideal world you would have enough money to fund RRSPs, TFSAs, RESPs, have adequate insurance coverage, do the things you want to do when you want to do them, but the reality for most is that you will have to prioritize.??You must choose which financial objectives to target and if your home budget contains categories for debt repayment and savings. People frequently believe that they need pay off all debt before beginning to save. Prioritizing debt repayment may make sense statistically, but you may end up feeling overwhelmed and exposed financially and emotionally if unplanned needs arise. ?It might be comforting to build a cash buffer, no matter how tiny.

Emergency Fund

A reserve fund is necessary for everyone. How much of an emergency fund should you have??Conventional advice suggests that everyone should have at least 3 months expenses set aside for any unexpected expenses. However, this is generalized advice and not really applicable to most people.?With proper planning and tracking your spending habits, I think most individuals are safe with having only one month’s expenses set aside.?Having too much in an emergency fund deprives you from long term savings and the magic of compound interest.?

Some of the questions you should know the answer to are:

·????????For most people, their greatest asset is their ability to work.?If you or your partner are unable to work, how would the bills get paid??Everyone should know what their disability coverage is and its limitations.?For example, most disability plans will end after five years.

·????????What is your life insurance coverage??If you were to suddenly die, would the current and future debt obligations get paid?

·????????Do you have any critical illness coverage??Critical illness coverage is a type of health insurance that provides a tax free lump payment should become seriously ill.?Conditions that are typically covered are if you diagnosed with cancer, suffer a heart attack, stroke, blindness, etc.?Although most work plans have disability coverage, most do not have critical illness coverage. Talk to your advisor about why type of insurance coverage is best for you.?

·????????How secure is your job??Is there a possibility that you might get laid off??Although this can be impossible to predict with any certainty you should nevertheless consider the question.?

·????????Could you afford to replace your car, any major appliance, water heater, roof, etc. should they break down?

·????????Do you have elderly parents that might require financial assistance?

If you own a home and you are financially disciplined, consider having a line of credit that can be used for emergencies only. If you are concerned that having a line of credit will be used for unplanned and unnecessary purchases, do yourself a favour and don’t get one.??

When to Pay Debt and When to Save

At times, it makes sense to put paying off debt before saving. For instance, it could be advisable to prioritize debt repayment before increasing savings if you have high-interest debt (such as credit card balances and payday loans)

When to put savings first? Do you only have low-interest debt, like a mortgage? Or is it possible to combine your debt into a secured credit line with a lower interest rate? If you are in a high marginal tax bracket consider depositing the funds to a RRSP account and lower your overall taxes owing; any refund you might earn could then be redirected to your debt. If you are in a lower marginal tax bracket consider depositing the funds to a TFSA account.

Debt Savings and Mindset

I have spoken to countless individuals who like the idea of having a large amount in a savings account while at the same time owe a large amount to a credit card with a high rate of interest.?Owing $20 000 on a credit card with 18% interest rate and earning 3% on a savings account doesn’t make much sense, but the reason most individuals do this is that they like the idea of having a sum of money that they can access without going into further debt.?It would make much more sense for individuals to pay off the debt and use their line of credit for emergencies only.?

The Habit of Saving

Learning to save is a habit that can be developed like any other behaviour.?Fortunately, with technology and advances in behavioural finance this has become easier than ever.?The best way to start saving and avoid debt is to automate, as much as possible, each one.?All of your expenses can be categorized as either committed or spendable.?

Committed expenses are characterized as no emotional attachment to the purchase, the amounts are fixed and predictable each month.?Examples of committed expenses are mortgage/rent; insurance premiums; property taxes; childcare.

Spendable expenses are often unpredictable from month-to-month, influenced by emotion and very easily to lose track of.?Examples of spendable expenses would be groceries, dining out, hobbies, gifts, entertainment, morning coffee, etc.

Once you know how much is spent in each category you can automate your cash flow strategy.??

This is how most individuals, without a behavioural cash flow strategy, manage their banking:

Here is an example of how it should look:

Once all of your committed expenses are in a separate account you are free to spend your spendable account however you wish.

Consolidating Debt

If you are a homeowner with good credit you should consider consolidating all of your debts into one lower interest payment.?The other added benefit of consolidating all of your debt is that it will be easier to track compared to having debts with several lenders (credit cards, personal loans, auto loans, etc.).??

If you would like to learn how to lower your debt faster and start building wealth, without sacrificing what brings you joy, feel free to reach out.