This Savings Myth Is Widening Wealth Gaps. Here's Why

There's an oft-repeated myth that any spare money earned should go toward paying off existing debt. And to be sure, paying off debt is worthwhile. Ridding yourself of high-interest debt frees you up to do other, more important, things with your money. It may also help you sleep easier at night. However, the idea that digging your way out of debt is more important than any other financial goal is pure malarkey. Here, we lay out why.

Impacts your ability to deal with emergency situations

On average, the current personal savings rate in the U.S. is 4.5%. That means if you bring home $75,000 a year, you're saving, on average, $3,375, or $281 per month. With the common refrain of, "You need to get out of debt!" running through your mind, you may be tempted to send the entire $281 to your credit card company or other creditor. That may or may not be the prudent thing to do, however.

If you have an emergency savings account in place with enough money in it to cover three to six months' worth of expenses, fire away at your debt. Do what you need to do. That means if you lose your job, get sick and can't work, or run into another emergency situation, you have the funds to take care of yourself without borrowing money to do so.

However, if your emergency fund is not large enough to carry you through, focusing solely on paying down debt could lead to bigger problems than you currently face. Without an emergency savings account to fall back on, you can find yourself deeper in debt.

The worst time to try to borrow money is when you desperately need it. After all, it's easier to accept lousy loan terms when you don't feel as though you have any other options.

Gives you less time to plan for retirement

Paying off debt is a worthy goal, but it's not an all-or-nothing proposition. Every year spent focusing solely on debt cuts down on the time you have to plan for a healthy retirement and work on growing your wealth. The following table shows how much it can cost to delay investing for retirement.

This scenario involves a 36-year-old, contributing $500 a month to a retirement plan earning an average return of 7%. They plan to retire at age 68. Even if they never increase their monthly contribution, here's how much they will have by the time they retire:

As you can see, compound interest can have astounding effects when it comes to dollars invested that are left to grow in your retirement accounts. Focusing only on debt paydown and delaying those retirement contributions by only a few years can cost you hundreds of thousands in possible retirement dollars. Looking at our example above, by starting contributions just four years later at age 40, you would lose out on $177,123 in retirement funds by the time you reach age 68.

So, before forgoing retirement contributions completely and throwing everything you have at existing debt, why not consider a compromise? Go ahead and make extra payments against that debt, but also harness the power of compound interest by investing in retirement as early as possible.

Let's say you carry $10,000 in credit card debt, at an interest rate of 16%. You're already paying $200 per month, but want to add more. Here's how much extra payments can help, even if those extra payments are small:

Take a look at how much money you have left at the end of the month, and split it in a way that allows you to address both debt and retirement.

It's all about balance

There's a great rule in personal budgeting called the 50-20-30 rule. According to the 50-20-30 rule, a household budget should be broken down into three spending categories:

1. Needs
2. Debt reduction and savings
3. Wants

The first 50% of your net income should go toward living expenses and necessities. Then, 20% should be dedicated to reducing debt and saving money. The final 30% should go toward the things you want, like a new pair of shoes or dinner out with friends.

Investing in the future comes out of that second category, debt reduction and savings. How you choose to divide the 20% is up to you. A good way to make the decision is to figure out which will benefit you the most in the long run -- debt reduction or investing. That's where you'll want to focus the largest portion of the 20%.

The ideal situation is to rid yourself of debt while also protecting your interests with an emergency savings account and growing investment portfolio.