Why You Might Want to Prioritize Saving Over Paying Off Debt in 2021

Here's how to pay off debt while stashing some money in your savings.

If you know the feeling of being one small emergency away from your finances falling apart, you're not alone. As it turns out, fewer Americans than ever before could cover a $2,000 expense if needed.

Being in this precarious financial position is stressful. It's a fact that looms in the back of your mind constantly, preventing you from feeling any sense of financial security. This is particularly true in the wake of a global pandemic, a recession, and high unemployment rates -- as many feel even more uncertain about the future than usual.

Keeping an emergency fund of cash that can be used to cover unexpected expenses is one of the best ways to give yourself financial peace of mind. But if you're currently in debt, you might think it's best to put all your extra cash toward paying off those balances and forgo a savings account. Here's why that might be a mistake.

Keeping cash on hand is important, even if you have debt

Apart from the mental benefits of knowing you have money in savings if you need it, there are practical reasons to save up a little cash handy even while you're paying down debt.

Consider how you would pay for an emergency expense right now. You might be tempted to put it on your credit card, adding to a balance you're already paying off. What if you don't have enough available credit to cover the expense? Even if you do, carrying a high balance causes your credit utilization ratio to go up, which drags down your credit score.

Adding to the debt you're already struggling to pay off can make your monthly payments unmanageable. If you end up unable to make those payments, you risk getting hit with late fees and negative marks on your credit report.

If you were to lose your job, having cash on hand to cover expenses would be preferable to living off of your credit card. If you had put all your disposable income toward your debt and had nothing in savings to cover your living expenses, you'd still be stuck financially. On the other hand, if you'd been redirecting some of that money toward a savings account and saved up even one month's living expenses, you'd have money to cover yourself while searching for a new job.

What's more, many forms of debt provide relief options in the case of economic hardship, meaning you can often pause or decrease your monthly payments. For example, some debts can occasionally be repaid according to your income level, so when your income drops, so do your monthly payments. Even some credit card issuers provided relief options in the wake of the coronavirus pandemic, including the options to waive interest or skip a payment.

Pay down debt and boost your savings at the same time

If you're already paying well above your minimum monthly payments, you've probably got enough extra cash to funnel some of it toward your savings for a while. It's a good idea to have at least one month's worth of living expenses in savings before you go back to doubling down on debt.

If your debt has a moderately low interest rate -- say, below 10% -- you might even want to bump your savings up to three months' living expenses. If you're paying off debt with an interest rate below 7%, you could aim for an emergency fund with a full six months' living expenses.

Let's say you're paying off $8,000 worth of credit card debt at a 17% interest rate. If you make $400 monthly payments, you'll have it paid off in 24 months and spend $1,474 on interest. If you cut those monthly payments down to $200 and funnel the other $200 into a savings account, it would take you 60 months to pay off your balance. And you'd spend a whopping $3,890 on interest. In this case, it's probably wise to keep your savings small and focus on paying off that high-interest balance as quickly as possible.

On the other hand, say you have an $8,000 loan that you're paying off at a 6% interest rate. Your $400 monthly payments will get that paid off in 22 months, and you'll spend $450 on interest. Cut your monthly payments in half and put the other half in savings, and you'll pay off your loan in 45 months and spend $948 in interest. For some, spending that extra $500 on interest might be worth the peace of mind that comes with knowing you have the cash to cover an emergency.

What to do if you can barely afford your monthly payments

If you're already stretched to your limit with your current minimum monthly payments, funneling some of your funds to a savings account probably isn't an option. In this case, it might be time to consider ways to lower your monthly payments.

One of the best ways to make paying off debt easier -- and to avoid interest fees -- is by taking advantage of a good balance transfer credit card. You can use these cards to pay off your current debt, and they come with 0% introductory APRs for anywhere from 12 to 20 months. (APR stands for annual percentage rate, and it's the yearly cost of borrowing money. For example, if you borrow $1,000 for a year at a 20% APR, the total to pay back would be $1,200.)

If you pay off the balance in full before the end of the introductory period, you won't have to pay any interest. That being said, the regular APR on these cards tends to be high, so make sure you understand how balance transfers work before you go this route.

A debt consolidation loan is another option. With debt consolidation, you use one loan to pay off all your various balances so they're all combined under one monthly payment. This often makes your monthly payments smaller, but it can also mean spending more money on interest and taking longer to pay off your debt.

That being said, if you're struggling to make ends meet every month, having a smaller monthly payment on your debt will give your budget some breathing room -- and it might give you a chance to save a little.