Interest Saved = Interest Earned
Have you ever wondered how you figure out what makes the most sense to do with your money? You have some cash saved up, but how do you decide what investment is best for it? Do I pay off my student loans? Do I invest in the stock market? There is no one right answer, but let’s break down the main pieces here.
Mostly, this is about balance. It’s about creating a financial picture that you feel comfortable with. It’s always a good idea to have some cash on hand for emergencies (see our post on Emergency Funds), so you don’t want to use every last penny to pay ahead on debt, or tie up in investments. On the other hand, you want to be sure you are putting your money to the best use.
Once you are comfortable with your emergency fund situation, you want to start looking at your debts. Generally, there are two schools of thought on debt pay down. The first is to pay off your highest interest loans first. This is the most financially beneficial option, in terms of cost of interest. The second school of thought is to pay off your largest loan first, which can feel good psychologically, like you are making progress toward paying off your debt. If you need that psychological encouragement, that might be a good choice for you, if that doesn’t excite you, then it may be better to target the higher interest loans first.
I know what you are thinking, ‘but how do I decide whether to build my savings or pay ahead on my loans?’ Well, the answer is simple, which has a higher interest rate? The interest you are paying on your loans or the interest you are earning on your savings. Whichever is higher is the option that makes the most financial sense. That is of course assuming you have that emergency fund squared away, which I’m sure you do.
If you are earning more interest on your savings than you are paying on your debt, then what goes in your pocket is the difference in interest earned over interest paid. If the interest on you loans is higher, then putting money into savings at a lower rate is the equivalent of losing that same difference every month. So if that’s the case, you are better off paying ahead on your loans and saving yourself that interest.