Let me clarify that a little, it is not the “financial freedom” that Suze Orman and Dave Ramsey will make you think it is. Those two may be misleading, and they are likely talking to a group of people that struggle to understand how to use debt properly.
We often hear that it’s essential to become debt-free as soon as possible. While it’s an admirable goal, the road to financial freedom isn’t necessarily paved solely with paying off debts. An equally crucial step in that journey is saving money. Here’s why you might want to prioritize saving before diving headlong into debt repayment.
Emergency Funds Are Crucial: Before anything else, everyone should have an emergency fund. Unexpected events – be it medical emergencies, job losses, or unexpected home or car repairs – can crop up at any time. Without savings, these situations can plunge you further into debt, often at much higher interest rates (credit cards have an average interest rate of over 20%). Having an emergency fund acts as a financial cushion, ensuring that you’re not just one unexpected bill away from a crisis. This kind of risk management is often discounted by planners. It is income-generating risk management – which is rare. And the risk that it managed is taking on the wrong kinds of debt, at the wrong time.
Liquidity is Freedom: Debts, especially the ones with low-interest rates, don’t deprive you of liquidity as much as not having any savings does. Liquid savings give you the freedom and flexibility to address immediate financial needs without having to resort to borrowing or selling assets. Many clients think that not having a mortgage in retirement is the key to a happy retirement. It’s not if you sacrificed saving enough money to live on.
Think like a Bank: Banks make money off the spread between the money they borrow from depositors (interest paid to you) and the Fed (money they pay the Federal Reserve) and the money they are able to lend out to others in the form of loans and credit cards. They make money on the space in between. You need to think the same way, if your debt is at a percent less than you can generate safely elsewhere, do that and make money on the space between.
All Debts Are Not Equal: It’s essential to differentiate between high-interest and low-interest debt. While high-interest debts such as credit card balances should be paid off as soon as possible, low-interest debts like student loans or mortgages might not be as urgent. In such cases, it might make more sense to save, especially if you don’t have an emergency fund or your savings can earn an interest rate or return that’s comparable to or higher than your debt’s interest rate.
Saving Encourages Good Financial Habits: The act of saving money regularly instills discipline and encourages a mindset of financial responsibility. This mindset can, in turn, make it easier for you to manage and eventually pay off your debts.
Peace of Mind: Knowing that you have savings can provide immense peace of mind. It reduces the stress of living paycheck to paycheck and helps foster a more positive relationship with money. On the other hand, aggressively paying off debt without any savings might leave you feeling financially vulnerable.
Benefit from Compound Interest: By saving and investing early, you allow your money to work for you over a more extended period, benefiting from the power of compound interest. Delaying saving to focus solely on debt repayment means missing out on these compounding benefits.
Retirement Savings: If your employer offers a matching contribution to retirement savings, it’s a great idea to take advantage of that before paying off low-interest debt. It’s essentially “free money” that you’re leaving on the table if you don’t contribute at least the amount needed to get the full match.
Economic Instability: The global economy is unpredictable. Recessions, depressions, or economic downturns can strike at any time. In such scenarios, having a financial cushion can be more beneficial than being slightly ahead in debt repayments.
Strategic Investing: If you come across a good investment opportunity that promises returns higher than the interest rate on your debt, it makes sense to invest rather than use the money to pay down debt.