Financial literacy 101: save first or pay off debt?

If you’re new to managing money, it’s hard to know where to begin. Should you save first or pay off debt? Should you build an emergency fund? Debt is very emotional, so it’s easy to feel pressure to become debt-free. Yet breaking bad financial habits and building savings can help alleviate financial stress too.

How do you know if you should pay off debt or save cash first? It sounds like a simple question, yet the answer isn’t always clear.

If your household budget includes categories for savings and paying off debt, you must decide which financial goals to target and prioritize.

Often people think “Pay off all your debt first, then start saving.” While it might make sense mathematically to prioritize debt repayment, it could leave you feeling overwhelmed, and emotionally and financially vulnerable should unexpected expenses arrive.

Creating a financial cushion - even a small one, can be reassuring. This financial cushion is your emergency fund.

Everyone needs an emergency fund. At the very least, earmark $100 monthly for emergencies before paying down high-interest debt.

An emergency fund lets you pull money from savings if needed. If all your extra money goes towards car payments, student loans, traditional mortgage payments, or other non-readvanceable debt, you can’t access that money for an emergency.

Note: this doesn’t apply to credit cards, lines of credit, home equity lines of credit, or readvanceable mortgages like Manulife One that allow you to borrow, pay down, and reborrow again to a predetermined limit.

To make sure your emergency fund doesn’t quickly become a shopping account, it’s wise to name your account “Emergency Fund” in your online banking. Seeing that name will remind you of why you’re saving.

Choose an easily accessible account such as a high-interest TFSA for your emergency fund/savings, so your savings will grow tax-free.

Sometimes it makes sense to prioritize debt payment over savings. For example, if you have high-interest debt (ie. credit card balances and payday loans), an emergency fund, and many years to go before retirement, it could be wise to prioritize debt repayment before adding to savings.

Is your debt all low-interest loans (such as a mortgage)? Or can you consolidate your debt into a low interest secured credit line? If so, it could be a good opportunity to prioritize retirement savings in a TFSA or RRSP.

The shorter your time to retirement, the more important it is to prioritize savings to maximize your tax-free investment growth.

If you struggle with answering “How much money should I save each month?”, the easiest way to find the answer is to begin with your end goal and your desired time frame, then work backward from there.

For example, let’s say you’re building a small emergency fund to cover one month of basic expenses of $3,000 (step 2 above), and you’d like to meet this goal in three months. You’d need to save $1,000 a month after paying your basic living expenses and minimum debt payments.

Once you meet that goal, you could then apply the $1,000 each month towards paying off your highest interest-rate debt.

Of course, the amount you’re able to save will vary based on your income, needs, and goals. If your numbers don’t look like the example we provided, don’t be too hard on yourself.