You finally have your diploma in hand! It's potentially the key to a great job and financial independence...and with it comes a heaping pile of debt. Those monthly payments aren't always easy to maintain.
If you're a savvy financial organizer, you won't spend the extra income you bring in each month, but rather, put it toward debt payments or savings accounts. Both options will lead to a better financial future, but should you put all your extras into saving or paying off debt?
Most people will choose to do both at once, some of their extra income going to debt and some going to savings. However, it probably won't be a 50:50 split. Here's some advice to help you prioritize one of these two essential categories post-graduation.
Take the Advice of Financial Advisors
Most advisors will tell you that a combination of both paying off debt and saving for an emergency are essential priorities, but you should apply more payments to one category depending on your situation.
"Consumers should calculate the opportunity cost of paying down their debt vs. saving," advises Nate Matherson of LendEDU. "Most high-interest savings accounts and CDs (certificates of deposit) pay less than 2 percent interest on an annual basis. In most cases, the consumer will save more money over the long term by repaying the debt. If the consumer has multiple types of debt, they should prioritize their payoffs by targeting the debt with the highest interest rate first. In general, consumers should pay off high-interest credit card debt before low-interest debt like student loans or a mortgage."
Dave Ramsey also advises a combination of paying off debt and saving using his well-known "Baby Steps."
"What we teach is that Baby Step 1 is to save up $1,000," Ramsey said on his radio show, The Dave Ramsey Show. "Baby Step 2 is to pay off all debts except for your home. The third Baby Step is to fully fund an emergency fund of three to six months of expenses. Baby Step 4 is starting to save for other things, so you've done this out of order in that sense."
Snowballing vs Avalanche
Ramsey also recommends snowballing your debt, so you throw all extra payments into the account with the lowest balance and the lowest interest rate until you've paid off everything.
Others take a different approach to paying off debt with what's called the debt avalanche method. NerdWallet columnist Liz Weston says, "You'll get out of debt more quickly by going after toxic debt first," she says, recommending the debt avalanche plan. "On the other hand, if you truly don't think you'll succeed without making small victories, a debt snowball is way better than doing nothing at all."
Consider both options when addressing your debt. Choose the option that makes most financial sense to you and will be easiest to maintain.
Evaluate Your Current Situation
The advice given to someone else may not work for you. The type of debt, your regular income, monthly expenses, and even your location can affect the smartest way to use your money.
First, understand the difference between good and bad debt. Good debt helps you build a strong credit score when you can keep up with the payments. It might include student loans, a mortgage, or a modest car payment.
Bad debt will tarnish your credit score and make it difficult to stay on top of your finances. You might have a high credit card balance, high-interest personal loans, student loans with little reward, or other debt that's difficult to manage.
If you have bad debt, paying it off as quickly as possible is probably your best option so you can get back to repairing your credit and maintaining a strong financial position. If you only possess good debt, however, it might not be so bad to simply pay the minimum on your monthly payment and use your extra income for a high-interest savings account.
Have An Emergency Fund
The vast majority of financial advisors tell you to build at least a small emergency savings account. It might be just enough to cover one month's expenses. It will offer a small layer of protection if you lose your job or can no longer make ends meet.
"If you don't have any savings, focusing solely on paying debt can backfire when unexpected needs or costs come up. You might need to borrow again, and debt can become a revolving door," warns Melissa Joy, CFP and director of wealth and Management for the Center for Financial Planning in Michigan.
Think About More Than Just the Now
Right now, you might lean more towards paying off debt than savings (or vice versa), but in the future, one option might be better than the other. Will you have a significant life event that will make high-interest loan payments difficult? Do you expect to be unemployed for a period and your emergency fund is essential for survival?
Everyone's situation is different, and what worked for a friend may not be ideal for your situation. Carefully evaluate the way your financial choices will influence your future, and use your money to build greater financial freedom.
