Pay the Debt or Save Away

It’s early 2010, about the time that bonuses are paid, and you may be wondering what to do with the extra cash. Hopefully, you weren’t depending on the bonus for your budget, and so you can use it for some of the long-term plans you have.

There are, essentially, three uses you can put the extra cash to:

  1. Splurge it on something – it’s extra, you don’t have a long-term plan for the money, so why not enjoy it.
  2. Save it – the extra $5,000 might help toward a down payment on a house, or pay for your child’s university.
  3. Pay the debt – after all, it costs you to keep that debt around, and if you’re like most people, you don’t like owing other people money, look at the Reasons You Are Still in Debt.

This pretty much guarantees we'll be left behind.Now, each person’s situation is unique, and there’s no rule for what to do. However, I’d like to address a reason to save when you might be inclined to pay debt which you may not have thought about.

Assume for the moment that you have a $5,000 balance on a line of credit which you pay 5% interest on, and you just received $5,000. The current rates of return on a GIC are about 2%, which means that by paying off your debt today, you’ll essentially save yourself 3% annually on ridding yourself of that debt today.

However, look at your monthly obligations to that line of credit (and this assumes that you are not continuing to borrow against it). On $5,000 of debt, your minimum monthly payment is probably in the area of $150 to $200. This is already in your budget, and you are already setting aside that money each month.

If you pay off your debt today, you will, in theory, free up that money to invest in a long-term plan. However, saving money is generally not treated as an obligation, while paying a debt is. That means that if you remove this debt from your monthly payments, you are not as likely to put the money into an investment.

For that reason, you may want to consider putting a portion of the bonus into an investment today. Sure, it’s going to cost you 3% to do that, but this way, you’ve managed to save that money, which otherwise might have been spent. If, on the other hand, you can convert your monthly payments for the line of credit into a monthly contribution to an investment, thereby ensuring that you do, in fact, contribute the savings each month, then by all means you should get rid of the balance on your line of credit as quickly as possible.