Should I Save, Pay Down Debt or Invest?

Today's post is by Leah Manderson; this is the first in a three-part money series.

It seems like 20-somethings get the short end of the stick when it comes to money. Entry-level salaries. Record student loan debt. Life’s biggest expenses right ahead, like weddings, houses and kids.

In this stage of life, distributing money toward your many financial to-dos can seem like a game of darts. Last month you threw a few extra hundred dollars at your debt. This month, you vow to finally open your Roth IRA. Next month, you’ll start saving to fulfill your dream of traveling.

But you know what’s better than guessing at where the money should go? A framework that you can stick to.

When it comes to whether you should prioritize paying down debt, saving or investing, the easiest and most obvious answer is do all three. However, we all have limited dollars per paycheck, and sometimes, we have to make a choice.

Below, I talk about when to prioritize each of these three money activities, as well as times where I chose one over the other.

When to Prioritize Savings

If you have less than $2,000 in both your checking and banking accounts you should prioritize saving over all other money to-dos. Why? In the event that you have any sort of big expense like a car repair, ER visit, replacing a stolen MacBook (heaven forbid!), you will get yourself into unnecessary, preventable debt.

No matter where you are in life (recent grad or almost-retiree), start by building your savings up to at least one month of living expenses or $2,000 -- whichever is greater. After that, you can start prioritizing debt repayment.

I learned this lesson the hard way. When I was fresh out of college, my much-loved VW Jetta unexpectedly collapsed in the body shop during its 100,000 mile tune up. Being that I lived by myself in a city with virtually no public transportation, I needed a car to get around. I hadn’t been saving up for the car AT ALL, and took out a big chunk of debt in order to finance my “new” (technically used, but new to me at least!) Toyota Corolla.

After that, I learned my lesson and realized how desperately I needed a nice pillowy cushion of savings to prevent me from taking out debt in the future.

Also, given that my car was financed at 0% interest, I was able to prioritize savings for a year and not incur any interest, which leads me to . . .

When to Prioritize Debt Repayment

Let’s say you’ve stashed your one month of expenses (or $2,000). If you have any high-interest debt (over 10%), or have high balances on your lines of credit, your main focus should be on paying down your debt.

Why prioritize high-interest debt repayment?

  1. Interest can add hundreds or thousands of extra dollars in payments over time. In this case, you are working to PAY extra money in interest, when what you really want is to EARN interest on your money.

  2. If your balances are high (meaning your total outstanding balance is 30% or more of your total lines of credit), you are probably doing damage to your credit score.

I thought I had an excellent relationship with debt, until *almost* too late.

Earlier in 2013, I was in the market for a home. At first, I wasn’t at all concerned about my credit history. I am a hyper-diligent about repaying my debt on time and have no high interest debt to my name (in fact, none of my debts carry any interest!). I had never taken the time, however, to calculate my credit utilization.

My total credit utilization was about 40% -- WAY higher than the 30% experts recommend. For that, my credit score was in the tank.

My credit score would determine the kind of interest rate I got on. A better credit score=lower interest rate=$100,000+ of savings in interest over the life of the mortgage.

After learning about my bad credit score, I diverted what would have been my savings and monthly investing contributions and paid down my debt. That brought up my credit score, and my husband and I ended up qualifying for a very low rate on our mortgage.

When to Prioritize Investing

Let’s say you’ve saved one month’s expenses and you feel you have debt under control. Now it’s time to whip out the investing books and get to learning (and soon, investing).

Two of the greatest books ever written on this subject are A Random Walk Down Wall Street and The Intelligent Investor. If these sound stuffy and don’t really tickle your fancy, check out Does This Make My Assets Look Fat? (if you’re a lady), or I Will Teach You to Be Rich by Ramit Sethi.

While you’re at it, buy an online subscription to The Wall Street Journal, and commit a couple hours per week to reading through the investing and personal finance sections of the site.

Let’s rewind for a minute: What does “having debt under control” mean?

To me, it means that you are comfortable with your balances, and you have a debt-payoff plan you know (like, REALLY know) you will stick to for the long run.

That said, you should NOT wait until you are completely out of debt to start investing. Why? If you waited until you paid off a 15-year student loan and a 30-year mortgage, you might not start investing until your 60’s. In that case, you’d have virtually no chance of saving enough to care for yourself in your old age.

Back to the action -- while you’re educating yourself about investing, take the time to build to your savings account to at least 3 months of expenses (up to 6 if you have a mortgage and/or kids).

After you’ve stocked your savings account, you can confidently start investing. I wrote a comprehensive post on how to start investing in an article published in GoGirl Finance called Invest With Confidence, A Step-by-Step Plan for Newbies.

The easiest way to get started is to ask your employer about getting started in the company 401(k) program. If your company matches any portion of your contributions, you are literally earning free money.

If you decide to go this route, schedule an appointment with your HR rep to learn about your company’s policies on matching, the tax implications based on your state and salary, your investment options, and any other details they’ll want to share with you.

If your company doesn’t offer a 401(k) program, you might benefit from setting up a Roth IRA on your own. In this case, head out to a low-cost brokerage firm like Charles Schwab or T.D. Ameritrade to discuss your options with a pro.

In Conclusion...

In a perfect world, we would all make enormous salaries and be able to allocate the perfect amounts to all of our money to-dos. For better or for worse, however, we have to make choices as to where our money is best used. By using the framework I outlined above, you can start to see the step-by-step path to prioritize saving, debt repayment and investing.

First, set up a savings cushion to prevent your from accruing more debt. Then, start aggressively paying down your high-interest or high balance debts. Once you have your debt under control, ramp up your savings and start investing for your future.

It won’t happen overnight, but by staying the course, you’re setting yourself up for a truly rich life.

Leah Manderson

More About Leah

Leah Manderson is a financial planner in training who has been featured on, LearnVest and The Daily Muse among other sites. In her blog and newsletter, she publishes weekly tips and tricks on earning more, investing wisely, and living richly. Join her free 7-day Money Made Easy mini-program to learn about how to simplify and automate your monthly financial to-do’s.