My post about how to save half your income got a lot of attention. It seems many of you are also interested in saving half your income, or if not fully half, then at least more than you’re saving today.
However, not all the attention was positive. I mentioned in that post that debt repayment counts as savings, and that was seen by one person as “magic math” and entirely stupid.
I’d like to explain.
Is Debt Repayment Savings?
No, not in the technical sense. Paying off your debt is commendable, and wonderful, but it isn’t technically savings since your money is going somewhere that isn’t your own bank account. However, unless you’re going to declare bankruptcy (and please don’t do that — it’s not a good idea for your long-term plans), your debt will follow you.
In fact, it will follow you around all your life. It’s like the annoying teenage kid you don’t yet have. It sucks your money dry. It can grow, even if you’re not actively increasing it.
It’s a heavy burden.
That debt? Unless it’s a zero-percent loan from your parents, your consumer debt has an interest rate. And unlike interest rates on savings accounts, it’s interest you have to pay, not interest you’re earning.
The rate will vary (but it’s not likely to decrease), but it won’t go away. Let’s say you have a credit card with 10% interest and a $10,000 balance. Every time you pay above the minimum toward the credit card, you’re getting a guaranteed 10% return on your investment.
How? Well, again assuming you’re not going to declare bankruptcy, you’re going to have that debt a long time.
If you look at online banking, you can see that the interest rates are abhorrently low.
So, what’s the best thing to do with $1000?
Option A) Put it in an online savings account. Net yield: ~$1/year.
Option B) Put it toward that $10,000 credit card. Pay $1,000 toward your $10,000 bill. This reduces your debt burden and saves you from paying that interest in the future.
Mathematically speaking, when you have consumer debt, the right thing to do is pay it off before you start socking money away in various accounts.
Or, rather, if you have debt with double-digit interest, it’s best to pay it off as soon as you can.
When This Doesn’t Work
You can only factor this in when you’re working on getting out of debt. This really doesn’t apply if you spend more money than you make, simply because financing a pair of shoes, then paying them off is not something we’re rewarding.
Rather, counting debt repayment as savings works when you have less debt at the end of the year than at the beginning. This is intended to help those of us still in consumer debt set up lifelong habits of ferreting money away in sock drawers and the stock market.
My Definition of Savings
Let’s focus on net worth, here, for a minute. What kinds of things increase your net worth?
- A deposit to your checking/savings account
- A payment above the minimum amount due on your credit card/car loan/student loan
- Any retirement contribution
- Money in the sock drawer (although you’d need a different spreadsheet!)
Interest increases your net worth as well, but with the exception of investing, there’s very little in the way of what you can do to change an interest rate, so I’m not counting that.
Looks like we’ve found my definition of savings:
Any activity that increases your net worth.
Further, it seems like we’re arguing over the wrong point.
I think we can all agree that paying off debt is noble. What helped me when I was digging my way out dollar by dollar was to think of it in the long term. “If I can pay an extra $500 toward my Discover card this month, that means in a few months, I’ll have $500 of my own money to put toward savings. Then I’ll be in charge of where my money goes.”
Can you invest in the stock market while you’re in debt?
Can you put money in a 0.1% interest bearing savings account instead of paying off a 10.99% credit card bill?
Sure, it’s a free country.
But if your goal is saving half your income, a really good way to start is to get rid of big interest debt first.
Then we can start investing!