If you are juggling between paying off some outstanding debts or saving up for an early retirement, you might be conflicted as to where to allocate your money first. Choosing to save, pay off debt or even invest first is a highly contested debate.

Before any of us can start working off our debt or building our wealth, we need to understand which financial scenario — getting out of debt, saving or investing first — we should prioritise for ourselves. Here are 5 things you need to consider to decide what suits you the best.

Build up an emergency fund that covers 3 to 6 months of expenses.

Even before you look into reducing debt, you should at least have an emergency fund in place. The most expensive mistake you can make is not budgeting for an emergency. If you do not already have an emergency fund, it is important to prioritise setting aside some cash in case an unexpected expense arises.

To have a better understanding on how much you need to save, consider these factors:

  • Your job security and employee benefits: A freelancer will most likely need to have a greater emergency fund versus a government employee. Additionally, consider benefits your company might offer, such as medical and dental insurance coverage.
  • The number of dependants you support: Those with larger families (e.g., children and ageing parents) may want to prioritise building an emergency fund large enough to provide for everyone in the household.
  • Your risk appetite: How much and what kind of risks are you prepared to handle?

To help build up your emergency funds passively, consider “paying yourself first”, by squirrelling away a fixed amount of money every month into a low-risk cash management product; this may be a money market fund or a high-interest savings account. In any case, your cash management strategy is an essential part of your financial plan.

Read more: How to save more money

Avoid taking on more bad debt

As Singaporeans, we were taught from a young age that all debt is bad. The truth is more complicated than that. Differentiating between good and bad debt can prevent you from taking on unnecessary financial burden and help create an effective debt repayment plan.

The difference between Good vs. Bad Debt

So what is good debt? Essentially, good debt is debt incurred from expenses that will help you grow your human and financial capital and has the potential to improve your overall financial health. In contrast, bad debt is incurred from expenses that will not help you generate income.

The main goal is to limit unnecessary expenses that can lead to bad debt, and to spend within one’s means. This can mean avoiding luxury purchases such as extravagant holidays or a costly designer watch.

Evaluate all your debts and loans

Know what kinds of debt you owe: list out all your debts, including interest rates, debt size, and payment due dates, and consider how to pay them off. The following table is an example of how to compile your debts and loans.

Examples of debt compiled

Begin to budget towards your monthly debt repayment plan just as you would with utilities and food. Debt expenses should be treated like any other expenses. After, allocate some of the leftover funds each month to other financial objectives such as investing or saving; if you don’t have any funds left over, your budget might be unrealistic and should be reworked.

Create and stick to a debt repayment plan

Some debt arrangements can roll on indefinitely while others have a monthly repayment schedule. Identify the debt arrangement and work them into your plan to lower your risk of incurring a huge interest expense.

To get out of debt fast, you can restructure your debts by paying off very high interest loans such as high interest credit card debt (around 25% p.a. in Singapore) by taking up a  personal loan with lower interest rates (lowest around 5-7% p.a.). This debt consolidation strategy allows you to save up on the interest rate difference of around 20%, especially if your loan quantum is high.

Another method of approaching your debt repayment plan and steering away from further accrued debt is by organising your loans by interest rate. Known as the “avalanche debt” method, you start by paying off those with the highest interest rates first.

Strategy: Avalanche method

Another approach is the “snowball method”. This strategy involves prioritising your debt by the dollar amount, and paying off the lowest to the highest amount. Though you might not save more, this method is more encouraging and has been shown to have more psychological appeal when it comes to building long-term financial habits.

Strategy: Snowball method

Making a call between investing with debt outstanding, or paying off all debt

Particularly in Singapore, we glorify the idea that being debt-free is the key to a successful financial life. Paying off all your debt does not always make sense. For example, if you have a long-term mortgage with an interest rate of 1.4%, but expect a return of 7-10% from the stock market each year, you can make your money work harder for you by investing your spare cash rather than using it to pay off your loan.

While this can be seen as indirectly leveraging on your investment, the risk of it has to be assessed carefully on a case-by-case basis:

  1. Match the time frame between your debt and investment. You should not make a long-term investment with high volatility for a debt that is due soon. This concept is also known as asset liability matching.
  2. Ensure that you are getting higher returns from your investment than the cost of debt. For example, you would not want to take up a personal loan at 10% interest rate to invest in a money market fund that yields less than 1%
  3. Consider any early loan repayment penalty. The interest saved from early loan payment could be less than the penalty paid.

Managing your debt well can help you enhance your life and achieve your goals.

As writer and entrepreneur Grant Cardone once said: “Rich people use debt to leverage investments and grow cash flows. Poor people use debt to buy things that make rich people richer.” Ultimately, debt is a double-edged sword that can work for or against us. Being deliberate and measured with our debt decision can allow us to use debt effectively for our financial goals.