People always want to know how to save money. If you follow financial news you probably already know that one of the biggest obstacles to saving is that people are spending too much money and are carrying too much debt. Anyone with large amounts of debt are being told that their primary focus should be on reducing as much of it as possible before interest rates start to rise.
But should people’s personal savings be sacrificed to repay debt? This article looks at two common approaches to saving money and offers an assessment of them.
Personal finance has a lot to do with human psychology and understanding how to save money is no different. Most people would agree that learning how to save money involves developing a habit of saving in the first place. Financial experts realize that many people find it too difficult to make the necessary sacrifices to save money, so they came up with two approaches that try to make saving money easy for everyone.
The first approach is all about starting small. It’s the start saving a few dollars a day kind of thing. It’s what David Bach famously referred to as the “latte factor” in his book The Automatic Millionaire. The idea behind the latte factor is that if you skip your morning Starbucks coffee you can use that money to kick start your savings.
Bach also encouraged people to set up an automatic savings plan to start saving a small amount of money each pay. He believed that if people were able to form the habit of saving a small amount on a regular basis then they would be able to ramp up their savings. Once people realize that they don’t miss the $25 a pay then they may decide to increase that amount.
The idea is to make your personal savings just another deduction on your pay so that you won’t miss the money that you don’t see. After all, that’s a strategy that has been successfully employed by the government to make sure that it receives its share of income tax and other deductions. The government recognizes that most people simply would not be able to save up their personal income taxes and pay them at the end of the year. So they instituted a system that automatically taxes employment income at the source. This system guarantees that they’ll get their money. If this system works so well for the government why not for us?
Pay Off Debt and Save the Monthly Payment
The second approach to saving money focuses on a person paying off some form of debt and continuing to save the monthly payment. The reasoning behind this approach has to do with the fact that because you’ve already formed the habit of paying that monthly payment, it makes sense to continue to save that money after the debt has been repaid because you are used to living without it. Below are 2 examples of when you can save money after paying off a monthly debt.
For example, if you have a student loan payment of $250/month once the debt is repaid keep saving that $250. You’ve already budgeted for it anyways. This is how some people build their savings and grow their wealth. Here’s an example from own experience.
When I first met my wife, she had a student loan of thirty-three thousand dollars. At the time she was paying back the bare minimum each month. As things got more serious and we began to have conversations about our future we agreed that the loan needed to be paid off quickly if we were to buy a house and move forward in life.
As we developed a plan to tackle the student loan, my wife didn’t realize that she could pay back more than the monthly minimum. Once she started to make extra payments, she managed to have the loan repaid within 2 years and began saving that money in her retirement account.For readers currently battling student debt, you might consider refinancing. Since my wife repaid her debt, a number of companies have offered to refinance educational debt. I have found this resource quite helpful.
If you have a 5 year car loan, you’ll probably be able to save the same monthly payment once the loan is paid off. In that situation, the same principle of saving your debt repayment money applies. You can either save the money or use it toward the purchase of a new car.
10 years ago an approach like this seemed reasonable but one of the more worrisome trends in our society today is that many people are extending their car loans for up to 7 and 8 years. That’s pretty scary not only because there will come a point when the amount owing on the loan is greater than the value of the vehicle, but also because it renders this savings strategy useless. By the time you manage to pay off an 8 year loan you’ll be ready for another car so the cycle will repeat itself endlessly.
What’s the Best Approach For Saving Money?
Of the two approaches outlined above I have to say that I find approach #1 to be the better savings strategy. Strategy #2’s major weakness is that most people find themselves in an endless cycle of debt so it’s questionable whether they will ever eliminate enough debt to be able to start saving. In certain instances and with some forms of debt, the strategy may work but will delay your savings for years while you pay off that debt. Also, when you factor in that car loans are now being offered with 7 and 8 year terms, I think strategy #2 starts to fall apart.
As for the merits of strategy #1, I’m sure that most people would find it easier to save $20 or $25 a pay. While that amount is a good starting point, Bach’s strategy only really works if a person is willing to keep increasing that amount over time. Increasing your personal savings takes discipline and involves challenging yourself to live on less and save more and more as time goes on. So it’s not quite the “set and forget” approach that Bach suggests in his book.
I think the main takeaway from both approaches is that, despite what the finance experts say, saving money isn’t as easy as they make it seem. If it were, everyone would be doing it and there wouldn’t be a negative savings rate or a personal savings crisis in the U.S. and Canada. I think the inescapable fact is that, if you want to build up your savings and one day enjoy financial freedom, it takes a strong commitment to that goal and the discipline to follow it through over time.