If you find yourself in the enviable financial position of earning more Money than you are spending, you might be wondering what’s the best use of your extra money each month. You might want to start saving for emergencies or upcoming large expenses. Another possibility is to start paying down your Credit card or other debt. While there is not a single correct answer that works in every situation, here are a few things to think about when deciding whether to pay off your credit card or save money.

Starting a budget

The very first thing that you should do is to start a budget. Creating a reasonable budget is the first step, because it’s only then that you’ll have a true indication of how much money you have extra each month. Without a budget that is written down and regularly reviewed, you’re basically guessing. Mint can help you as you look at how much you spend in different categories each month. Knowing your historical spending habits can help you as you start to create a budget.

Pros of paying off your credit card first

Once you have a budget in place, you can start thinking about the best ways to spend any extra money you have. One good plan is to pay yourself first each month — that way instead of waiting to see if you have any money left at the end of the month, you take care of yourself first. Here are a few of the advantages to paying off your credit card first:

• Saving money on interest — credit card debt can come with some of the highest interest rates of any debt you might have. Paying off a credit card that has a 24.99% interest rate is like getting a 24.99% return on your investment. Few investments will have that kind of guaranteed return.
• Peace of mind — having outstanding debt can weigh on your emotions and make it hard to concentrate on other areas of your life. Paying off your credit cards and other debt can help you sleep easier at night.
• Improving your credit score — lowering your total amount of debt will also help your credit score. This can help you lower your interest rates and improve your overall financial situation.

How paying down debt affects your credit score

Your overall FICO credit score is determined by a number of different factors. Two of the largest factors are your payment history and your utilization percentage. The first thing that you’ll always want to make sure to do is make your payments on time, each and every month. If you’re struggling to do that, consider using some of your extra money each month to make sure that happens. 

The other factor that helps make up your credit score is your utilization percentage. This is defined as the percentage of your total available credit (the sum of your credit limits) that you are actually using. If you have one credit card that has a $5,000 limit, and your balance is $4,000, then that is a utilization percentage of 80%. The lower your utilization, the better it is for your credit score. Try to keep your credit utilization ratio under 30% if at all possible.

When to focus on savings

There are also valid reasons to focus on saving money as well. Here are some situations where you might want to prioritize savings:

• Emergency fund — if you don’t have any money saved in an emergency fund, it’s usually a good idea to save at least $1,000 before focusing on paying off your credit cards or other debt. That will make sure you can handle small to medium emergencies.
• No high interest debt — if the debt you have carries relatively low interest rates, you might find that you’ll get a better return by saving or investing your extra money.
• 401(k) employer match — if your employer offers matching contributions to a 401(k) or similar program, you’ll want to make sure to take advantage of that savings opportunity. For example, if your employer matches 100% of the first 3% of your salary, then you’re getting a 100% return on your money for that first 3% that is saved.

Striking a balance 

As with most things, the trick to decide whether to pay off your credit card or save the money instead is to strike a balance. If you have no emergency fund at all, then consider building up at least a modest emergency fund ($1,000 or so). That will make sure you won’t have to turn to credit cards if a small or medium emergency comes up. Then with that peace of mind, you can start paying down your debt. Consider the debt snowball or debt avalanche methods as two different ways to prioritize your spending.

The Bottom Line

Knowing whether to pay off your credit card or save money first depends a lot on your specific financial situation. In many cases, it’s a good idea to build up an emergency fund that can cover at least smaller unexpected expenses. That will give you the peace of mind of knowing you

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