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Should You Save or Pay Off Debt?

Kimberly Palmer

If you're lucky enough to have some "extra money," in the form of a recent raise, unexpected gift, or freelance earnings, you might be wondering how to spend it. Should you put it toward paying off debt, save it, or splurge?

The savings-versus-debt debate is a common one, so let's take a closer look at which option makes the most sense. Here's a five-step guide to making the best decision for you:

[Read: 10 Smart Ways to Improve Your Budget.]

1. Do you already have an emergency savings account? We all need an emergency savings account, even if we still have high-interest credit card debt to pay off. That's because emergencies can happen at any time--we could suddenly need a root canal, a plane ticket home, or washing machine repairs. At a time when credit is tight, we can't necessarily count on credit cards and other sources of loans to be there when we need them, so we need our own stash of cash for these types of emergencies. You should aim to have at least three months' worth of expenses stored away.

Even if money is tight or you're just out of school, putting a portion of your paycheck aside for a rainy day is a top priority--even more important than paying off debt. If you already have an emergency savings account ready to go, continue to the next question.

2. How much is your debt costing you? Many people don't make this simple calculation, but it shows just how costly debt is. To do the math for your own debts, make a list of all your loans: Auto loans, mortgage, credit card debt, and anything else on the books. Next to each amount, write down the interest rate. (If you don't know off the top of your head, look it up!) Multiply the two numbers--that's how much each loan is costing you per year. A $10,000 car loan at a 6 percent rate costs about $600 a year. Keep that number in mind as we move on to the next step.

[Read: 10 Questions That Will Help You Earn More Money.]

3. How much would your savings earn you? If you do save this cash infusion, where would you put it? In a bank account that's earning a 1 percent return? Or into a money market fund, which might pay you more? In the current market, it's difficult to earn much more than 1 or 2 percent without taking on more risk. Pull out your notepad again and write down the total amount of cash in question, and multiply it by the rate of return that you could get on the money.

Now, take a moment to compare your findings from step two and step three. Would paying off a chunk of your debt save you more money than you could earn by saving the cash? If so, then you're might be better off getting rid of the debt. That's a valuable piece of information that will help us make the final decision.

4. What are your expected earnings in the near future? If you expect to receive an additional windfall in the near future, in the form of a freelance check, gift from parents, or any other income boost, then you have a little more flexibility because you'll have more money to work with soon, and perhaps you can pay off debt as well as save.

[Read: 12 Money Mistakes Almost Everyone Makes.]

5. What are your financial goals? If you have big plans that require a lot of cash, such as starting a small business, buying a house, or traveling around the world, you probably want to pad your savings account so it contains more than just an emergency fund. Of course, paying off debt can also be helpful because then you can embark on these new financial adventures without the added weight of old loans. But you still need cash to make those big goals happen.

The final answer will depend on how you answered the questions above--and it might involve a mix of spending, saving, and paying off debt.

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