In a Crisis, is it Better to Reduce Debt or Increase Savings?

Americans have done their best to stay optimistic through the corona crisis.

We initially thought the lockdown might last a couple of weeks. But here we sit, months later. The states with the tightest restrictions are just beginning to somewhat ease their social distancing guidelines.

But the root problem – the virus – hasn’t actually been “solved.”

Despite that fact, a recent government survey reflected 78% of unemployed Americans view themselves as temporarily furloughed. Most Americans anticipate getting their jobs and hours back.

This optimistic outlook means the strategies some Americans have been using to save money or pay off debt may no longer be congruent with the financial realities in front of us.

Things might not go back to “normal” for a while.

Epidemiologists, economists, Wall Street bankers, and almost every other type of professional are not currently predicting a quick recovery. Until we have a vaccine, the root problem won’t disappear. And that’s going to affect the way we bring money into our homes.

“I think we might be in for a long recovery,” says Bola Sokunbi, Certified Financial Education Instructor (CFEI) and owner of Clever Girl Finance.

She notes that in this moment, the government is supplying a lot of stimulus through the CARES Act, including stimulus checks and unemployment benefits increases. This is making people feel slightly less uncomfortable in the short-term.

But it’s a poor indicator of the abiding financial consequences of COVID-19.

“This aid is not sustainable long-term,” says Sokunbi. “As people plan out their finances, they should focus on being mindful of their spending now – especially their non-essential spending.”

To do this, she suggests learning how to budget and making it a priority. You’ll want to pay extra attention to areas where you can cut back on spending. She also encourages budgeters to focus on any areas that can generate additional income.

You can then apply the difference to your financial goals, whether that’s saving or paying off debt.

Should I build my savings or pay off my debt?

Nearly three in ten American adults – especially those with high debt loads — can’t handle a $400 emergency on a good day. And we’re not living through good days.

Most American households should prioritize savings over paying off debt during this pandemic.

“This is because people will still need to put food on the table and have a safe place to live no matter what happens,” says Sokunbi. “It’s okay to keep making minimum payments on your debt right now while you focus on savings. Once you get to a good place with your savings, you can shift to aggressively paying down your debt – starting with your highest interest debt.”

You need a sufficient emergency fund. The best time to start building one was five years ago. But the second-best time is today.

The best time to build an emergency fund was five years ago. But the second-best time is today.

When should I use my savings to pay off debt?

The savings you put into your emergency fund should not be used to pay off debt. If your income streams dry up in the future, this money is supposed to be used for essential living expenses like:

• Food
• Shelter
• Utilities
• Health insurance
• Access to transportation

How much should I save in my emergency fund?

“Three to six months’ [worth of expenses] is the typical advice – and for good reason,” says Akeiva Thomas, Certified Financial Planner (CFP) who features in The Bemused.

“In the age of coronavirus, some may want to consider beefing up their emergency funds to a period of at least six months or more. That would give most people a decent runway while looking for a new source of income or recovering from illness.”

Sokunbi agrees that your reserves should be larger in the current financial crisis. She encourages people to build incrementally.

“Given the uncertainty of this pandemic, the more you can save the better,” she says. “If you have no savings, focus on saving your first $1,000. If you have 3 months put aside, aim to get 6 months and if you have 6 months set aside, aim for twelve.”

“Given the uncertainty of this pandemic, the more you can save the better.”

Bola Sokunbi, Clever Girl Finance

Throughout this period, making minimum debt payments is okay. But after you’ve reached that twelve-month mark, you can start diverting any extra money towards larger debt payments.

Remember to perpetually maintain your emergency fund even if you start aggressively paying off debt. If you draw money from your emergency fund, you’ll need to stash away more in order to replace your withdrawal.

How do I pay off debt and save money at the same time?

Even though minimum debt payments are a must in most cases, it’s still wise for most borrowers to prioritize savings while they’re paying off debt during the ongoing pandemic.

Depending on the type of debt you’re carrying, you may be able to find ways to reduce or even eliminate monthly payments during these trying times.

Strategizing consumer debts and loans

Prior to the pandemic, installment loans and payment plans often had two deferral allowances built-in. That means that in most circumstances if you hit a point of financial strain, you could call in and ask for the payment to be deferred. You could do this twice.

Your payment wouldn’t be due that month. Instead, it would be tacked on to the end of your loan.

While this is not a new benefit, it is currently being advertised by many financial institutions as a COVID-related program.

“Another option could be to ask for a revised payment plan with lower payments until things get back to normal,” says Sokunbi. “Lenders will want to recoup their debt, and many are willing to work with you.”

She notes that even with deferment and extended payment plans, you’re not getting off scot-free. You are likely to pay more interest over the course of your payment plan now that the terms have been extended. You’re also likely to incur fees.

Explicitly ask your lender about any potential balloon payments. These massive payments can build up astonishingly quickly. They can also take you off guard with a huge surprise payment at the end of your repayment period.

About Mortgages

If you have a federally-backed mortgage, you may be taking advantage of the forbearance option under the CARES Act. Under this legislation, your mortgage payments won’t be due until September 2020.

However, Sokunbi stresses the importance of remembering that those due dates will arrive. This is not a debt forgiveness program. If you’re not making payments in between then and now, they’ll all come due at once.

“With other debt deferment programs, you may have the option to go back to monthly payments after the deferment period is over,” she says, citing car notes as an example. “However, with mortgage deferment, some lenders require a lump sum payment once the forbearance period is over.”

If you’re worried and don’t know how you’re going to get caught up, contact your lender. They may be willing to work with you; they have tools available that could help. Sokunbi lists a loan modification – where the original terms of your mortgage are modified into a new agreement — as one of these potential tools.

Help with Student Loans

Student loans are a different beast. While you will have to rely on some of the above methods for private student loans, there is relief for those who have federal student loans.

“Specifically, for federally-held student loans, borrowers may want to consider changing their repayment plan to get a lower required minimum payment,” says Thomas.

Though you may not need to due to CARES Act legislation. Thomas lays out the terms you should bring up to your loan servicer:

• Payments are suspended March 13, 2020 through September 30, 2020
• Interest rates can be lowered to 0% for the same time period
• Income garnishment will not be happening during this time period
• Auto debit payments made during this time period can be returned to the borrower

If you’re pursuing Public Service Loan Forgiveness (PSLF), these months will count towards forgiveness whether you pay or not. These months of nonpayment will also be counted towards rehabilitation for federal student loans in default. Those on Income-Drive Repayment (IDR) plans will not have to recertify until September 30, 2020.

Additional steps for emergency financial planning

Thomas notes that beyond easily-accessible savings and debt repayment, there are other aspects of emergency financial planning Americans should be examining in this moment, too – particularly in the realm of estate planning. Estate planning can include:

• Health insurance. Thomas would take a second look at her client’s health insurance policies and care options to ensure proper coverage if they become ill.
• Power of attorney. This is a person you designate to make legal decisions for you when you can’t make them yourself. They typically deal with property and personal finances, but can also make healthcare decisions depending on how your paperwork is drafted.
• Healthcare proxy. Your healthcare proxy has the legal authority to make medical decisions for you when you’re unable to make them yourself.
• Will. Your will splits up your property in the event of your death. Having a will can shorten the probate process – where the Courts decide how to divvy up your property while your family waits and pays legal fees. But when written in conjunction with certain trusts, a will can evade the probate process altogether so your family can access your money right away should the worst come to pass.
• Life insurance policies. You’ll want to ensure these are accounted for in your will, and that all your listed beneficiaries are current.

Many of these services will require financial and legal professionals. But you don’t have to be rich to get started. You can search for pro bono legal services or services prorated according to income here.

For financial services, you can check out the free COVID assistance provided by organizations like the Association for Financial Counseling and Planning Education (AFCPE).

Share your thoughts

As businesses reopen and people slowly return to work, what do you think is more important; rebuilding savings or paying down debt? Share your thoughts in the Tiller Money Community!