The tone and content at Get Rich Slowly have shifted a lot in the past five years. When I started this site, I was a financial novice. I was learning about smart money management. Now, I’m in what I call the third stage of personal finance, and the basics come naturally. (Most of the time, anyhow.)

I’m glad that GRS has evolved with me. At the same time, though, I sometimes forget to focus on the fundamentals. April is Financial Literacy Month in the U.S., and I plan to spend a few weeks reviewing the basics at that time. Meanwhile, though, Ilya wrote with a question I’d like to address now:

I started working full time about six months ago, which means that now my student loans (over $20,000) have gone into repayment. Plus I had to get a new car (not actually ‘new’, but new to me), so I took out a loan — partly through my credit union, and the rest from my other accounts and money borrowed from my mother (who kindly does not charge interest).

I’m on a ten-year plan to pay off my student loan, and a four-year plan for my car loan. The car loan is about $5000. The money I borrowed from my mom isn’t a huge priority, though I’m sure she’d like it repaid sooner rather than later. But she won’t be upset if I can’t pay for a little bit. None of my loans have early repayment penalties.

My basic fixed expenses, with some allotment for going out and having a little fun every so often, allow me to save a few hundred dollars each month (this is after a 5% contribution to my 403b).

I have about $2000 in my basic online savings account and another $3000 in my 403(b). (Part of that I can’t touch because I’m not fully vested for another six months.) That’s not a huge amount, but it’s enough to get me through a rough patch. That’s why I’m not sure if it’s better to increase that savings or to decrease my debt (or some combination of both).

My question is this: Is it wise to use my surplus to pay down my loans faster? Or should I just put it in my savings account?

I receive some variation of Ilya’s question every week — and sometimes more often than that. It’s tough to know whether it’s best to save or to pay down debt. There are a lot of variables involved. Let’s walk through some general guidelines have worked for a lot of people — including me.

Laying a foundation
Most experts suggest that before you begin paying off your debt, you establish some sort of emergency fund to act as a buffer against the unexpected. It can be frustrating to be chipping away at your debt only to suffer a series of minor setbacks — car repairs, unexpected medical costs, and so on. With a “starter” emergency fund, you’re able to deflect small problems while focusing on debt.

Ilya has $2000 saved for emergencies already. This sounds like a perfect number.

Note: Some folks, like columnist Liz Weston, actually recommend a $0 emergency fund. They argue that it’s best to carry no emergency savings at all, but instead apply all spare cash to debt immediately. If an emergency does arise, then use credit cards to cope with it. I’m not in this camp. To me, a credit card is not an emergency fund.

The next step is to tackle the debt in earnest. For most people, that means credit-card debt. It sounds like Ilya is smart enough not to have a credit-card problem, so that’s a point in his favor. What he needs to do — and I think this is where he’s at right now — is decide what order to repay his debts. He should pay the minimum balance on all of them, and throw everything he can at the one he considers the highest priority. (That might be the debt with the highest interest rate, or the debt with the lowest balance, or the debt with the biggest psychological burden. It’s up to him.)

Once that first debt is defeated, he can move on to the next one. And so on. Eventually — meaning: in several years — he’ll have repaid all of his debt.

While this is going on, he should maintain that emergency fund at $2000 — or whatever balance keeps his mind at ease. When all of his debt is repaid, he should boost the balance in his savings account so that it can cover several months of expenses. (Nobody agrees on what this number should actually be; it’s whatever makes sense for Ilya.)

Once that’s finished, Ilya can begin saving for other priorities.

After reading and writing about money for five years, this is the process I’ve seen be most successful for folks wanting to lay a solid financial foundation. It’s what I consider the first stage of personal finance.

Note: If all of this seems similar to Dave Ramsey’s advice, that’s because it is. I followed his Total Money Makeover to work my way out of debt, and I liked it. Ramsey’s advice isn’t original, but he’s done a fantastic job of popularizing this method, for which I am grateful.

Specific steps
To summarize: If I were in Ilya’s situation, I’d do the following:

  • Continue contributing to the 403(b). If he has a surplus every month even after 5% contributions, I think it’s smart to continue that habit. It’ll pay off in the long run.
  • Build the emergency fund to the point where he can sleep at night. For me, the $2000 he has now is plenty. That’s enough to cover most minor emergencies.
  • Pay off mom. Lending money to family and friends can jeopardize the relationship. And borrowing is simply the other side of lending. I know Ilya’s mother isn’t charging interest, but I’d still pay this off before anything else.
  • Repay the car loan. The car loan probably has higher interest than the student loans, which makes it the mathematically smart choice. Plus, it has a smaller balance, which makes it the next logical option when using the debt snowball method.
  • Attack the student loans.
  • Once the debt is gone, boost that emergency fund from $2000 to whatever feels comfortable. For Ilya, that might be $5000 or it might be $20,000. He’ll have to make that call.

After all that’s finished, Ilya can boost his savings rate to get a jump-start on retirement and to set aside money for things that are important to him, whether that’s travel, entertainment, or maybe a new house.

Finally, I want to point out that although there are some best practices involved, there’s not actually one right answer to this question. Everyone’s situation is different. Ultimately, Ilya has to do what is right for his circumstances and his mindset.

What general advice do you have for folks choosing between saving and debt reduction? And what specific advice do you have for Ilya’s situation? Should he add more to his savings before tackling the debt? And which debt should he tackle first?

Note: Originally, I had Ilya’s gender incorrect, for which I apologize. I’m not familiar with Slavic names, and made a false assumption. I’ve corrected gender references in the post, but not in the comments below. Sorry for the confusion.

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