Pay Down Debt or Sock it Away in Savings?

29 October 2015

If there's extra money in the budget, should you save it or pay down your credit card?

As a financial coach, I often get the question, “should I put my extra money into savings or pay down my debt quicker?” 

I always pause before answering because it really is a good question.  On the one hand, it makes sense to pay down debt first.  After all, any interest that you earn in the bank or credit union is going to be miniscule compared to the interest and fees you might be paying on a credit card balance or personal loan.  On the other hand, having no money in savings can be problematic and result in a need to borrow from your credit card or line of credit, thereby increasing your debt load.

While individual situations often dictate my response, when there’s extra money available in the budget, I encourage a balance of savings and debt pay down.  Generally, for the average single person with 1 child, I suggest an emergency savings fund of $500.  Many of us have heard that we need to save 3-6 months of our income.  For most of us, even those of us with expendable income, this is a near impossible feat.  By directing $25 per paycheck to a savings account, $500 is achievable—and it’s enough that might get us out of a jam, such as a car repair, an extra high heating bill, or an unexpected expense for our child.

Once the emergency savings is built, I encourage clients to use any extra monies to pay down their   credit cards or personal loans.  My first suggestion is that they stop using the credit cards, or if they must use a card, use one with no balance and charge only what can be paid in full each month.  Then, on the cards with balances, I offer a choice—pay down the highest interest rate first, or, make payments toward the loan with the lowest balance.

Consider the following example:  Jim and Tammy have 2 credit cards with outstanding balances exceeding $10,000.  They use their cards regularly and only pay the minimum required.  One of their credit cards has an interest rate of 21% and a balance of $8,500.  The other card has an interest rate of 12% with a balance of $1,550.  If we focus on the card with the highest interest (and also the highest balance), and they only pay the 4% minimum required on the outstanding balance ($340 for the first month, but a few dollars less each month due to the decreasing balance and decreasing minimum required), it would take them 14 years and 2 months to pay this off and in the end they would pay $6,442 in interest.  If they were able to set aside $340 every month toward this balance, they would have the card paid off in just under 3 years and pay far less in interest, “only” $2,776.

Alternatively, Jim and Tammy could use any extra funds to pay off their lowest balance card first.  Often, the sense of accomplishment and gratification that people feel when they pay off a loan gives them the encouragement to continue working on freeing themselves from other burdensome debt.

Unlike a mortgage, student loan, or even a car loan, credit card debt is not an asset.  It’s often a compilation of groceries, on-line purchases, coffee runs, take-out, and other expendable items long forgotten.  That’s why credit cards should be used as a convenience and paid in full each month to avoid fees and interest.  But, when we do have to carry a balance, paying it off as quickly as possible will result in fewer interest charges and a more financial freedom.

 

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