Saving money versus paying off debt
By Gary Foreman
The New Frugal You
Dear New Frugal You,
Right now I owe $3,100 on my credit card. I have $6,000 in my savings but am trying to hit a benchmark of $10,000 in my savings. The way I've been saving I should hit the $10,000 mark in three months. However, the balance on my credit is glaring. My total credit limit is $4,500. Should I pay this debt immediately, slowly, or should I continue to pay a small amount just over minimum to hit my benchmark of $10,000, then anything I make after will be strictly towards my debt? Please and thank you. -- Waqas
Congratulations on your savings success. I'm sure that it feels good to be so near to your goal. Your question is a good one and one that many people ask: Does it make sense to put money in a savings account while you still are repaying debt?
Let's look at the question a couple of different ways. First, we'll discuss why we want/need a savings account and why we borrow money. Second, we'll look at the purely mathematical aspects of your question. Then, finally, we'll consider some of the emotional/psychological issues your question brings up.
I'm guessing, but I suspect that you started saving because you became tired of having unexpected expenses that could be paid only by using your credit card. And, to tell the truth, those bills aren't really unexpected. We know that a car or the fridge will break down or we'll need to visit the doctor. What we don't know is when it will happen.
As to why we use credit cards the story is usually the same. In the beginning, it's just convenience. They're easier to use than cash. Plus they're handy for the unexpected bill that we can't handle out of savings. Typically we want to spread the bill over the next few months and pay down the credit card account.
Sometimes we find that difficult to do. And today's unexpected expense gets added to the one from six months ago that we still are working on repaying. So our balance doesn't disappear, but rather seems to be growing. That sounds like what you're experiencing, Waqas.
Next, let's examine the math of the question. If you're asking what's the quickest way to both save $10,000 and repay your debt, your answer will lie in the interest rates. Compare the interest rate being earned on your savings to the interest rate being charged on the credit card. You should put any extra money you have on whichever is higher.
It's almost certain the credit card bill should be paid off first. Your interest rate on the unpaid balance is probably in the teens. Your saving account is probably in the low single-digit range. Once you've paid off the credit card you can resume adding to the savings account.
If your only concern is how quickly you can accomplish both you'd actually be wise to pull $3,100 from savings to totally pay off the credit card balance. But some would argue against that. Which leads us to the final way to look at your question.
Are there any emotional issues that would suggest that you should save the money before repaying the debt?
There are some people who, for various reasons, must have some savings available to them. Without it they feel vulnerable. For them it would be best to build the savings up to an acceptable level and then use extra money to repay debts. It won't be the quickest way, but it will help prevent sleepless nights!
What should you do? Only you can decide how comfortable you'd be if your savings was suddenly cut in half. But you might feel relieved knowing that the credit card debt was wiped out. In either case, at the rate you're going, you should reach both goals in about six months. So you won't have too long to wait. Congrats!
See related: Using your 401(k) to pay off debts
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Published: January 11, 2014