What's Better: Less Debt or More Savings?

By Dan Rafter on 22 May 2017 0 comments

Money advice can be confusing. Financial planners say that you should pay off high-interest debt — especially credit card debt — as quickly as possible. They also say that you should build an emergency fund you can use for repairs to a busted transmission or a leaking water heater. But what if you have just enough money in your emergency fund to pay off all your credit cards? Doesn't your high-interest credit card debt qualify as an emergency?

You might be surprised to hear that no, you should not spend your whole emergency fund on credit card debt. The better approach is to use some of your savings to pay off a chunk of your debt, while still keeping a reserve stashed away. (See also: The Fastest Way to Pay Off $10,000 in Credit Card Debt)

An emergency fund can help you avoid debt

Emptying all of your savings to pay off your credit card debt might feel good. But having an emergency fund is key to avoiding more high-interest debt in the future.

Financial pros recommend that you build an emergency fund large enough to cover three to six months' worth of daily living expenses, but that's just the bare minimum. An emergency fund that can cover a year of daily living expenses is better.

You might not realize just how badly you need this cash reserve until an expensive emergency pops up. Say your roof suddenly needs replacing, or your water heater calls it quits. Without any savings, you'll probably turn to credit cards to pay your contractors. Now, you'll have to pay interest on the repair.

Or, what if you unexpectedly lose your job? Most people don't find new employment overnight. A job hunt can take months, and your emergency fund can help pay for your daily living expenses in the meantime. Without an emergency fund, a job loss could have you trying to use credit cards to pay for everything from groceries to filling your car's gas tank. And that could lead to a mountain of future debt.

The better approach to paying down high-interest debt

You can use your savings to help pay down credit card debt. The key is to use only some of the money, never depleting or critically draining the fund.

Say you have $15,000 saved in an emergency fund, and $12,000 of credit card debt. Maybe you could withdraw $6,000 from your savings to cut your credit card debt in half. That will still leave you with $9,000 in savings that you can use to handle any financial emergencies that come your way.

After you tackle that large chunk, you can work aggressively to pay off the remainder of your credit card debt on your own. There are several approaches to paying down this debt, two of the most common being the debt avalanche and debt snowball methods.

In the avalanche method, you first pay as much as you can each month on your credit card with the highest interest rate, making the minimum payments on your other cards. Once you pay off the card with the highest rate, you begin making larger payments on the card with the next highest rate, and so on until you've paid off all your cards.

You can also try the debt snowball method, where you instead focus on first paying off your credit card with the smallest balance, making minimum payments each month on your other cards. Once you pay off your smallest debt, you move on to the card with the next smallest balance and so on, again until you've again paid off all your cards. (See also: 6 Secrets to Mastering the Debt Snowball)

The avalanche method is the cheapest because you tackle highest-interest debt first. The snowball method, though, comes with a psychological boost: There's a good feeling involved with paying off a debt in full, even if it is a small one. For some people that provides critical motivation for sticking with a debt repayment plan.

If you find yourself struggling to handle a large debt repayment effort, you can also try the debt snowflake method. In this approach, you find any minuscule way to shave money off your everyday expenses. You then use those savings to make frequent payments on your credit card debt. It may seem like you aren't doing much, but every payment, no matter how small, makes a difference. You can use this method in conjunction with the snowball or avalanche, too.

Choose the approach that works best for you. And remember, as tempting as it might be, don't completely drain your savings. You never know when life will throw a financial emergency at you.

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What's Better: Less Debt or More Savings?

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