When to Use Savings to Pay Off Debt
One of the most common questions over on the Wise Bread forums is some variation on, "I have $X in savings but $Y in credit card debt. Should I use the savings to pay down the debt?" The answer, of course, depends on your situation--and there's a reason why the question keeps showing up. Here's how to do the analysis.
The first step toward answering this question is to ask another: do you have an emergency fund?
That's because figuring out the cheapest thing to do is easy--just compare interest rates. If your savings are earning you less than the cost of your debt, then you'll save money by paying off the debt. But that's only the right choice if you have an adequate emergency fund.
Of course "adequate" is a tricky question for emergency funds. I've written a whole article on figuring the size of your emergency fund that breaks down the reasoning behind the rule of thumb that you want at least 3 and preferably 6 months spending in your emergency fund.
For people with debt, though, the calculation changes. You still need at least a minimal emergency fund, simply to manage little glitches in cash flow (such as a payroll or banking hiccup that delays your direct deposit over a holiday weekend). But once you go beyond that minimum--maybe $1000, maybe one month's take-home pay--any extra emergency fund cash is probably costing you bunches in interest on your debt while earning almost nothing.
A lot of people seem to think that having extra debt means they need to have extra in their emergency fund--so that they have cash to cover their debt payments during a period of unemployment. Sadly, I can't say that's definitely wrong: If you can't cover your minimum payments and start racking up late fees, those charges will totally swamp any interest payment savings.
The analysis has to come down to your best guess on what the future might look like. My take is that getting the debt paid off sooner rather than later improves your situation so much that it's worth taking a small risk. After all, even a large emergency fund will go pretty quickly if it has to cover large debt service payments.
So, my general advice is:
- Establish a small emergency fund--something like $1000 or 1 month's pay--to cover the ordinary cash-flow mismatches that always show up between income and outgo.
- Once that's done, aggressively pay down any debt (with the possible exception of long-term debt where the interest rate is both low and fixed, such as some mortgage and student loans).
- Once you're debt-free, bring your emergency fund up to the 3 to 6 months standard.
- Once you've got a healthy emergency fund, direct future money to investments. (Don't neglect non-financial investments, which will often return more than financial investments.)
As I said, there's a reason the question shows up over and over again: There's no way to know the right answer. The more aggressively you pay down your debt, the cheaper it will be--unless you run your cash down so low that an interruption in your income means that you're unable to cover your debt service expenses. Since you can't know the future, any choice that you make will have to be based on your best sense of what the future may bring.