Deciding whether or not to save money versus paying off debt is one question. But what if you already have savings in the bank? Should you use it to pay off your debt, or is saving it for another purpose a better option?
Once again, the right answer isn’t so clear. To help you decide, here are some questions to ask yourself when deciding whether to use savings to pay off debt.
What interest rate are you paying on debt?
Mathematically, the answer is simple: If you’re paying higher interest than the return on interest from savings, you’ll be better off paying the debt with savings. No matter how you choose to look at this situation, you’re losing money whenever you don’t pay off debt in this case.
Right now, a savings account might return less than 1% interest, lower than any debt except debt that’s interest free. This makes the above the more likely scenario.
However, math isn’t the only thing to think about.
First off, even though interest rates are higher on the debt, they might not be all that much higher. Yes, the interest costs money, but a mortgage with a 3% interest rate is much different from a credit card with a 30% APR.
Secondly, there are tax benefits for paying interest on some types of debt, like a home mortgage and student loans. While the interest rates are likely already lower for these loans compared to credit card interest rates, you can reduce the expense even further.
Getting rid of the most toxic debt, like credit cards, is almost always a good decision. With rates that average around 14% and that can go much higher, credit card interest rates are a real killer, and it’s hard to justify paying this when you’ve got money lying around in the bank that can wipe out this debt.
What will you keep in an emergency fund?
If you’re thinking about using some or all of your savings to pay down debt, you should consider how that will impact your emergency fund, regardless of what the math says.
Many experts recommend keeping an emergency fund so you don’t have to rely on credit in emergency situations. Because of this, using all your savings to pay down debt usually isn’t advisable since any crisis may bring you back to relying on credit cards and put you in debt again.
As a baseline, $1,000 is an often-recommended bare-bones amount to maintain as an emergency fund. But if you have more in the bank, you might want to keep more in the emergency fund rather than putting it towards debt. While $1,000 can cover minor emergencies, it will be no match for the big stuff like large medical costs, major car repairs, or job loss.
There’s no single right answer here, but to come to your own conclusion, think about what you’re comfortable with. You can think of it in terms of months of living expenses you’d like to have covered if that makes choosing an amount easier.
What else do you plan to do with savings?
Aside from emergencies, your savings might be kept for a certain purpose. Are you saving for a house, wedding, or vacation? All of these things might be important to you and might mean that keeping the savings around instead of applying it to debt makes sense.
Better yet, maybe you plan to invest this money soon in the future, which could make more financial sense than paying of the debt by itself.
Can you do both?
Maybe the best solution is to pick a middle ground; use some of your savings to pay down the debt, but keep enough in the bank that you’ll feel comfortable rather than more exposed to problems down the line. Sometimes the peace of mind from having extra savings just makes sense versus doing what saves or earns the most money, too. And that’s perfectly okay.
One strategy may be to just pay off the debt with the highest interest, such as credit cards, and then gradually pay off the rest as income rolls in. You still won’t save all the money that you could by using all your savings, but you’ll at least avoid paying the highest interest rates.
Of course, if you’re considering this, there’s no excuse to not get serious about paying off debt with income. Perhaps even considering some less conventional yet effective strategies will make the task even easier.