Which should he do first?
Emergency Fund or Debt Repayment?
by Gary Foreman
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Right now I owe $3100 on my credit card. I have $6000 in my savings, but I am trying to hit a benchmark of $10,000 in my savings. The way I've been saving I should hit the $10k mark in three months. However, the balance on my credit is glaring. My total credit limit is $4500. Should I pay this debt immediately, slowly, or continue to pay a small amount just over minimum until I hit my bench mark of $10k in my savings?
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 debts?
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 surfaces.
I'm guessing, but I suspect that you started saving because you became tired of having unexpected expenses that could only be paid 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.
Next, let's examine the math of the question. If you're asking about the quickest way to both save $10k 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 $3100 from savings to totally pay off the credit card balance, but some would argue against that. This leads us to the final way to look at your question.
Would you like to
pay off your credit cards
in less time
for less money?
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!
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.
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