My former roommate was a hardworking guy with good values, but I could never understand his logic when it came to credit cards. We shared an apartment for 3+ years and during that time, he consistently had a balance on his credit card of a few thousand dollars.
If he was unemployed or going through some other hardship that could be understandable, but that wasn't the case. During this time he was gainfully employed with a good income and minimal living expenses. So he could pay off $5k in credit card debt during this 3 year period if he really set his mind to it… but he didn’t. The only reason?
“I want to keep the money in my savings account.”
He’s not the only one who thinks this way. From what I hear on my site CreditCardForum, there are quite a few folks out there who are hesitant about using savings to pay their high interest debt.
Credit card debt vs. emergency fund?
Some financial pundits like Suze Orman insist on having up to an 8 month emergency fund. I can’t disagree with that. In fact, I think it should be even larger.
However if you have unsecured debt (credit cards, personal loans, etc.) which you are paying interest of 10-20% or more on, I think you need to really weigh the pros and cons of tapping your savings to pay it off.
Since savings accounts typically only earn 1% or less interest these days, it’s not like your money in the bank is growing (in fact, its value is actually decreasing due to the 3-4% inflation). So that means the only reason to have the emergency fund is for exactly as the name implies – to cover emergency expenses.
In my roommate’s situation – since he had good credit and minimal living expenses – he probably should have plowed some of his savings towards paying down that high interest debt. Sure, it would have decreased the size of his emergency savings, but if push comes to shove he does have credit to tap.
In short, what I’m saying is weigh the pros/cons of two options:
(A) Paying off or decreasing the high interest debt by using some of your savings. Then if a costly emergency arises and you don't have enough savings to pay for it, as a last resort you will still have the credit to fall back on. Obviously this is not an ideal situation, but during the time in-between paying the debt and the emergency arising, at least you wouldn’t have been paying interest on the credit card.
(B) Keeping an ample amount of money in savings while carrying high-rate debt. This is exactly what my roommate was doing. He had over $10,000 in a savings account which probably earned less than 1%, all the meanwhile paying over 10% interest the entire time on his $5,000 of credit card debt.
There’s no one-size-fits-all answer to this, because everyone has different obligations (like a mortgage, which can’t be paid with credit in an emergency). But what I’m saying is that sometimes, automatically taking the stance that you should continue to build savings before paying debt isn’t always logical. You need to consider the advantages and disadvantages, based on your specific circumstances.
Credit card debt vs. investing?
On a related note, I knew someone who inherited a chunk of money and rather than paying off his high interest debt, he thought it would be smarter to “invest” the inheritance.
Simply put – unless his name is Warren Buffett – it’s unlikely his investment is going to yield a higher percentage than what a credit card charges. We all know the market return over the past 10 years has basically been flat, but even if you go out on a 50 or 100 year historical average, the return for the Dow is below 10% per year.
However keep in mind that earning the same as the indexes (Dow, NASDAQ, S&P) is actually unusual. Due to the irrational nature of us humans, most people earn below average market returns. Think you’re smarter than the masses? Well, keep in mind that over 50% of fund managers underperform the indexes, too!
So statistically speaking – whether you’re an amateur or professional investor – the odds of earning 15% to 20% annually are pretty darn slim. Plus, keep in mind that you have to pay taxes on those earnings. So even if you earned a whopping 20% in one year, it won't necessarily be worth more than the 15% interest on your credit cards.
Last but not least, I have heard from people who think that earning cashback, airline miles, or gas rewards makes sense (some even claim it’s an “investment”) while they have debt on their cards. When you consider the fact that even the best credit cards typically yield rewards worth only 2% or less, unless you’re paying 0% interest, than you are definitely not coming out ahead!
In a nutshell…
Paying off credit cards should be a top priority, because it’s highly unlikely your money will be earning more in a savings account, the stock market, or anywhere else for that matter.
Mike owns and operates CreditCardForum, where you will find his rankings of the top gas reward cards. However he urges people to remember that gas credit cards and other reward programs don’t make any sense if a balance is carried, because the finance charges will significantly outweigh the rebates.
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