You’re ready to take control of your finances. The problem? Your savings account is nearly empty and your emergency fund? It doesn’t exist. At the same time, you’re struggling with thousands of dollars of credit card debt.
This leads to a big question: Should you pay off your credit card debt first or concentrate instead on building your savings?
The answer is complicated. But the consensus from financial pros is simple: If your credit card debt comes with a high interest rate – and it usually does – focus on paying that down first. Just make sure that you have at least some cushion of savings while you do this.
It’s little surprise that financial professionals recommend that consumers tackle that credit card debt as quickly as possible. The high interest rates that come with credit cards cause this debt to grow quickly if you don’t pay it off in full each month. Making just the minimum payment each month means that you’ll pay thousands of dollars in interest before you pay off your debt.
Just consider this example: Say you have $6,000 of credit card debt at 17% interest. If you never make any additional charges on that card and you only make the minimum required payment each month, it will take you 118 months, or more than nine years, to pay off what you owe. You’ll pay more than $3,099 in interest during this time.
Devin Pope, certified financial planner with Albion Financial Group in Salt Lake City, says that most credit cards charge interest rates ranging from 9% – 21%. These high rates can be overwhelming as you watch your card’s balance grow each month, even when you make your minimum payments on time.
Because of that, Pope recommends that you devote extra money to paying down that debt as quickly as you can.
“The interest charges per month can make it difficult to climb out of a debt hole,” Pope said. “Even if you don’t have a cash reserve, getting out of the debt hole makes sense.”
But it’s equally clear why financial experts recommend, too, that you build at least a small financial cushion of savings while you’re paying off your credit card debt. If you don’t have this emergency fund, what happens if your car’s transmission blows or your home’s furnace conks out in the middle of winter? If you don’t have an emergency fund saved up, you’ll have to pay for these repairs on your credit card. That will boost what you owe and result in even higher interest payments.
Aaron Norris, vice president of The Norris Group, a California-based real estate investment company, says that the benefits to having an emergency fund of savings are massive. Experts say you should have from two months to a year’s worth of daily living expenses saved in such a fund. Norris says that having a six-month reserve provides a sense of financial security that he calls “hard to describe.”
But he also says that paying down that credit card debt should be a top priority. Again, this comes down to the amount of interest consumers pay when they have credit card debt that they don’t pay off in full each month.
“Chances are, you’re making some large interest payments in your life and you just aren’t paying attention,” Norris says.
Say you’re carrying a balance on a credit card that charges 15% interest. Is your savings account of emergency fund dollars earning 15% interest? Certainly not. Paying off that credit card debt, then, will save you a significant amount of money.
Norris adds, “By paying down that debt faster, it’s like you’re earning that interest on your money because you aren’t paying it to someone else.”
Balancing these two competing interests then – building savings while paying off high-interest-rate credit card debt – remains the challenge. You’ll have to look carefully at your household budget to make sure you have money to both pay off your credit card debt and build an emergency fund of savings.
Just be realistic with this budget. Only devote dollars that you can actually afford. If you can only save $100 a month in an emergency fund, that’s fine. After a year, you’ll have saved $1,200. If you can only afford to pay $200 a month toward your credit card debt, that’s fine too. Just make sure that you don’t keep adding to that debt by making additional purchases with your card.
When you are looking at your budget, cut out as much discretionary spending as you can. If you reduce the number of meals you eat out, you can devote that extra money to paying down your credit card debt. Just be realistic: You’ll want to eat out occasionally. Budget accordingly.
Marques Lang, business and financial wellness coach with Paradigm Consulting & Coaching in Hood River, Oregon, says that from a purely financial standpoint, aggressively paying down your credit card debt makes the most sense.
But, as Lang says, “Life is not best lived by solely looking through a financial lens.”
Lang recommends that his clients pay off their debt while also saving at least some money for an emergency fund. How much they devote to each goal depends on such variables on how much these clients earn, how big their credit card debt is and how much they must spend on other expenses such as mortgage payments or rent.
Why not devote all your spare dollars to credit card debt? Lang says that such an approach will inevitably lead to even more credit card debt in the future. That’s because emergencies almost always pop up.
“If an emergency arises, and you don’t have any savings, it doesn’t matter how much debt you have paid down,” Lang says. “You are going to charge the emergency to a credit card or let it go into collections. Then you will be right back in the position you started in, or worse. Even if the emergency fund is a relatively nominal sum, it will provide a cushion when the rainy day inevitably comes.”
How are you balancing debt and saving? Let us know in the comments below!
The post Pay Off Credit Card Debt or Build Savings? It’s the Big Financial Question appeared first on ZING Blog by Quicken Loans.
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