A reader emailed to ask the following question:
I currently have around $2,300 in my savings account and just under $2,000 on my credit card. I realize that I could easily pay off my credit card debt with the funds in savings but I’ve worked really hard to get that savings balance up and will feel like it’ll be a blow to my personal finances if I use it for the credit card. I’m not sure what is the best move here. Should I pay off credit card with savings or keep my savings as an emergency fund and slowly pay down the debt each month?
This is a common question and I tend to see a lot of people asking the same thing on various personal finance message boards. Most people will find that they get several pieces of advice, with most of that advice starting with the words: it depends…
So what does it depend on? The first things to ask yourself is whether or not you have a stable income source/job. The second thing to ask is what the Interest rate on the credit card is.
If you have a stable income and your credit card has more than 2% interest rate then it’d be my opinion that you should pay all of the credit card off using the savings. The reason for this is that you’d be losing more money in interest on your debt and inflation than you would make from your savings account. Thus you’d end up saving money in the long run, particularly if your credit card interest rate is quite high.
Consider that 18% is now a common interest rate for many people’s credit cards. With a $2,000 debt on that card, you’re paying approximately $30 per month on that debt. That’s $30 extra dollars you could be saving if you had paid the debt off completely.
But I won’t have any money for an emergency
This is a common objection for using your savings to pay off debt and understandable. However, if the card is kept open after paying it off then you can just tuck it away for an emergency until you are able to build your savings back up again for a proper emergency fund. While this is not ideal, the worst case scenario is that you just end up back where you started with the same credit card debt.
Of course, the key here is to ONLY use that paid off credit card for a desperate emergency. And an emergency does not include needing money for a night out with friends or buying a new set of clothes. After all, the whole point of using your savings to get out of debt is so that you’ll hopefully stay out of debt. The plan falls apart if you run up a balance again.
What if you don’t have a stable income
If you don’t have a stable income source then you’ll likely want to keep at least a portion of your savings. The idea is that since your income is not reliable, then your budget situation is much more shaky and you will more likely need that savings for things that you can’t pay with a credit card, like rent or mortgage for instance.
So in this case, it depends on how much is in your savings account and what you’re comfortable with as a cash cushion. Some gurus like Dave Ramsey recommend having $1,000 in your savings, then using the rest to pay off debt. Others would likely say 3 months of earnings is needed. Personally, I think a good cushion would be 3 months of minimum living expenses.
Either way, the question of should I pay off credit card with savings isn’t as simple to answer without more information about your situation. As mentioned above, much will have to do with the stability of your income source.