Email question: What is the best way to pay off debt?

Hi Pete,

My husband and I recently bought a house which took a good portion of our savings account. Over the next few months, through the course of unexpected home repairs, etc. and general "moving into a new home" expenses, we incurred a bit of credit card debt. (Note - this was before we got on our new, "Pete the planner" monthly budget system, which we have now stuck to for two straight months!). Basically, the amount remaining on our credit card is just about equal (slightly less) than what's currently in our savings account (which is close to 2 months of expenses).

So my question is - should we use the majority of our savings account to pay off the debt once and for all and then work aggressively to build the savings back up? Should we leave the money in savings untouched and work aggressively each month to pay off the debt (ie. redirect the 10% from our budget for savings into the CC along with any other "left over" money from other categories)? Or should we still be contributing to savings each month which would mean paying less on our CC? We know how important it is to have the emergency savings fund (and we know ours needs to be bigger) but we also hate the idea of paying interest charges each month knowing we technically have the cash to pay it off.

Thanks!

Kelsie

Hey Kelsie and Husband, welcome to homeownership! Your email had me chuckling with your "moving into new home expenses." Not chuckling at you of course, chuckling with you. This is the part of homeownership everyone forgets about when they are buying a house. I'm betting your pre-house purchase conversation went something like this:

Spouse #1: Should you put the majority of our savings into a down-payment?

Spouse #2: Yeah, I've always read it's good to have a bigger down-payment.

And technically, Spouse #2 is correct, a bigger down-payment is a good thing, but when it wipes out your savings you will definitely run into problems. As you have learned firsthand, Kelsie.

I'll get to the actual answer to your question here in a minute, but first I want to remind you of the bucket system. Have you read the blog post about the buckets before? If not, I'll give you a crash course. Your savings shouldn't be lumped all in one pool, your money should actually go into three "buckets".

Short-term bucket = your emergency fund

This is three months worth of expenses and it should be used for actual emergencies. This is not money for a downpayment. Having an emergency fund is the buffer which keeps you from using a credit card. Does your furnace need fixed? Okay, use your emergency fund for the repair and then immediately begin re-saving until you are back at your three months expenses level.

Mid-term bucket = extra savings

If you have a fully funded emergency fund and are contributing to your retirement account (we'll get to that in a minute) then all extra savings goes here. And guess what? You can do WHATEVER you want with this money. It's for a downpayment, a new car, investing, travel, a hamster farm, basically this money is for whatever tickles your fancy.

Long-term bucket = retirement savings

First goal: meet the match, second goal: increase your contribution percentage annually, third goal: meet the government's cap.

So what does all this have to do with your question? Everything actually. You are past the point where you can prevent the credit card debt, but that doesn't mean you can't learn from your mistake. This is how you should save money from now on.

Finally, I'll get to the point. Here is the answer to your question: The technical advice is that you should use whatever you have on hand to pay off your debt because paying interest is bad, but the practical advice isn't so cut and dry. The real question is, will you be more motivated to pay off debt or to save money?

The one true benefit of debt is that it's the perfect opportunity to address and fix bad financial behavior. The technical advice of using your savings to pay off debt doesn't really teach you a lesson. Sure it feels good to pay off debt quickly and painlessly, but it doesn't do anything for your net worth.

The practical advice, which is harder to do, but better for your financial life, is to pay off the debt with your income. By cutting expenses, bringing in more income, or some combination of the two, you can aggressively pay off your debt in a few months. What does this do? It creates a great habit of living off of less, or in different words, it breaks your dependence on your income. Once your debt is paid off you can use your new habits to help you build up your emergency fund.

A third, middle ground option, is to use some of your savings to pay off debt, perhaps leaving $1,000 in your savings. Once the debt is paid off then you can work towards building your savings.

Kelsie, I also answered your question on The Pete the Planner Radio Show on WIBC so if you prefer to listen, I've got you covered.