Should you use your savings to pay off debt?

Written by
Peter Dunn

Hi Pete -

I started a new job in Indy at the end of January 2014. Along with the new job came a larger salary (yea). I am excited to relocate to Indy so I can be closer to family. I have family located here and they are allowing me the opportunity to live with them while I figure out where I want to live and while I sold my house in the city I was moving from. This opportunity of being basically rent free has been wonderful and given me the opportunity to pay off existing debt such as student loans etc and position me for better things down the road.

I am down to my last $7500 in debt which is on a credit card at zero percent interest until July 2015.

My question is how to allocate my funds. I am working to save for a larger down payment on a house and I'm $10,000 away from my goal amount. I currently have $30,000 saved but I would like to ultimately have $40,000 available. I don't plan on buying a house for at least 6 months and maybe longer because I'm not sure where I want to end up within the city.

I also have an emergency fund which I dipped into in order to pay off some of my student loans because they were at an 7% interest rate. So, my emergency fund is currently at $5,100. My goal is to have at least $10,000 in it and hopefully longer term around $15,000.

So my question is where do I focus my attention? Should I look to get my emergency fund built back up to at least $10,000 because I can earn interest on it (I have it in a higher interest saving account rather than just a normal savings). I have been really focusing on being debt free before I move out of my free housing situation at the end of this year; but, at this point, I'm not sure how to make the most of the money I have right now. I've been working the numbers multiple ways and if I borrow more from my emergency fund, I can pay off my CC this month. I like that idea because it fits with my debt free strategy. However, I also want to make my money work for me. So, I'm wondering if I shouldn't just keep rebuilding my Emergency Fund and House fund with my extra funds and budget to have the CC paid off around July when my deal ends.

What do you suggest? Thanks.

Teresa

Teresa, congrats on a great situation! I'll give you an answer, but just know you're doing great.

For many financial questions there is a technical answer and a practical answer. I try and find the sweet spot in between those, so let's dive in.

First off, don't worry about gaining interest on your emergency fund. The idea of earning more interest is appealing. I get it, but any interest you would earn is insignificant. Your emergency fund is not intended to gain interest. It's there for you to use when emergencies arise. See my "buckets" post for more on which funds are meant for growing.

You mentioned you are hesitant to pay off your credit card since saving the money could potentially earn you interest and your credit card is interest free. I understand the logic here, but math is only one facet of this issue. Even though your credit card isn't charging you interest there is still a monthly obligation to make a minimum payment on the card. This is what you should be concerned with. Regardless of interest, having debt is a suck on your current income. It keeps your current money in a relationship with your past, and doesn't allow it to be used for your present or your future. This is why paying off debt should be your priority.

But as much as I want you to pay off your debt, I don't want you to use your savings to do so. Taking a chunk of your savings to pay off your credit card does absolutely nothing for your net worth. It's a lateral move. From now on you need to make decisions based on how they impact your net worth. The only way to increase your net worth while paying off debt is to use your income. You have six months in your rent free situation, use it. Determine how much you need to pay on your credit card each month to have it paid off by the time you move out and make it happen.

Aggressively using your income this way will do two things. First it will get you debt free before you move out, and secondly, the moment your debt is paid off you can move that money toward building your emergency fund.

Using your income, not your assets, to pay off debt is the best way to reach financial goals while increasing your net worth.

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