Lots of people make financial mistakes, and here is an old question that people typically ask when wondering if they are doing the smart thing with their money. The question for today is whether or not to use savings to pay off debt (like credit card debt for instance) or to keep it in savings and continue to build.
Some people love to have that cushion of money sitting in their bank account and don’t want to use it up to pay off debt because it just feels better to them having a comfortable cushion to sit on. Is this smart?
People rationalize all kinds of things and find ways to make sense of nonsensical in their minds, while on paper it doesn’t look so good.
This one seems pretty simple to solve as all one needs to do is figure out how much interest one is collecting from the money that is sitting in savings, and then figure out just how much interest one is paying on the debt they’ve incurred. If you have enough money in savings to pay off the debt, and the interest being earned on the savings account (typically 0%) is less than the amount being paid on the debt, then one should definitely pay off the debt and rebuild the savings again once it’s paid.
Let’s say you have $10,000 in savings and about $10,000 in credit card debt. Let’s also say you’re paying just under 10% on the debt, and making 0% on the savings account. You have other types of “savings” accounts that earn interest, and together the total of your “savings” is around $30,000. But again, your brain is telling you that the combined cushion of those savings accounts feels good because it seems like you have that $30,000 to make you comfortable.
But it isn’t true. You really only have $20,000 in savings because the debt cancels out $10,000 of it and is consistently eating away and any profits you might be getting from the interest gained on the other accounts because you are paying $1000 a year for the privilege of saying you that you have $30,000 in savings. So, with that in mind, it makes much more sense to pay off the high-interest debt and start again saving that money back up.
If you do, you will have a little more money make that happen since you won’t be throwing it out the window anymore paying all the interest on the debt, and should be able to build that saving back up relatively quickly. But if you leave the money in the savings, and continue to pay interest on the same amount of money that you could be paying it off with, you are only hurting yourself by believing the illusion that you have more of a cushion than you actually have.
On the flip side, if you have money in stocks or other types of investments that are producing a higher return than what your debt is costing you, then clearly holding the debt is a positive thing.
For example, if you have a $100,000 loan out on your house with a 5% interest rate, and at the same time, have $100,000 invested in the stock market making you an average of 10% a year, then clearly you want to keep the debt. Your yearly interest payment is $5000, yet you’re collecting $10,000 in investment returns.
So, the lesson here is to stop rationalizing about money, and always make decisions based on cold, hard facts. Only then will you know that your decisions about your assets will be prudent, and your investments will be sound.