Savings or Debt Reduction First?
By: Gary Foreman
Dear Dollar Stretcher,
When planning a budget should I use extra money to pay off credit card
debt? Or should it go in a savings account?
Based on the number of similar questions we get, Kathy is not the only one trying to answer this question. And, if she's asked friends, she's probably found people who will tell her that it's absolutely essential to pay off the credit cards first. She's also probably found other people recommending an immediate savings program. So who's right?
The truth is that neither side is right for everyone. This is one of those situations where the right answer for you might not be the best choice for Kathy.
We'll begin by looking at the purely financial side of the issue. Whether you're paying off a credit card or putting money into a savings account you'll get a return on your investment.
When you repay debts you're paying back some principal this month to avoid
owing an even greater amount next month. How much greater is determined by the
interest rate that you're paying on the account. According to Bank Rate Monitor www.bankrate.com
the average on a credit card account runs from 15.5% to 18% now. So any money
that Kathy pays on her credit card account will earn that rate.
On the other hand, she could put the money in the bank or a money market account. Depending on what she chooses, she'll earn between 4.5 and 7% on her money.
There are probably a few of you that are thinking that we should include taxes in our calculations. After all some interest (home mortgage for instance) is deductible on our income taxes. And almost all income will be taxable.
It's simple to adjust for taxation. Begin by finding out if the interest paid or earned is taxable or deductible. If so, you'll need to reduce the interest rate by your marginal tax rate. The math is pretty simple. Just multiply the interest rate by your marginal tax rate.
For example, suppose that you were earning (or paying) 10% and your tax rate were 15%. Multiply 10% by 15% (.10 x .15 = .015 or 1.5%). Subtract that from the original interest rate (10% - 1.5% = 8.5%). So 8.5% is the actual after-tax rate that you're paying or earning.
Generally, the only interest that's tax deductible is for your home mortgage. And you can expect most savings to be taxable except for retirement plans.
One side issue. Some of you are thinking that we forgot to include employer contributions if Kathy puts her savings into a 401k retirement plan. We did that for a reason. Savings in a 401k plan generally aren't available for the type of periodic emergencies that families face. You'll see why that's important in a minute.
OK, so we know how to compare the after tax return between savings and debt reduction. And, most of the time, you'll earn more on your money by paying off debts. It all seems pretty simple. Those that advise getting the highest return say Kathy should pay off debts first. And, admittedly, they have a pretty good argument.
So why would anyone suggest that Kathy begin a savings program first? And why do they think it's so important? Again, the answer is fairly simple. They think that it's essential for Kathy to stop using credit cards as a crutch.
The scenario works like this. Suppose that Kathy uses extra money to pay off debts. And she's doing good until the car breaks down. Since she doesn't have any savings, she'll pull out the plastic to pay for the repairs. Naturally, she won't be able to stick to her plan this month.
But, she does get back on track. And stays there until two months later when the water heater dies. One plumber later she's added another $350 to the card balance. And she's beginning to get the feeling that maybe she can't eliminate the credit card debt. Soon she throws in the towel and begins to charge up a storm just like the old days.
Those advisors who think that savings come first believe that Kathy is more likely to be successful if she follows a different path. They tell Kathy to pay cash for everything that she buys. Or, if she just can't cut up the cards, at least to pay for any new purchases completely when the credit card bills arrive. No more accumulating debt.
Let's replay our scenario. Kathy faces the broken car test. But instead of breaking out the plastic, she has built up some savings over the months and uses that to pay for the repair.
A couple of months later it's the water heater. Again, she dips into savings for the repair. By now her savings are pretty well depleted, but she still hasn't had to use a credit card to borrow any money. Her resolve to not add any additional debt is still intact.
And that's the key. Those who favor saving first say that people need to draw a line in the sand (i.e. no new debt) and enjoy some success (i.e. paying an 'emergency' bill) if they're going to stick with a program long enough to pay off their debts.
So who's right? That really depends on Kathy. If she has trouble overcoming obstacles, then perhaps she would be better off to save some money first and resolve to pay cash for any new purchases. It might take her longer to get out of debt, but she'll have fewer disappointments and reasons to give up along the way.
On the other hand, if Kathy's a persistent person, she'd be better paying the debts first. Sure she'll face some months where unexpected bills interrupt her progress. And she'll need bulldog determination to stick with the program. But, paying off her debts first will generally give her a better return on her money.
We hope that Kathy selects the program that matches her personality and soon all her debts are paid in full!
Gary Foreman is a former Certified Financial Planner who currently edits The Dollar Stretcher website (www.stretcher.com) You'll find hundreds of free articles to stretch your day and your budget.