|Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
The Dollar Stretcher website
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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? Thanks.
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
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
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 was 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
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