Having a cushion of cash in the bank to cover emergencies is always important, particularly if you’re paying off debt. Sure, throwing all of your money at your credit cards or student loans will wipe them out faster but if you don’t have a rainy day fund set aside, you might end up having to take on additional debt if an unexpected expense pops up out of the blue.
If you’ve built up a decent amount of savings, using some or all of it to knock out a big chunk of debt all at once is pretty tempting, especially if it could save you money on interest. Whether or not you should do it, however, really depends on the answers to these four questions:
1. How Much Is the Debt Costing Me?
The first and most important thing to consider if you’re on the fence about paying off debt with your savings is what you’re paying in interest. For instance, if you owe $5,000 on a credit card that’s got an APR of 15 percent and you’re making a $150 payment each month, the interest would cost you just over $1,500 by the time it’s paid off. On the other hand, if you’ve got a 9 percent rate the interest would be cut in half.
Figuring out the interest is important because it puts how expensive the debt is in perspective. Instead of looking at it as draining your savings, the better way to view it is in terms of what you won’t have to spend on interest if you go ahead and wipe out the debt.
2. How Much of My Savings Am I Comfortable Parting With?
As a general rule, having three to six months’ worth of expenses saved is recommended for an emergency fund but the actual amount you’ll need depends on a lot of factors. If you’re single and your cost of living expenses are relatively low, for instance, you may be able to get away with having less money in the bank.
Knowing where your comfort zone is can tell you if you should or shouldn’t pull money out of your savings to pay off debt. If you’ve got $10,000 in debt and $12,000 in the bank, you have to think about whether knocking it down to $2,000 is going to keep you up at night. If you get sweaty palms just thinking about it, becoming debt-free ahead of schedule may not be worth the anxiety that goes along with having less money in savings.
3. How Quickly Could I Build It Back Up?
If you’re okay with using some of what you’ve socked away to pay off debt, you need to have a plan for replacing it down the road. Ideally, you’d want to be able to build your cushion back up relatively quickly so that you’re not vulnerable to a financial emergency such as a job loss.
Taking a look at your budget can tell you what kind of cash flow you’re working with. Obviously, if you’re not making payments towards your debt anymore you can shift that money over to savings but you shouldn’t stop there. If you can find a few extra dollars by getting rid of cable or changing your cellphone plan, for example, you can tack that on to the total.
Setting a time frame for achieving your goal can help you to get on the right track. For instance, if you’re taking $5,000 out of savings and you want to put it back in your account within six months, you’d need to set aside $833 a month to hit your target. Breaking it down on a monthly or weekly basis can help you decide if your plan is realistic.
4. Is There Another Option for Paying the Debt off Faster?
Paying off debt is a time-consuming effort and that’s why using savings to get rid of it is so appealing. However, it’s not the only way to speed up the process. Before you raid your account, it’s worth it to look at some other possibilities for getting out of debt faster.
If you normally spend windfalls, for example, throwing them at your debt is a much better way to make use of them. Transferring your credit card debt to a card with a 0 percent promotional rate can also get the ball rolling more quickly. When you’re not throwing away money on interest each month it’s a lot easier to chip away at your balances.
Stepping up your income can also help you achieve debt freedom more quickly. Taking on more hours at work or picking up a part-time job can bring in few hundred extra dollars each month. You could earn even more by starting a side hustle, such as freelancing or tutoring, and both of those are things you can do without even leaving the house.
The Bottom Line
Using savings to pay off debt is a smart move as long as it doesn’t put you at financial risk. If you know that a shake-up is coming at work that could affect your job or you’ve recently developed a health condition that requires ongoing treatment, you may be better off holding on to your cash instead.