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Savings
or Debt Reduction First?
by Gary Foreman of The
Dollar Stretcher
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.
Kathy
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 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. You'll find hundreds of free
articles to help you save time and money. There's even a free
weekly ezine. Visit Today!
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