Doucefleur // Shutterstock Between mortgages, loans, and credit cards the average American has around $104,215 in debt, including $6,501 in credit card debt, according to recent Experian data. When you know you have big, outstanding debt, you might be tempted to use your savings to pay off what you owe. In most cases, using your savings to cover outstanding debt isn’t a good idea. While it is important to pay down your debt and make regular payments, maintaining some sort of savings is crucial for financial security. Draining your savings is a dangerous habit that can impact your savings goals, livelihood, and credit. Prosper breaks down everything you should think about before using your savings to pay off your debt. What type of savings are you using? Before you consider if you should use your savings to pay off debt, it’s important to understand what each part of your savings is intended for. There are some savings you want to avoid using, while using other savings to pay down debt may help you save money over time. Savings is the money you have set aside for all of your financial goals. This could include your retirement fund, an emergency fund, stock investments, and money for a specific goal, like a down payment on a house. A retirement fund is normally an account like an IRA or 401k. In it, you set aside money to live off after retirement. Often, there are penalties for withdrawing these savings early. Draining your retirement fund to pay off debt is usually not a good idea. An emergency fund is somewhere between $1,000 to six months of living expenses set aside for emergencies. This could include layoffs, medical bills, or unexpected housing expenses. Don’t drain your emergency fund to pay off debt. Stock investments include money that you’ve put into the stock market. They can be a part of a retirement plan, but you can also make individual investments in the stock market. If your debt is growing and you have stocks, this may be a good fund to pay down debt. Other savings: It can be heartbreaking to withdraw money you’ve set aside for a specific goal, like a down payment on a house. Yet, this is one type of savings that can pay off your debt and save you money over time by avoiding interest payments. Feeling overwhelmed? Consider starting with learning about financial literacy. You shouldn’t deplete your entire savings (especially your emergency fund and 401k) to pay off your debt–here’s why. The risks of depleting your savings to pay off debt There could be penalties for draining your savings You may have spent years diligently putting money away for retirement. Pulling money from an account like this can come with some hefty fees. A withdrawal from a retirement account before you’re 59 ½ can result in a 10% penalty. Say you withdraw $30,000 to pay off outstanding debt. You could lose around $3,000 in fees. Lack of consistent work could leave you in a worse spot Are you self-employed or have a commission-based job? You’ll likely never know when a dry month is around the corner. Having savings you can live off of is vital. Draining your savings with unpredictable work could leave you in a much worse position in a month or two than you’re in right now. Potential for high-interest debt if new emergencies arise Draining your savings can leave you financially vulnerable. Accidents happen–from a medical emergency to your car breaking down. Incidents like these hinder your ability to make money. If you deplete your savings to settle your debt and then experience an accident, you might end up in a worse financial position than before. You always need money to support yourself, so you can avoid resorting to high-interest debt to get through a challenging situation until you can return to work. Using your savings to cover your debt won’t help you stay out of debt If you’re regularly dipping into your savings to make debt payments, you’ll likely have no savings at some point. Consider if your debt came from overspending or an unavoidable event. If it came from spending outside your means, re-examine your budget and determine where you can cut back or make more money. Balance debt repayment and savings Assess your debt and savings situation Ask yourself the following questions and get clear, concrete answers: How much debt are you in? What are your interest rates on each debt amount? What are the repayment timelines (if any)? What big expenses are coming up? How much do you have saved? What are the interest rates on each savings account? What are your financial goals (debt-free, buying a house, a new car, etc.)? These questions will help you get a baseline of your savings and debt. Make a budget and debt repayment strategy You can’t repay your debts or save for your other financial goals without creating a budget. Ask yourself the following questions to get started building yours. How much money do you make each month? (If your income fluctuates, try to find an average over the last year.) How much are your living expenses each month? What are your current credit card minimum payments? What are your current loan minimum payments? Comparing your income to spending helps you see if you’re living above your means. That way, you can cut back or consider a side hustle to pay off the outstanding debt or pad your savings. Make a plan to pay down your debt 50/30/20 rule: If you’ve never used a budget or find it hard to stay on budget, consider using the 50/30/20. Allocate 50% of your income to essentials, 30% to wants (like vacations, hobbies, or dining out), and 20% to paying down debt or adding to your savings. Many folks enjoy the 50/30/20 rule because it allows them to still indulge in little pleasures, like an occasional coffee run at your local coffee shop, happy hour with friends, or a fun trip. Prioritize high-interest debt: If some of your debt has a higher interest rate than the rest, you can pay off that debt first. This repayment plan is called a debt avalanche. People make the minimum payments on all their accounts but put any extra money towards their current highest interest rate. Once that debt is paid off, use any excess funds, including the minimum payment of your already paid-off debt towards the next highest interest rate. This method can save you a lot of money over time in interest. Prioritize smallest accounts: Is it hard to make payments on your highest interest debt because the amount feels huge? Consider building your momentum by using the debt snowball method or paying off your smallest debt first. Debt consolidation loans: Having a hard time keeping track of multiple credit cards and loans? Consider a debt consolidation loan, which combines many interest balances into one potentially lower rate. Make a debt repayment plan that doesn’t leave you with $0 Paying off your debt is not just about paying off debt today. It’s about establishing healthy financial habits, like healthy budgeting, knowing your financial situation, and only using your emergency fund for emergencies. These habits can last a lifetime and help reduce the amount you pay in fees and interest, as well as your debt and anxiety around money. Each little action matters. Much like interest, your spending habits will add up over time. Make sure your actions make you feel confident in your spending decisions. And, if you can help it, don’t leave yourself with $0 in your account. Frequently asked questions about using savings to pay off debt How much should I have in my emergency fund? While most experts recommend having at least six months’ worth of living expenses in your emergency fund, having any amount saved is better than nothing. If you haven’t started saving for an emergency fund yet, make a goal of $1,000 to get started. What if I can’t afford to save while paying off debt? Paying off debt and saving is a delicate balance. It’s smart to save up an emergency fund of at least $1,000 before paying down your debt, just in case. Then, you can focus on tackling your outstanding debt rather than saving. After that, you can concentrate on setting savings goals. Should I empty my savings to pay off my credit card? No, you shouldn’t empty your savings to pay off your credit card. This can leave you vulnerable to a worse financial situation. Instead, take baby steps to pay down your credit card debt while protecting your emergency fund. Is it better to pay off my credit card and have no savings? No, it is not better to pay off your credit cards and have no savings, as this could leave you in a tough situation if something happens–like your car breaks down or you have to make a trip to the hospital. In these situations, you could find yourself throwing those bills back on your credit card, which could trap you in a cycle of debt. How long will it take to pay off my credit card debt? How long it takes to pay off your credit card debt will depend on your income, savings, spending habits, and interest rates. Use a credit card payoff calculator to estimate how long it would take. You can speed up the timeline by negotiating with creditors to reduce your balance, interest rate, or both. This story was produced by Prosper and reviewed and distributed by Stacker Media.
Balancing act: Why you shouldn't empty your savings to pay off debt
Sep 17, 2024 | 12:30 PM
