Should I Use My Savings to Pay Off Debt?

Financial experts typically agree on a handful of principles, two of which are to save money and not to carry too much debt. Those two guidelines sometimes battle each other, especially in your own mind. That is: Should you use your savings to pay off your debt?

Your strategic answer to this question depends on your short-, medium-, and long-term financial goals.

Using Savings to Pay Off Debt

Regardless of your strategy, your goal is to get rid of your debt, hopefully without wiping out whatever nest egg you’ve built. Your savings probably give you peace of mind, while your debt does the opposite. Paying off your debt will bring you more serenity, so long as you don’t have to wipe out your savings to do it.

Transferring savings to your debt is only a temporary fix if you don’t address the habits that created the debt. Look at your recent spending patterns. Separating needs from wants, and trimming where you reasonably can, keeps new balances from taking the place of the ones you just paid off.

As you think about your best direction, distinguish between “savings” and “retirement savings.” The difference between the two is that retirement savings are (or should be) sheltered from immediate taxation as they sit in a 401(k) or traditional individual savings (IRA) or in a tax-beneficial Roth IRA.

It’s rarely a wise idea to dip into retirement savings to pay off a debt.

Once you decide on a payoff plan, create a budget for each month going forward. Then execute your plan.

A quick tip: Rarely can someone pay off debt in one transaction. For a great majority of us, eliminating personal debt happens incrementally, with long-term, month-after-month payments.

You won’t see much progress if you constantly look at the goal and where you are today. You’ll feel better about your effort if you peek at the results every three or six months. You’ll see a shrinking debt line and know that you’re on your way to achieving something meaningful for yourself or your family.

When Is Paying Off Debt with Savings the Right Choice?

On one level, analyzing the tradeoff of savings vs. debt payoff is a math problem. One equation is looking at the interest that your savings are generating every month or every year vs. how much interest your credit card charges you per month and year.

Take it one step further and do the math. Look at how much you save on one side vs. how much you get charged on the other.

It’s almost certain that the interest on your savings account (even a high-yield savings account) won’t touch the interest charged by your credit card company. This calculation will tell you a lot. You want to compare your debt’s annual percentage rate (APR) to the annual percentage yield (APY) from your savings.

APR is the annual cost of borrowing money, and it includes interest and fees. (You want this number to be as low as possible.)

APY is the yearly return on savings or investments, including compound interest. (You want this number to be as high as you can get it.)

For most people, credit card debt is the No. 1 problem to attack. And it should be. Credit card companies often charge their customers 20% or higher interest. For most Americans, this is the highest-interest debt they’ll have.

The worst kinds of personal debt include:

• Credit card debt
• Car title loans
• Payday loans

Some scenarios are well suited to tapping your savings to make a debt payment. One of those is resolving the balance of a revolving credit card. Getting credit card debt to a zero balance will immediately improve your credit score, which improves your ability to borrow money for an investment, such as a home mortgage.

However, be careful not to put every last dollar of your savings toward your credit card debt. Preserve your personal emergency fund to handle unexpected bills that inevitably arise. If you don’t keep some cash tucked away for those expenses, you’re likely to have to pay for them with a credit card, creating a situation in which you’ll have another major debt to pay off.

Hidden Disadvantages of Paying Off Debt Early

When you get to the point that you want to be rid of your debts forever, there’s a temptation to look for ways to pay it all off at once and be done with it. That’s an admirable notion, but it’s not always the best approach.

It’s better to have cash hidden away for emergencies. You never know when one is going to hit. Car accidents, fires, health concerns, issues with parents, kids, grandkids or a spouse. Life happens, and when it does, you want to be able to reach cash quickly.

Resist the temptation to apply so much of your savings to pay off debt that you don’t have money to deal with an emergency situation.

One more thing to check before a lump-sum payoff: prepayment penalties. They’re far less common than they used to be. Federal rules that took effect in 2014 barred them on most home loans, and where one is still allowed, it can’t last beyond three years or cost more than 2% of what you pay off. FHA, VA and USDA loans don’t carry them at all. You’re more likely to run into a penalty on a home equity line of credit, a loan on a rental property, or certain personal and auto loans. Read your loan agreement or call your servicer before you make a large payment.

Another hidden disadvantage is the opportunity cost. That means you’ll never know how much you could have generated from the money you spend by paying off your debt early. This is especially true if you’re paying off a student loan or if you’re paying off a mortgage.

Student loan debt and mortgage debt stand apart from other debts. Student loan debt is fixed. The terms won’t change. Mortgage debt is typically tied to a growing asset. Odds are the home you want to pay off will be worth more at the end of the loan term than it was at the beginning.

When you pay off debt, you’re moving money from one of your possessions to someone else’s. The kicker is you won’t get it back.

If you aggressively pay off debt, you may lose the chance to make a later financial investment that could generate more money. One example of this is, again, a house that you find after you have made a large payoff and now cannot afford. If you don’t have the money, that house is going to someone else.

There are two other things to consider. One missed opportunity is retirement savings. Instead of paying off your student loans early, you’d be better served to pump that extra money into your company’s 401(k), a personal traditional IRA or Roth IRA. In all three instances, that money will double, triple or quadruple (depending on your age) before you’re ready to use it.

The second consideration is your credit score. Paying off debt early doesn’t always help it the way you might expect. Although eliminating debt is a positive for you, your score can drop when you close an account. Often, that dip is temporary. If you close out multiple accounts at the same time, “temporary” could last a little longer.

Don’t let a short-term dip discourage you. Keep making on-time payments on your existing accounts and avoid taking on more debt, and your credit score will grow over time.

Finding Your Financial Balance

The most effective way to handle a savings-to-debt transfer is to keep it balanced. That includes keeping your emergency fund intact while consistently and aggressively paying off your balances.

Consider one of two structured, time-tested payoff strategies: the snowball or the avalanche.

With the snowball strategy, you pay off your debts in order from smallest balance to largest balance. This gives you small payoff wins at the start, building your momentum and giving you confidence that you can get this done.

In the avalanche method, you tackle your debts in order of interest rates, from highest rate to lowest. The balance on each card is mostly irrelevant because you first want to get rid of the ones that are costing you the most money.

Either method works so long as you stick to a regular payment plan. You can help yourself with this regularity by automating your payments and ensuring that you make payments on time, avoiding penalties and late fees.

Set up autopay options through your bank’s website. Make sure you don’t target payments that could overdraw your cash or checking account and accidentally run up overdraft fees. Even small payments multiple times a month add up over time. You will knock your debt down.