Using Savings to Pay Off Debt: Good or Bad?'/

Undoubtedly, you’ve heard these two most common pieces of financial advice:

  1. Build an emergency savings account
  2. Pay off debt as fast as possible

While both of these instructions are extremely straightforward, things get a bit murky when it comes to the order in which you’re supposed to do them in. Do you pay off debt before saving money? Or do you set aside cash before ridding yourself of debt? Or do you do both simultaneously?

Mentally, most people want to be unburdened from their debt as quickly as possible. So they’ll funnel all their spare dollars towards paying off an outstanding balance. And in many situations, this makes the most sense when it comes to their bottom dollar, too.

Interest rates on savings accounts continue to remain extremely low, hovering between 0.5 and 1 percent. Which means that currently, you’re earning virtually nothing by having your cash stashed in savings. In contrast, interest rates on car loans, mortgages, and credit cards is typically higher—sometimes, significantly so (especially in the case of plastic).

For example, if you have a credit-card balance of $10,000 that levies a 17.75 percent interest rate, and you have $10,000 in the bank earning 0.75 percent interest, it’s undeniable that you’re losing money from your bottom line by leaving the money in savings while slowly paying off your credit-card debt.

But let’s say that you transfer that outstanding $10,000 balance to a card that offers 0% APR for 18 months. You’re financially ahead to keep your money in savings—you’ll earn a bit of interest, after all—provided that you pay off your credit card debt before the introductory interest-free period ends.

What if you have an emergency, however, like your hot water heater dies or you’re in a fender bender and your car requires $2,000 worth of repairs? If you’ve been focused solely on paying down your existing debt and don’t have any money set aside, you will be forced to pay these bills with your credit card, adding to your existing balance. Paying with plastic, as opposed to money from your savings account, will end up costing you more in the long run because of the additional interest you’ll be charged.

Because of this, paying down debt while also building your emergency fund is ultimately your best option. This is especially true if you only have low-interest debt like a mortgage or a car loan. But even if you have high-interest credit-card debt, you should try to set aside something every month while also putting something towards the outstanding balance.

Otherwise, you’ll always be replacing old debt with new debt. And that’s a cycle that is virtually impossible to break free of.

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Published July 1, 2013 Updated: July 8, 2013
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