Financial advice can be a little hard to follow. We’re supposed to be saving for emergencies and paying down debt and planning for retirement and investing? Talk about confusing. If you have debt, It may seem easiest to simply throw all your extra cash at your loans instead of setting up a savings account and hope that gets you ahead. And it’s true, paying down your debt is a smart way to stay financially healthy, but should you use your savings to pay off debt? The answer might surprise you.
Here’s what you need to know before emptying your savings account:
The Importance of Saving for Unexpected Expenses
More than half of Americans do not have enough cash easily accessible to manage a $1,000 emergency . That means that a child’s broken arm, a car repair, or even just an unexpected trip to see a sick family member can bring them into the red.
When you take out debt, even to cover small expenses, you usually end up paying more over time as interest accumulates. That means that your $1,000 expense that you put on a credit card can end up costing you much more by the time you actually pay it off. This cycle is one reason why it can be a good idea to have an emergency fund.
An emergency fund can help when hit with an unexpected expense, so you don’t have to rely on credit cards or help from family or friends to meet your needs, which can sink you deeper into debt. But how do you know when to stop saving and start putting that money towards paying off debt instead?
A healthy emergency fund should be able to cover all your expenses for at least three months . Yes, that is much more than that $1,000 emergency, but imagine what would happen if you were to lose your job and be out of work for several months. How would you pay your car payment, your mortgage, or your child’s tuition?
Many of us are tempted to answer that we would put it on a credit card, but relying on credit cards to cover emergency expenses can create a risk that your debt can spiral out of control.
Instead, you might aim to have more than enough to cover day to day living expenses for at least a few months saved up. That way, you know that you won’t be stuck putting ramen noodles on a credit card if you unexpectedly lose your job.
Whether you’re shooting for three months or a full year of savings, an emergency fund should be easily accessible, so that if that emergency arises you have quick access to your cash.
Using Savings to Pay Off Debt
While saving for emergencies is important, so is paying down debt. Everyone’s situation is different, of course, but there may be some major downsides to cashing out your entire savings to pay down debt. For one, using all your savings to pay off debt means that when the $1,000 (or more!) emergency inevitably pops up, you might not have the cash on hand to cover it.
In that case, you could find yourself needing to rely on credit cards to cover the expense, starting the cycle of debt all over again. Think of it this way—it can be much harder to get yourself out of debt if you keep using credit cards to cover unexpected costs.
Instead, you might focus on slowly paying down debt while building up your emergency fund. That way, you can focus on paying off high-interest credit cards without putting more unnecessary expenses on them.
Some people also wonder about using retirement savings to pay off debt. In general, saving for retirement early is one of the smartest things you can do to protect your financial future. The main benefit of saving early for retirement is that your savings have time to grow.
If you pull your retirement out of savings in order to pay down debt, you take away the opportunity for that money to accrue interest over time, which means you can miss out on the extra money when it comes time for retirement.
So should you ever use savings to pay off debt? Once you save up an emergency fund and make a plan for retirement, you might consider putting some extra cash towards debt, particularly high-interest debt like credit cards. Just remember, prioritizing a healthy cash reserve can help keep you from getting stuck in debt to begin with.
Using a Personal Loan to Save Money On Debt
One reason most people are tempted to use their entire savings to pay off debt is that they know that the longer they take to pay, the more interest will accrue. Which means that, in the long run, you may end up paying large amounts of interest on top of the initial amount you borrowed.
This is especially true with high-interest debt, like credit cards. One alternative to dumping all your savings into your debt, while still (ideally) saving money on interest, is to consolidate your debt with a personal loan.
Using a personal loan to pay off debt may sound counter-intuitive at first, but many people find that taking out a personal loan to pay off high-interest debt can be a major money-saving measure because, in general, credit card interest rates tend to be much higher than personal loan interest rates.
Consolidating high-interest debt by trading it in with a personal loan may help you lower your interest rate, which may help to save you some serious cash on your debt—and help you pay it off faster.
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