You probably know that having savings can keep your finances from falling apart by using it to pay off debt. There are also other reasons why this is such an important part of your monetary situation. In fact, most experts agree that having sufficient savings is an essential component of financial success.
While society is aware of the importance of saving money, this difficult goal has been unattainable for way too many Americans. According to an article from Money Under 30, the ideal saving rate should be at least 10% to 15% of the consumer’s income. However, a recent report from Statista reveals that the current personal savings rate in the country is only 3.4%, which isn’t even half of what it should be.
While it could make sense to pay off debt first, many people are unsure if they should use their savings to do so. After all, this is money you already have and might not want to see leave your account. Plus, some experts will frown at the idea.
But if you do the math, you could lose more if you keep your savings intact while your debt accumulates. Looking at interest rates alone, debt typically has a higher interest rate compared to a savings account. So, it makes more sense to pay off your creditors first since you will be saving more in the end by eliminating those pesky interest payments.
However, making that decision can be tougher than it seems. Some people need the security of a savings account, which is why they opt to keep it intact. Ask yourself the questions below to make the right decision for both your financial and emotional peace of mind.
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5 questions that can help you determine how to pay off your debt
If you are torn between using your cash reserve to pay off your debts, here are five questions you need to ask yourself.
1. Where will the savings come from?
There are many types of savings accounts you can use to finance your debt repayments—with the question being, “Should you?” A survey conducted by Merrill Lynch and Age Wave found that one-fourth of respondents aged 18 to 34 said they had withdrawn funds from their 401(k). Thirty-one percent of those respondents said they withdrew money to pay off credit card balances.
While using your retirement savings can be an option, you should never tap your account if at all possible. You are saving to fund the lifestyle you want after retirement. By using that money now, you are essentially taking it away from yourself. And don’t forget the hefty penalty for withdrawing the funds early.
2. Do you have sufficient emergency savings?
If you don’t already have an emergency savings account, it is strongly recommended that you create one and contribute to it as often as possible. That way, unexpected expenses won’t throw your finances in a loop.
Anything more than the recommended 3-6 month’s worth of expenses can be used to cover your debts. But it is important that you don’t deplete your emergency account. If something should happen, that money can enable you to focus on the issue and not scramble for the funds. If you have anything above the proposed amount, you might want to use it to pay off your creditors.
3. How much is your debt and the respective interest rate?
If you are struggling with multiple debts, make a list and take note of each interest rate. For those loans that are charging more than 9%, you will likely end up saving more money if you pay off your outstanding balances first.
The best scenario to finance debt payments through your savings is when you have mostly credit card debt – which can reach a whopping 36% in interest.
4. Are you expecting any extra money soon?
Another question is: can you count on extra money coming in soon? This should be something guaranteed like a commission that is already being processed, a confirmed holiday bonus, or your tax refund. Go ahead and use your savings but be sure to replace the funds as soon as the extra money comes in.
5. Is it in line with your financial goals?
Smart money management requires you to set goals and make decisions aligned with them, while also avoiding decisions that could stand between them.
If you are putting money away for a down payment on a new home, it might not be the best idea to use your savings to reduce your debt. But if lowering your debt increases the chance of qualifying for a low-interest loan, those savings could pay off in the long run.
Other options to pay back your debts without touching your savings
If your answers point you towards not using your savings to resolve your debts, there are other ways to tackle those outstanding balances.
A survey from The Ascent revealed that 78% of Americans have a savings account. However, if you feel better leaving it alone, there are other options that can allow you to pay down debt while still adding to your savings:
Debt Consolidation Loan
With this option, you take out a loan to pay off multiple high-interest credit card balances. Your new loan should have a lower interest rate and monthly payment since you will have a longer amount of time to pay it off. Managing one loan is a lot easier than juggling a few with various payment due dates.
Debt Management
This is another form of consolidation – but this time you will have the help of a credit counselor. For $40 to $75 a month, they can help you with a careful analysis of your debts and the creation of a Debt Management Plan or DMP.
You determine the monthly amount that best fits your financial and comfort level. You will send your payments to your counselor, who will pay the creditors for you. This eliminates the temptation of spending money on something else.
Debt Settlement
If the thought of resolving multiple lines of credit sounds appealing, this could be the right solution for you. Debt settlement involves hiring a company to negotiate down the amount you owe and paying off the rest in a lump sum. If a creditor is willing to engage in negotiations the balance may be forgiven, and the account will be marked as paid in full. This can take 24-48 months or longer. But in the end, you could save thousands of dollars.
Before you tap into any savings accounts, it’s important to do your homework. If the action surpasses the consequences, it could be a smart move. But if you can avoid withdrawing money from your retirement fund and keep the minimum in your emergency account, you will be on more solid ground with your finances.