Q: I have $9,500 in credit card debt, but I also have some savings. Can I avoid dipping into my savings and just make higher monthly payments to lower my debt? Will that still be OK for my credit score? I’d like to have savings in case of an emergency.
A: Many of us were brought up with the notion of personal savings being critical to financial well-being, and I agree with that. But you have to keep in mind priorities when it comes to debt situations. Let me explain.
It’s common to want to balance the potential need for immediate access to cash without the risk of going over your credit limit or being turned down for an additional loan. But it might be in your best interest to use your savings towards your debt load to lower the principal and your repayment period.
First off, to answer your questions: Yes, you can avoid dipping into your savings and make higher monthly payments to lower your debt. If you make at least your minimum payments regularly and on-time, and you are not over your limit, your credit score won’t get any worse. However, your credit score also considers something called credit utilization. Credit utilization is the ratio of how much you owe as a percentage of your credit limit. An excessively high utilization rate hurts your credit score. To improve your credit score, lenders recommend a credit utilization rate of 30% or less. In other words, it pays to pay your debt down significantly.
If you only make the minimum monthly payment on your credit card, your credit score would still be OK, but I would advise against this because you will be extending your debt repayment period and – more importantly – paying a heavy price in terms of interest costs. So, the higher the payments you make towards the debt, the better. You’ll be lowering the principal amount on the debt, paying less interest, and achieving debt relief much sooner.
This brings us back to using your savings towards your debt. Let’s assume you have $1,000 saved up for emergencies. I’ll also assume that your monthly minimum (which is often 3% of the current balance) is $285 and that your credit card interest rate is at 18%.
If you only made the minimum payment, it would take you 22 years and five months to pay off your debt completely. You will also have paid $9,298 in interest, for a total debt repayment of $18,798. This is how credit works: the longer you take to pay a balance off, the more you pay the lender in interest.
However, since you wish to make higher monthly payments, I will assume you plan to pay $100 more than your first minimum payment, so $385. If you paid $385 a month, it would now take you 59 months (4 years and 11 months) to completely pay off your debt. That’s better but you will still have paid $3,638 in interest, for a total debt repayment of about $13,138. See the difference in interest charges that that extra hundred dollars makes over the life of your loan?
Now, let’s put your savings towards the debt as a one-time lump sum addition to your next payment. So, you pay $385 regularly, in addition to $1000 once. This would reduce your repayment time to 31 months (2.6 years), and you would lower your interest cost to $2,150. That’s a $640 savings over scenario two where you left your savings in your bank account and paid $385 for five extra months.
The question is, can you earn $640 on your assumed $1,000 in savings in just under three years. That’s unlikely (impossible) at today’s rates. In almost all cases it makes more sense financially to pay down credit card debt than it does to leave money in a savings account. Once your debt is paid off, you can always start saving again. Yes, we’d ALL like to have savings now, but when you are in a debt situation, your realistic options are limited. Back to prioritization.
Recent studies have shown that security and peace of mind are critical to many people in their financial lives. I meet with people every day whose real trouble is stress. They are unhappy because of their debt load. Carrying debt isn’t good for you mentally, physically or emotionally. It takes a toll on relationships. It often needs addressing first before much else can happen to improve someone’s life.
If you feel you really need to avoid using your savings to lower the cost of your debt, then I would strongly recommend making as large a monthly payment as you can to reduce the overall life of your loan. I’d also forgo any further savings until your debt is paid in full. The interest charges are often what keep people trapped in a never-ending debt repayment cycle, so do everything you can to make high payments towards your debt. If you need help budgeting, a free online budgeting workbook might help.
Scott Terrio is Manager, Consumer Insolvency at Hoyes Michalos & Associates Inc., Licensed Insolvency Trustees at Hoyes.com. Follow him on Twitter @ScottTerrioHMA
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